CHAPTER ONE: INTRODUCTION

1.1 Background
Agriculture remains the backbone of the Kenyan economy. It is the single most important
sector in the economy, contributing approximately 25 per cent of the GDP, and
employing 75per cent of the national labour force (GOK, 2005). Over 80 per cent of the
Kenyan population live in the rural areas and derive their livelihoods, directly or
indirectly from agriculture or agriculture related activities. The national baseline survey
of the MSE sector revealed that there were 1.3 million such enterprises employing 2.4
million Kenyans (GOK, 1999). Given its importance, the performance of the sector is
therefore reflected in the performance of the whole economy. The development of
agriculture is also important for poverty reduction since most of the vulnerable groups
like pastoralists, the landless, and subsistence farmers, also depend on agriculture as their
main source of livelihood. Growth in the sector is therefore expected to have a greater
impact on a larger section of the population than any other sector. The development of
the sector is therefore important for the development of the economy as a whole.

The provision of agricultural finance has increasingly been regarded as an important tool
for raising the incomes of rural populations, mainly by mobilizing resources to more
productive uses. One question that arises is the extent to which credit can be offered to
the rural poor to facilitate their taking advantage of the developing entrepreneurial
activities. The generation of self-employment in non-farm activities requires investment
in working capital. More than one third of the enterprises die young due to inadequate
working capital (Head, 2003, Watson et al, 1996) However, at low levels of income, the
accumulation of such capital may be difficult. The government has also identified lack of
credit as the second severest problem faced by MSEs the most being lack of markets and
competition (GOK, 2005).

Formal financial institutions such as commercial banks fail to cater for the credit needs of
smallholders, however, mainly due to their lending terms and conditions. (Ngobo, 1995)
indicates small enterprise owners cannot easily access finance to expand business and
they are usually faced with problems of collateral, application requirements and the
unexplained bank charges. The financial access survey by the central bank reveals that 38
per cent of the country’s bankable population is excluded from financial services and
related products (CBK, 2007). It is generally the rules and regulations of the formal
financial institutions that have created the myth that the poor are not bankable, and since
they can’t afford the required collateral, they are considered uncreditworthy (Alila, 1991).

1.2 Statement of the research problem

SMEs in Kenya form a very crucial sector in terms of employment generation, wealth
creation, welfare improvement and their immense contribution to the national GDP.
However, SMEs are generally undercapitalized due to operational difficulties in
accessing finance. Lack of working capital and low liquidity limit the entrepreneur’s
ability to purchase productivity enhancing inputs like seeds, fertilizers and pesticides and
more stock (Nyoro, 2002). The average production efficiency levels are higher among
producers who have access to finance in agricultural related enterprises in Kenya
(Kibaara, 2005).

The lack of finance is one of the most binding constraints in the growth of SMEs, as only
14 percent of SMEs might resort to borrowing, out of which two thirds was for capital
Investment. Many SMEs are not going to banks to meet financial needs due to various
reasons including lack of knowledge regarding bank products, low market penetration by
banks, lengthy and difficult loan procedures, lack of security, lengthy documentation, and
social as well as religious reasons.

Within the context of the agriculture industry, there is a great need for credit for in order
to accelerate the growth of MSEs. The demand for rural credit has outstripped the supply
over time. The current annual demand is estimated at Kenya shillings 75 billion while the
supply stands at 18–22 billion Kenya shillings (MoA, 1995; Kimuyu and Omiti, 2000).
The various intermediaries for finance and credit include commercial banks, non-bank
financial institutions, the Agricultural Finance Corporation, agricultural boards, non-
governmental organizations and rural-urban savings societies. The proportion of credit

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for agriculture constitutes only 10–12 per cent of the total loan advances from these
institutions.

The majority of the world’s poor live in rural areas. Yet most lack access to the range of
financial services they need. Financial services available to them are relatively costly or
rigid, whether from formal or informal financial providers or traders and agricultural
processors offering input credit. Financial institutions seeking to work in rural areas face
numerous constraints, such as poor infrastructure and high loan administration costs
Moreover, the main products of many microfinance institutions short-term working
capital loans with frequent expected repayments are not well-suited to seasonal or longer-
term agricultural activities.

Agricultural finance is notoriously risky. Many farmers need credit to purchase seeds and
other inputs, as well as to harvest, process, market and transport their crops. While
borrowing on the basis of anticipated crop production might seem logical where collateral
assets are few, such loans expose the lender to production and price risk. Natural
disasters, a decline in market prices, unexpectedly low yields, the lack of buyers of
agricultural produce, or loss due to poor storage conditions are only some of the factors
that can result in lower than-expected revenues. Such a fall in revenues can often lead to
high default rates on agricultural loans. The overwhelming failure of state development
banks that provided billions of dollars in subsidized agricultural finance to farmers in the
1970s and 1980s, combined with scant rural penetration by risk-averse commercial
financial institutions, has led to a widespread dearth of agricultural credit.(CGAP, 2005).

