ARBAMINCH UNIVERSITY

SCHOOL OF POST-GRADUATE STUDIES

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

COURSE TITLE: - to review on rural financial service and its contribution to

agricultural growth and productivity in Ethiopia

BY:-TEMESGEN TAREKEGN -----------------ID NO ….PEBE/030/15

SUBMITTED TO: - AMANUAEL (ASSIS.PROF)

MARCH; 2023
ARBAMINCH, ETHIOPIA
ACRONYMS AND ABBREVIATIONS
AEMFIs: Association of Ethiopian Microfinance Institutions

CGAP: Consultant Group Assisting the Poor

DECSI: Debit Credit and Saving Institution

GDP: Gross Domestic Product

GNI: Gross National Product

NGO: Non-Governmental Organization

OSS: Operational self-sustainability

ROA: Return on Asset

ROE: Return on Investment

SFPI: Specialized Financial and Promotional Institution

I
 Table of Contents
Contents page

ACRONYMS AND ABBREVIATIONS.......................................................................................II

Abstract..........................................................................................................................................III

1. Introduction..................................................................................................................................1

1.1. Background of the study.......................................................................................................1

1.2 markets for growth and poverty alleviation...........................................................................4

1.3. Objectives of the study..........................................................................................................5

2. LITERATURE REVIEW............................................................................................................7

2.1. Theoretical Reviews..............................................................................................................7

2.1.1. Definitions and concepts of Microfinance.....................................................................7

2.1.2. Financial Markets in Rural Areas of Developing Nations.............................................8

2.2. Roles of Rural Finance and Financial Systems.....................................................................9

2.2.1. Role of Rural Finance to Growth...................................................................................9

2.2.2. Financial Markets in Rural Areas of Developing Nations...........................................10

2.3 Challenges in Rural Finance................................................................................................10

2.3.1. Problems of Lending to Agriculture.............................................................................12

2.3 Empirical findings................................................................................................................13

2.4 Reflection on Key Issues......................................................................................................16

2.5 Lessons.................................................................................................................................17

CONCLUSIONS...........................................................................................................................18

REFERENCES..............................................................................................................................20

II
 Abstract
The economy of Ethiopia is characterized by its reliance on subsistence agriculture and the
existence of underdeveloped financial institutions, especially in rural areas. In the literature, the
role of credit as an instrument to boost productivity and welfare has long been justified. The
main goal of this paper is to show the agricultural credit access landscape and investigate the
impact of credit constraints on agricultural productivity in Ethiopia by using a household survey
data from rural Amhara collected in 2013. After adjustments throughout the data cleaning
process, the study relied on a survey of 1082 households which are found with valid information
for all the variables considered in study.

The study revealed that 66.17 percent of households are credit constrained which shows how the
rural credit market landscape in Ethiopia is highly imperfect. By using an endogenous switching
regression model, the study tried to show the effect of demographic and other socioeconomic
variables on credit constraint status of households and simultaneously the impact of credit
constraints on agricultural productivity. Finally, the paper uncovered the existence of a huge
productivity loss due to various types of credit constraints. The cumulative impact is estimated to
be 17.94 percent, i.e. an additional per hectare income of 1410.17 Ethiopian birr productivity
gain if all types of credit constraints happen to be eliminated. This calls for a well-coordinated
policy intervention compatible with the dynamics of rural institutions and other location
bottlenecks

III
 1. Introduction

1.1. Background of the study

Like its fellow African economies, agriculture is the main stay of the Ethiopian economy. It
remains the largest employer having a share of around 80 percent of the total labor force,
accounts half of GDP and 88 per cent of exports (CSA, 2009). The sector holds the key to
creation of demand in other sectors of the economy and remains by far an important indirect
contributor to the country’s GDP. The capability of the economy to address poverty, food
insecurity and other socio economic problems is highly dependent on the performance of this
sector (EEA; 2013). In fact, food security is emerging as an important policy concern, and the
role of agriculture in ensuring equitable access to food has added a new perspective for policy
makers.

