Last week I traveled to Jinotega, Nicaragua as part of a Global Business Brigade aimed at promoting economic development in rural, impoverished areas of Latin America. I was assigned to work with an agricultural cooperative operating in a rural area outside of Jinotega.
My week in Jinotega essentially functioned as a heavily compacted consulting engagement. We were assigned a client (the agricultural cooperative), then met with these clients in order to assess their business problems and attempt to derive solutions.
My client's problem was broad; they struggled to generate the capital necessary to support their growing lending business. Simply-put, they did not have enough money to lend out to agricultural producers who required loans to fund their own individual operations.
While I worked with only one cooperative during my time in Nicaragua, I learned a great deal about the market inefficiencies related to capital access in developing economies and their negative impacts on economic growth.
The Role of Capital in Economic Growth
The relationship between capital and growth is one of the fundamental drivers behind classical economics; large-scale banking is one of the critical innovations of the last few thousand years. Simultaneously, a lack of capital access can drastically hinder economic growth.
Businesses raise capital because they believe that they have a business model that works (or at least has the potential to work). Oftentimes, businesses raise capital because the demand for their products/services are growing, and they require investments in order to meet that growth.
For example, let's imagine I have machine that produces a special kind of lamp. I produce the machine, which is costly, and then use it to produce lamps, which are relatively cheap. I am gambling (or I know) that enough people will want enough lamps to justify the cost of the machine.
Now if my lamps are very popular, what can I do to expand? My machine produces 10 lamps per week, but there is enough demand to sell 100 lamps per week. While that demand exists, I do not have the money in my pocket to craft a new machine. In a developed economy, I typically go to a bank (or in some cases a private equity or venture capital firm), and ask them for money that I will pay back via interest (or ownership in my company). I use this money to create 9 more machines, and suddenly my revenue has increased by 10x per week.
In a developing economy, getting the capital required for more machines can be very difficult, which functions as a major inhibitor of economic growth. Numerous businesses find themselves in similar situations, with severely slowed growth rates due to this lack of capital access. Ultimately, this leads to a drastically lower national economic growth-rate than could be realized with an improved capital marketplace.
Raising Capital in Rural Nicaragua
The lack of institutionalized banking in many rural regions leads borrowers to turn to other sources.
Without going hands-on with an agricultural cooperative in a developing economy, it may be hard to envision the particular role that these cooperatives play in society, in short, they play an expansive and important one.
In addition to offering production support services, cooperatives serve as the primary source of credit for agricultural producers. For small-scale producers, receiving a loan is not as simple as going to a local bank and asking for money; the banking system can be unreliable and interest rates unrealistic. Predatory lending is another major problem for agricultural producers without much subject-matter expertise related to banking and lending.
Without reliable sources of capital, it's incredibly difficult to grow any sort of business. Business of any kind usually requires investment, and without enough dollars in your pocket, individuals typically rely on banks as the sources of funds for their entrepreneurial endeavors. Even a winning business-model is often dead-on-arrival without an infusion of capital to support it.
Agricultural cooperatives step in to fill this capital-infusing role for local producers. Cooperatives can offer lower rates than regional banks, in addition to technical support (processing, supplies, expertise, etc.). Cooperatives end up acting like industry-specific banks, dishing out loans in return for interest payments on top of the principal.
The cooperatives face similar problems as producers, but on a larger scale. In order to meet the demand for loans, successful cooperatives must raise relatively large amounts of capital. Once again, in a more developed economy, businesses of this scale would typically turn to banks to raise such capital. The lending process should be simpler than for an early-stage entrepreneur, as businesses such as the cooperative I worked with are in growth-mode and already possess a proven business model; the capital infusion is simply meant to accelerate that growth.
In developing economies, raising capital remains a persistent challenge for businesses at this stage. The cooperative I worked with refused to go to the bank at all, and sought recommendations for how to more efficiently generate and allocate capital of their own. They did not have enough capital to meet the ever-increasing demand for their lending services.
Possible Solutions to Capital Access in Developing Economies
1. The Expansion of Institutionalized Banking
Solution: The most obvious, long-term solution to these problems will be the continual development of institutionalized banking in developing economies. As central banks become larger, more efficient, and ultimately more powerful, their influence should spillover into commercial banks and pave the way for their growth.
Risks: There are numerous challenges to the development of a banking system in developing nations; some of the major ones are regulatory. Governments have to strive for regulation that creates a banking-friendly environment while simultaneously staying ahead of the corrosive, corrupting influences that can undermine that environment's positive effects.
2. Large-Scale Cooperatives
Solution: The most feasible solution to this problem may come in the form of cooperatives that are able to grow and fill the void left by the lack of major banks in rural areas. The more customers these cooperatives take on, the more efficiently these cooperatives should be able to allocate capital based on improved risk profiling (and thus generate ever-increasing profits to fund continual growth).
Risks: An inherent risk here is the ever-delicate balance of supply and demand. If there are too few cooperatives dominating the marketplace relative to increasingly high amounts of capital demand from producers, the cooperatives will be able to act increasingly selectively in their lending business, making it difficult for producers in greatest need to receive capital from the monopolistic cooperatives.
3. Data Analytics/Machine Learning
Solution: An alternative solution for many mid-sized cooperatives may come from investments into data analytics and machine leaning. As any consumer bank can attest to, the more accurately a bank can generate risk profiles for its customers, the "smarter" its lending business will be. While mid-size cooperatives cannot dump billions of dollars into data analytics like major U.S. banks, small-scale investments into analytics and ML could generate huge returns, paving the way for a capital marketplace full of thriving mid-size cooperatives who can meet agricultural producer demands.
Risks: For small businesses, every dollar spent can be the difference between life and death. Those who pour too many dollars into technology before establishing a foothold in the market may accelerate their own demise. Additionally, cooperatives that are able to successfully invest in technology may drastically distance themselves from competitors, generating similar potential problems as discussed under solution #2.
Ultimately, my team devised solutions to help our cooperative to more efficiently generate and allocate capital to support their lending business. We designed and created a website to attract large-scale agricultural buyers, designed a simple database to enhance data collection, and provided a snapshot financial analysis to provide insight into lending profitability based on categorizations of loans.
These small efforts are extremely helpful, but ultimately large-scale, sweeping change will be necessary to solve the immense capital access problems in developing economies.