The agricultural sector value added is registered to be 4.9% for 2011/12. But this figure is not
consistent with the targeted 8.6% growth by GTP (EEA, 2013). Even though it's is slightly
declining, the agricultural sector greatly influences the rate of economic growth in Ethiopia. The
percentage share of the agricultural sector from the entire growth rate of the economy was 47.76
within 2000/01-2004/05, 37.13 between 2005/06-08/09, 35.16 in 2010/11 and 24.41 in
2011/12(EEA, 2013). Partly, the declining growth share is explained by the astonishing
development of the service sector which accounts the highest share of GDP and growth of GDP.

Ethiopia's 12.7 million smallholder1 farmers account for approximately 95 per cent of
agricultural GDP. With a total area of about 1.13 million km2 and about 51.3 million hectares of
arable land, the country has tremendous potential for agricultural development (IFAD, 2011).
But the Productivity of vastly smallholder dominated Ethiopian agriculture is very low. Low
yield per unit area across major crops is considered as a regular feature of Ethiopian Farmers.
Lack of irrigation facilities; Small and fragmented land holding; Lack of timely availability of
quality seeds, fertilizers and insecticides in many parts of the country are considered reason for
the existing low productivity agriculture (IFAD, 2011). A study by Toenniessen et.al (2008)
documented that to increase productivity, profitability, and sustainability of small holders' farms,
they need greater access to affordable yield-enhancing inputs, including well-adapted seeds and

1
new methods for integrated soil fertility management, as well as to output markets where they
can convert surplus production into cash. Therefore, with better access to credit in agriculture, a
number of allied activities and related services such as technology, soil conservation, irrigation,
storage and marketing etc. Can be easily provided which would also help in reducing costs of
production.

Following the aforementioned rationales, increasing productivity in smallholder agriculture is the

Ethiopian Government’s top priority, recognizing the importance of the smallholder sub-sector to
mitigate the high prevalence of rural poverty and the large productivity gap (Chanyalew et.al,
2010). Ethiopia's current highly ambitious2 plan, i.e GTP, promises to ensure smallholder
agriculture as the main source of agricultural growth in its main strategic directions. Yet, the use
of improved inputs, such as fertilizer and improved seeds is very low in the country. The
overwhelming reason for low use of modern inputs is that they are considered too expensive or
that there is lack of cash on hand and failure to acquire it through the capital market. The
prevalent of high costs of credit adds to the cost of fertilizer resulting low productivity
(McIntoshaet.al, 2013).

Complementary developments in rural financial institutions often provide services for activities
related to agriculture, such as input supply, production, or distribution and marketing of
agricultural products. More importantly, loans for investments and working capital are crucial
elements that enable rural entrepreneurs to make investments, create economic opportunities, and
purchase agricultural inputs and working capital (Pollard and Heffernana,1983). Signifying the
role of credit in agriculture, the global food price crisis has moved agricultural finance on top of
the African and international development agendas. Access to financial services for all types of
agricultural producers and agribusinesses is key for unleashing Africa’s agricultural potential and
funding the growth of the sector (MFW4A, 2012). However, agriculture in Africa continues to
receive only a small share of total credit, leaving farmers, particularly smallholder farmers, to
rely on insufficient savings and informal sources of credit with only about 10 per cent of the total
portfolio of commercial banks goes to agriculture, including agro-industries, and loans are rarely
extended to smallholders (World Bank, 2009; cited in MFW4A, 2012). As explained by Besley
(1994), the above problems arise due to the very nature of rural credit markets which are
characterized by scarce collateral, existence of underdeveloped complementary institutions,

2
prevalence of covariance risks and segmented markets in the small holder community and the
enforcement problems as well. These imperfections constrained the rural credit markets from
reaching the smallholder efficiently.

In Ethiopia, rural financial markets are still largely under-developed, despite the fact that the
economy experienced significant growth in financial service provision. Ethiopia has one of the
lowest financial inclusion ratios compared with its peer countries in Africa (Amha and Peck,
2010; Amha, 2011). Though recent figure is not available, during the 2005/06 season, only 26%
of farmers accessed credit from formal sources (PASDEP, 2006).

Ethiopia ranked 127th out of 183 countries for ease of Getting Credit, behind Rwanda, 61st, and
Kenya, 4th (USAID, 2012). Inadequate access to financial services is one of the major
bottlenecks impeding economic growth and household incomes in rural areas where there is still
a huge demand-supply gap (IFAD, 2011). The rural financial market landscape in Ethiopia is
characterized by the coexistence of formal, semi-formal, and informal lenders. These finance
providers or lenders vary in the cost of screening, monitoring and contract enforcement. The
formal financial providers in Ethiopia include banks, MFIs and cooperatives. Iqqub or Rotating
Savings and Credit Associations, iddir, mahiber, etc. are semi-formal financiers. The informal
finance providers are the moneylenders, relatives, traders and suppliers, friends, church, etc.
Although illegal, as per the regulatory framework in Ethiopia, NGOs, government and donor
projects are providing loans to beneficiaries (Amha, 2011).

Generally, the status quo of the Ethiopian financial system is highly questionable. The problem
becomes even worth in the rural parts of the country. It is obvious that the financial system is a
primal lubricant for a meaningful expansion to happen in different sectors of the economy. Due
to lack of complementary institutions complemented with expected high probability of default of
smallholders, formal financial institutions usually abstain themselves to deliver financial
services. However, the ongoing recent microfinance revolution creates opportunity for
smallholder farmers in rural areas; one can easily notice that lack of liquidity is yet on top of
problems in rural areas. Finally the theoretical and empirical implication of underdeveloped
financial services on agriculture is elaborated in the following section. Rural financial

3
1.2 markets for growth and poverty alleviation
The efficient provision of loans, deposits, payments, and insurance service encourages rural
entrepreneurship and help to rural economy to grow (World Bank, 2003). Presence of
financial services helps to rural economy to grow and reduce the poverty. Access to working
capital can substantially accelerate the adaptation of modern agricultural technologies and
production and thereby improving the ability of the rural sector to meet the subsistence need
of the poor. It also helps to produce the surplus in primary and intermediary products
required for urban consumption, export, and avoid environmental degradation (World Bank,
2003).
Ethiopian Financial Sector Review with respect to Agriculture Unlike its East African
neighbors (Kenya, Tanzania and Uganda) and other developing countries, Ethiopia is not yet
opened its banking sector to foreign investors, though it liberalized the sector for domestic
participation in 1992. There is no capital market and it has only a very limited informal
investing in shares of private companies. This ends the financial development status quo of
the country questionable. As reported in the diagnostic of Agricultural finance potential in
Ethiopia by Amha and Peck (2010) and a study by Amha (2011), the Ethiopian financial
sector is characterized by the presence of formal, semi-formal and informal financial service
providers.
Formal providers include commercial banks, MFIs, and insurance companies while
semiformal providers are financial cooperatives (SACCOs). Informal providers consist of
social groups that provide savings and lending functions (e.g., Iddir that focus on savings and
lending for social ceremonies such as burials, or Iqqub that provide savings and lending
services within homogenous social groups), private money lenders, friends and relatives, as
well as trade partners. The commercial banking sector consists of one state-owned
development bank (Development Bank of Ethiopia (DBE)), two state-owned commercial
banks (Commercial Bank of Ethiopia (CBE), Construction and Business Bank (CBB)), and
16 private commercial banks (NBE, 2013). Despite the continuous increase in the capital
base, the banking industry in Ethiopia is still very small compared to some big banks in
Africa

4
1.3. Objectives of the study
The general objective of this paper is to review performance of formal rural financial Institutions
in Ethiopia. In attaining this general objective, the paper tried to examine the following specific
objectives.

 To assess smallholders access to agricultural credit from different sources in rural

Ethiopia
 To examine factors that distinguish farm households who are credit constrained from
those who are not
 To witness the link between credit constraint and agricultural productivity
 To review performance of formal rural financial Institutions in terms of outreach,
financial sustainability and welfare impact on agricultural productivity
 To review challenges faced by these Institutions

5
 2. LITERATURE REVIEW

2.1. Theoretical Reviews

2.1.1. Definitions and concepts of Microfinance

The definition of Microfinance institutions proposed by some authors and organizations are
seemingly different from one another. However the essence of the definition is usually the same
in which microfinance refer to the provision of financial services primarily savings and credit to
the poor and low income households that don’t have access to commercial banks (Arsyad, 2005).
Léger wood (1999), defines it as the provision of financial services (generally saving and credit)
to low income clients.

Microfinance is the provision of financial serves to the poor people with very small business or
business projects (Mayou, 2006). Only a small fraction of the world population has access to
financial instruments, essentially because commercial banks consider the poor people as
unbendable due to their lack of collateral and information asymmetries.

Microfinance is the “provision of a broad range of financial services such as deposits, loans,
payment services, money transfers, and insurance to poor and low-income households. In some
cases, the microcredit programme involves saving services, but the services are limited to the
collection of compulsory deposit amounts from the borrowers to collateralize the loans issued.
Borrowers cannot access these compulsory deposits and cannot have voluntary saving accounts
in microcredit programmes (World Bank, 2008). to those who do not have access to or are
neglected by the commercial banks and other financial

Rural finance, as defined by the World Bank, is the provision(give) of a range of financial
services such as savings, credit, payments & insurance to rural individuals, households, &
enterprises, both farm and non-farm, on a sustainable basis.

Credit is defined as a legal contract between the lender and the borrower, where the borrower
receives resources or wealth with a promise to repay in the future. Credit refers to terms and
conditions associated with deferred payment arrangements. Credit is a means to enable
investment by solving a liquidity problem. The liquidity problem arises from the fact that outlays
6
triggered by the investment precede (expected) future returns. Investment in turn is guided by
certain higher-level goals such as profit or income generation (Petrick, 2004). In Agriculture,
access to credit is primarily seen as a tool to increase agricultural output and productivity,
adoption of new technologies, stabilizing household’s income, and improving farm’s inputs such
as fertilizer, increasing rural employment and reducing poverty (Foltz, 2004).

2.1.2. Financial Markets in Rural Areas of Developing Nations

The term rural finance refers to the financial transactions related to both agricultural and
nonagricultural activities that take place among households and institutions in rural areas. In
some cases, rural finance has been wrongly equated with agricultural credit, based on the
assumption that credit is the binding constraint to achieving project objectives related to
agriculture. A more effective and comprehensive view of rural finance encompasses the full
range of financial services that farmers and rural households require, not just credit (IFAD,
2009). Access to credit remains a major challenge for smallholder farmers in most developing
countries. The problem often is seen in terms of limited access to production credit to buy and
use farm inputs as well as pay for non-family farm labor and other farm maintenance costs.
Because smallholder farmers cannot afford yield-enhancing inputs, farm productivity often
remains low on smallholder farms despite available technology for achieving higher yields
(Onumahand Meijerink, 2011)

Agricultural finance is the economic study of the acquisition & use of capital in agriculture
Saturday, May 30, 2020 Rural Finance. It deals with the supply of and demand for funds in the
agricultural sector of the economy. Knowledge of fundamental economic & management
principles & analytical procedures facilitates obtaining control over capital and using it
efficiently. Microfinance is the provision of financial services for poor and low income people
and covers the lower ends of both rural and agriculture finance. Financial analysis related to farm
income, repayment capacity, and risk management indicates the total amount of capital the farm
business can profitably and safely use.

Information and knowledge on the legal aspects of borrowing, leasing, and contractual
arrangements helps the farmer select the means of acquiring and controlling resources that will
contribute most to the farming operation.

7
2.2. Roles of Rural Finance and Financial Systems

2.2.1. Contribution of Rural Finance to agricultural productivity

 Technological revolution including mechanization, improved varieties, modern chemical
pesticides and fertilizers, and new production methods have contributed to the increase
in production per acre, per animal, per labor-hour.
 These technological and structural changes in agriculture have increased the risks of
owning and operating a farm business.  The increased use of credit in farm business
along with narrower profit margins has increased the financial risk of farming.
 The importance of finance in agriculture has significantly increased over time in
accordance with the change in technology and the increase in production. Saturday, May
30, 2020 Rural Finance By Mideksa D(MSc in Agricultural Economics)

• Policy should be directed at developing a market-based financial system for rural finance, but
because of market failures to support disadvantaged groups, a special-priority program may be
needed to get credit to women, smallholders and the rural non-formal sector. Subsidizing
interest rates is not the way to help marginal borrowers. Instead, they can be helped through
fixed-cost subsidies & selfselected targeting.

• Commercial banks should be encouraged to lend on other bases than the mortgage and
passbook system. Saturday, May 30, 2020 Rural Finance By Mideksa D(MSc in Agricultural
Economics)  They should consider lending for such downstream agricultural activities as agro-
processing. To improve rural financing, the system of property rights, title and default
enforcement must also be strengthened, among other reforms.  Generally, to improve
performance in the rural economy and efficiency in financial institutions, rural credit markets
must be liberalized. The following reforms are important in an economy:  Avoiding produce
and price controls;  Operation of commercial banks in a competitive environment; 
Availability of credit to support productivity growth for agricultural smallholders and small
producers of the rural non-formal sector, where growth potential of developing countries lies;
and  Credit availability to women and to the rural poor for consumptionsmoothing and for
sustainable income-generating activities.

8
2.2.2. Financial Markets in Rural Areas of Developing Nations
The term rural finance refers to the financial transactions related to both agricultural and
nonagricultural activities that take place among households and institutions in rural areas. In
some cases, rural finance has been wrongly equated with agricultural credit, based on the
assumption that credit is the binding constraint to achieving project objectives related to
agriculture. A more effective and comprehensive view of rural finance encompasses the full
range of financial services that farmers and rural households require, not just credit (IFAD,
2009).

Access to credit remains a major challenge for smallholder farmers in most developing countries.
The problem often is seen in terms of limited access to production credit to buy and use farm
inputs as well as pay for non-family farm labor and other farm maintenance costs. Because
smallholder farmers cannot afford yield-enhancing inputs, farm productivity often remains low
on smallholder farms despite available technology for achieving higher yields (Onumahand
Meijerink, 2011).

2.3 Challenges in Rural Finance

 It is recognized that rural areas and populations remain underserved, yet economic dev’t
for these areas & populations are key components in the overall development of a
country.
 The donor community and providers entering the market have shown a renewed interest
in economic growth leading to poverty reduction within rural populations.
 In spite of their renewed commitment, significant challenges to the successful
implementation of effective delivery of services & outreach remain prevalent.
 Given these facts the question remains: what are these challenges Saturday, May 30,
2020 Rural Finance By Mideksa D(MSc in Agricultural Economics) Saturday, May 30,
2020 Rural Finance By Mideksa D(MSc in Agricultural Economics)
 and what can institutions do to respond to them to make agriculture credit work?
 Some factors unique to rural and agricultural markets that constrain both the supply and
demand for finance in those areas could be economic, political, legal, institutional, and
weather related.

9
  Economic challenges: Rural finance faces varieties of challenges resulting from the
economic reality of a country including the following:
 Transaction costs – High transaction costs for both borrowers & lenders;
 Economic activities – Often limited economic opportunities available to local
populations;
 Risk – High risks faced by potential borrowers and depositors due to the variability of
incomes, exogenous economic shocks and limited tools to manage risk;
 Concentration of activities – Heavy concentration on agriculture and agriculture related
activities exposes clients and institutions to multiple risks;  Crowding–Crowding out
effect due to subsidies & directed credit;
 Portfolio concentration – Increased risks associated with the concentration of a portfolio
on agricultural activities;
 Collateral – Lack of adequate or usable collateral (lack of assets, unclear property rights);
Infrastructure – Undeveloped or inadequate infrastructure;
 Land fragmentation – Land held may be too small to be sustainable in an optimal use;
and
Sources of income – Individuals may be dependent upon only one crop with no other external
sources of income. Political, legal and institutional challenges:
The following are some of the political, legal, & institutional challenges faced in rural
finance.
•Institutional capacity–Weak institutional capacity including poor governance and operating
systems, low staff and management skills;
• Political intervention–Risk of political intervention, which can undermine payment morale
through debt forgiveness & interest rate caps;
• Policy – Inhospitable policy, legal and regulatory frameworks;
• Legal systems–Undeveloped legal systems, inadequate contrac

2.3.1. Problems of Lending to Agriculture

In Africa in general and Ethiopia in particular, agriculture is yet the main sector of the economy
in which the formal financial sector is not conspicuously successful in delivering financial
services to farmers in need. In the continent, finance for agriculture and the rural economy in

10
general is unable to meet the rising demand. Inherent difficulties, risks, and costs impede the
effectiveness of finance in each of these areas (Hoonah and Beck, 2007). The following are some
of the reasons from the literature why the financial system fails to meet the demand of the
agricultural sector
I. Seasonality with longer gestation period
Agriculture is very seasonal, from planting to harvest which takes longer gestation periods. The
result is that cash flows are highly seasonal and sometimes irregular, with earnings concentrated
in certain times of the year. As such, there is a slow rotation of the invested capital as
investments are spread over longer time horizons than for non-seasonal businesses
II. Exposure to systematic risks
Most agricultural households are not truly risk diversified. Even emerging farm businesses and
SMEs tend to be either very concentrated in one activity or to have a portfolio of activities that
are all exposed to similar key risks like droughts. Production and price risks have a large impact
on the profitability and repayment capacity of the borrower. Moreover, risk mitigation
mechanisms such as crop insurance or hedging are rarely available (Honohan and Beck, 2007).
III. Limited collateral
The lack of collateral is often viewed as a bottleneck to improve access to credit. Inadequate
collateral or lack of it implies that the borrower is likely to become credit constrained. Collateral
can signal the quality of borrower and the availability of collateral may decrease moral hazard
problem (Hoff and Stiglitz, 1990; Boucher and Guirkinger, 2008). Consequently, most of the
time banks are more likely to provide a loan if the borrower can pay back the loan by pledging
collateral.
IV. Higher transaction costs
Agricultural financing involves higher transaction costs than in urban areas given the distances,
lower population densities, and lower quality infrastructure. Together, these factors make it hard
to aggregate agricultural loans into portfolios that make branches viable. In addition, it can be
costly to have branches and staff in remote areas, handling small transactions

2.3 Empirical findings

MFIs in Ethiopia charge low interest rates and hence they all have low financial revenue ratio.
Interest rates have positive and negative effect for the twin goals of sustainability and outreach

11
that MFIs have to balance for. But they are poor performers on depth of outreach and their
sustainability seems to go hand in hand with their size. So still it seems that they have to lower
down their interest rates even further to reach more poor as they will secure their sustainability
from economies of scale and size effect rather than from charging high rates from the upper end
of the market.
Study by Haileselassie (2005) on financial sustainability of microfinance institutions by taking a
case study of SFPI and PEACE revealed that outreach, financial self-sustainability and
institutional building are the main indicators of microfinance performance. His findings indicated
that MFI’s have achieved extensive outreach in providing financial services to the urban and
rural poor. Saving mobilization was significantly increased and at the same time repayment rate
was very high in both institutions (98 percent and 99.6 percent of SFPI and PEACE
respectively). The trend of financial performance showed that there is a good and steady progress
towards reaching operational self-sufficiency. But both institutions are still subsidized. It is
possible to say that the performance of the institution affects the impact of the intervention in
poverty reduction.
According to Getachew and Yishak (2006) in terms of financial self-sufficiency, Ethiopian MFIs
are also worse than their African counterpart. The adjusted return on assets and equity suggest
that like their African peers, the MFIs in Ethiopia are not operationally and financially self-
sufficient, but tend to be worse than the average for Africa when the magnitude of the loss is
considered. Ethiopian MFIs, on average, tend to charge a lower lending rate on their loan clients
compared with their African peers, which may have negative implication on their operational
performance although outreach expansion requires lower lending rate. On efficiency grounds,
Ethiopian MFIs tend to reach out more clients at lower costs than their African peer. The loan
quality of the MFIs in Ethiopia generally looks good, though slightly worse than that of the
average for Africa.
In spite of methodological difficulties involved in measuring the impact of credit, studies have
demonstrated that the availability of credit for micro-enterprises can have positive effects on
income. A study by the government, NGOs, and banks involved in providing financial services
for poor household that had received credit were compared with households, which had not. The
results demonstrated that credit provision could enable household incomes to rise (Susan and

12
Rogaly, 1997). If credit were found to be adequate and productive, it would enable optimum use
of resources and fuller application of improved technology.
Farmers must spend additional sums of money on improved seeds, fertilizers, and farm
implements to increase their agricultural productivity. However, a study Heidhwes (1995) have
observed, because of low level of real income small farmers in particular cannot undertake such
investments without external credit support. Their studies have asserted that such farmers do not
have sufficient capital to invest. Although a detail or comprehensive
Study research has yet to establish whether the delivery of financial services to the poor through
the MFIs actually eliminated or reduced poverty, the results of the few case studies have clearly
indicated that access to finance did indeed reduce poverty. Meehan (2001), in her case study of
DECSI, reveals that overall credit provision had a significant impact on increasing agricultural
production through build-up of production assets, particularly draught oxen, and increasing the
amount of land formed by clients who were able to retrieve land previously rented out and farm
it themselves, and clients who were able to get more land through rent. Trading activities
engaged in by clients also increased in scale. Female clients were particularly able to take on
trading activities, which had previously been inaccessible, to them due to lack of capital. The
increased income generated by the credit input had a possible impact primarily on household
food supply, and on educational provision for children as well as clothing and other basic
necessities.
Study by Decon (2000) on the impact of Gasha Micro finance Institution also reveals that only
those clients who had used the loan on productive activities have increased their income to some
extent. His study further reveals that there were signs of consumption, poverty reduction and
rapid improvement in primary enrolment rates in rural Ethiopia. The results also suggest
improvement in primary health care delivery.
Another study by Getaneh (2001) reveals that the financial services of ACSI has increased
income and improved food security of clients. Access to finance in the rural area has improved
access to education and health services. The clients reported that they were that they were better
off after obtaining the financial services ACSI provided. Credit to small farmers increases their
productivity and improves their standard of living.
Bisirat (2011) has conducted study on role of Microfinance in alleviating urban poverty in Jimma
town of Ethiopia. His study indicates that microfinance programs have increased the income of

13
households of the respondent clients i.e. in terms of both nominal and real income. The
employment opportunities created following microfinance use of clients is encouraging, though
mostly in the form of self-employment and family-employment. Borchgrevilk et al., (2005)
conducted a study on the impact of credit on marginalized groups such as young households,
rural landless households, and urban house-renting households by taking a case study of DECSI
in Tigray regional state. The study targeted more on extremely marginalized groups of female-
headed households.

2.4 Reflection on Key Issues

Role of Rural Finance to Growth
 Technological revolution including mechanization, improved varieties, modern
chemical pesticides and fertilizers, and new production methods have contributed to
the increase in production per acre, per animal, per labor-hour.  These
technological and structural changes in agriculture have increased the risks of
owning and operating a farm business.
 The increased use of credit in farm business along with narrower profit margins has
increased the financial risk of farming.
 The importance of finance in agriculture has significantly increased over time in
accordance with the change in technology and the increase in production.
 Generally, to improve performance in the rural economy and efficiency in financial
institutions, rural credit markets must be liberalized.
The following reforms are important in an economy:
 Avoiding produce and price controls;
 Operation of commercial banks in a competitive environment;
 Availability of credit to support productivity growth for agricultural smallholders and small
producers of the rural non-formal sector, where growth potential of developing countries lies;
and
 Credit availability to women and to the rural poor for consumption smoothing and for
sustainable income-generating activities
 Finally, credit removes the financial constraint to production and helps to accelerate the
adoption of new technologies, increase productivity, and improve national and personal

14
 incomes. In addition, it constitutes an integral part of the process of commercialization of the
rural economy and a convenient means of addressing rural poverty (MoA, 1995).
2.5 Lessons
Credit Services Strategies
 It should decrease combination of factors including:
Asymmetric information(reduce the information problem through creation of credit bureaus
and the diffusion of group and graduated credit delivery methodologies )
 high transaction costs,
 perceptions of high risk,
 limited investment opportunities,
 lack of competition among suppliers of credit, and the legacy of ill-conceived and poorly
administered state interventions in input, product, and capital markets
Insurance Services Strategies
 Another important service that has been overlooked is the provision of insurance products.
 Policies that would pay death, accidental, and health benefits and cover damages caused by
flood, fire, wind, pests, and drought, would allow rural households to be less vulnerable to
welfare reducing contingencies.
 Why insurance markets have not appeared is due to average lower incomes of rural
residents, costly information, client dispersion, and the size of the
Problems in Rural Financial Market Development
The rural finance strategies should focus on how to improve access to three specific financial
services: credit, deposits, and insurance. The primary but not exclusive target groups are small
scale agricultural producers and business operators. In order to do so, several problems must be
resolved:
 Imperfect information,
 High levels of price and production risk,
 High transaction costs,
 Inadequate contract enforcement,

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 CONCLUSIONS
The microfinance programs have increased the income of clients. i.e. in terms of both nominal
and real income. The employment opportunities created following microfinance use of clients is
encouraging, though mostly in the form of self-employment and family-employment.
Microfinance programs have improved savings of households through letting access to saving
services and increasing household income out of which they can use to save. After joining
microfinance programs, mean monthly expenditure of the clients has significantly increased in
food, clothing, housing furniture, health, education, and service items.

The need for sustainable financial services is very clear. How to realize this desirable objective is
a bit controversial. As we have seen, the first option would be to let the market decide on such
items like the micro-credit interest rate and the clients to judge for them. One may even argue
that it is better if the poor can access finance even if they pay higher interest rate – that is, if the
alternative is NOT having the access at all’’. Since the poor are fully repaying and coming back
for repeated loans, this means that, under the given circumstances, they ‘value’ the service and
have the real demand

 Support Innovation in Financial Services: Challenges in expanding microfinance outreach to

the majority poor, both in rural as well as urban areas, emanate in no small part from the
absence of appropriate microfinance methodology suitable for the local circumstances. For
example many MFIs are still mainly using the one-size-fits-all type group lending
methodology. While many potential borrowers do not like this modality, and while they also
have the ability to offer enough material collateral that more than match the 'value' of the
borrowed money, they cannot access the loan simply because the material wealth they have
do not have the 'legal title' to serve them as collateral. There are various potential solutions
to this, being effectively implemented elsewhere.
 Expand BDS service: Credit must, above all, be accompanied by some kind of marketable
skill development, which the poor seriously lack. Credit alone can only increase the "scale"
of existing activities rather than enabling the poor to move into new or higher value
activities. Some kind of cultural transformation may also be called for at this particular
juncture in order to change the attitudes of some otherwise poor people who are reluctant,

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 for cultural reasons, or lack of ‘role models’ to engage themselves in non-traditional
activities which are much more rewarding indeed.

Finally, the paper review the persistence of a considerable agricultural productivity gap between
constrained and unconstrained households. We have estimated that if all types of credit
constraints prevalent among credit constrained households are eliminated, credit constrained
households will enjoy a 17.94 percentage increase in their annual agricultural yield. This gain is
estimated to be an additional 1410.17 birr per hectare of credit constrained households, if they
are lucky enough to be rescued binding credit constraints. This is a huge deal for the highly
subsistence low productivity and credit constrained rural economy of Ethiopia and the national
economy at large and also this review has identified various challenges that constrain MFIs from
efficient operations. The stated mission of the MFIs is to expand their outreach and their impact
is partly evaluated by the number of their clients on the one hand, and on their capacity to
manage their operating cost on the other. The fact that the MFIs are dealing with clients with
low-income base would mean that the outreach objective could not be achieved at the desired
speed without compromising self-sustainability.

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