In order to realize economic growth and implement vision 2030 four critical economic
sectors have been identified i.e. wholesale and retail trade, agriculture, manufacturing and
financial services. The integrated household budget survey reveals that 45.6 per cent of
households get credit from neibhours or friends. Another 13 per cent obtain credit from
grocery or local merchants and 11.9 per cent from SACCOS. (GOK, 2007).

Agricultural productivity can be increased, farmers incomes raised, more people fed and
in deed, the general economic welfare enhanced In order to improve smallholder farm

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productivity as well as increase incomes; smallholder farming must be changed from
producing for subsistence to commercial profitable businesses. It will then attract private
entrepreneurs willing to invest therein and employ modern farming techniques necessary
to achieve increased productivity. When agriculture is technology-led, not only is food
security achievable but also poverty alleviation is also possible. Inability to afford new
and readily available farming technology, however, is partly blamed on poor access to
financial resources, especially in a nation where the majority, and not only farmers, are
poor and the financial markets have not developed to support agricultural investment.
(Alila, 2006).

Improving the availability of finance to this sector is one of the incentives that have been
proposed for stimulating its growth and the realization of its potential contribution to the
economy (GOK, 1994). Despite this emphasis, the effects of existing institutional
problems, especially the lending terms and conditions on access to credit facilities, have
not been addressed. In addition, there is no empirical study indicating the potential role of
improved lending policies by both formal and informal credit institutions in alleviating
problems of access to credit. Knowledge in this area, especially a quantitative analysis of
the effects of lending policies on the choice of finance sources by entrepreneurs, is
lacking for the rural financial markets of Kenya (Kibaara, 2005).

Access to finance for SMEs is still a major problem, despite the fact that Kenya has a
relatively well-developed banking system. Risks associated with farming business,
coupled with complicated land laws and tenure systems that limit the use of land as
collateral, makes the financing of agriculture and the off farm enterprises by the formal
banking industry unattractive. In addition, corruption, political interference in the
operations particularly of state-owned banks and dysfunctional court system in the past,
gave rise to culture of default, thereby leading to high levels of non-performing loan
portfolio in the balance sheets of the banking institution affected. This development
forced many banks to change prohibitively high interest rates to their customers,
including farmers in order to remain afloat (Nyoro, 2002). This study therefore seeks to

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examine the role of agricultural finance on the growth of MSEs in Kenya and the
constraints to provision of agricultural finance in Kenya.

1.3 Research objectives

1.3.1 General Objective
The main objective of this study is to examine the role of agricultural finance in MSE
growth. The study seeks to find out whether agricultural finance has played any role or no
role in MSE growth.
1.3.2 Specific objectives of the study are:
a) Review the lending procedures of agricultural finance institutions.
b) Assess the effect of agricultural finance on MSE expansion and growth.
c) To analyze the major constraints hindering the availability of agricultural finance
to small and micro enterprises in the study area.
d) To evolve policy recommendations that will improve the administration of
agricultural finance to small-scale enterprises in Kenya.

1.4 Research questions

The study seeks to answer the following questions
a) Do lending procedures of AFC affect the availability of agricultural finance?
b) What is the effect of agricultural finance on SME expansion and growth?
c) What constraints hinder the availability of agricultural credit in the study area?
d) What policy suggestions should be recommended to ease administration of
agricultural finance to small scale enterprises in Kenya?

1.5 Importance and justification of the study

The study is important as a means of finding out ways of supporting the agricultural
SMES through the provision of agricultural finance. The study will provide additional
knowledge on agricultural finance and its role on MSE growth.

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Policy makers
The findings of this research will enable policy makers in government formulate
constructive and effective policies. The SMES in the agricultural sector are critical to
economic growth and sound policies that facilitate provision of agricultural finance are
critical for economic growth.

Research institutions
The study will benefit scholars to further understand the linkage between agricultural
finance and economic growth and the use of agricultural finance to target the unbanked in
the society and the relationship to SME growth.

Community
Agricultural finance services allow the community to reallocate expenditure across time.
Entrepreneurs need finances for startup, growth and expansion of SMEs hence the
community can understand the role agricultural finance plays in the improvement of their
economic wellbeing.

Entrepreneurs
This study will benefit owners of small and micro enterprises to identify sources and the
cost of agricultural finance and look at factors that work to their advantage to maximize
profit and expand their businesses. It will also reduce the operational difficulties
encountered in accessing credit by the entrepreneurs.

Civil society organizations

The research will enhance civil society’s role of building farmers’ capacity to organize,
generate and utilize resources more effectively. Results will also assist the civil societies
carry out roles of advocacy which will ensure that barriers to credit access such as
ownership of collateral by women and children are addressed.

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1.6 Scope of the study
The study population will be SMEs operating in Machakos district. The study will focus
on agro-based enterprises both farm and off-farm. The study will focus on SMEs
employing between 1 and 50 people and have been in operation for more than 18 months.

1.7 Limitations of the study

Since the cost of carrying out the study requires adequate finance, the financial
constraints of the researcher will not permit to facilitate more in-depth investigations of
the problem. Such facilitation could have been in form of a research assistants,
convenient transport and ample communication amenities. Apart from limited time
frame, the accessibility of some key respondents in the target population may not be easy
leading to a lot of time spent than will be necessary, due to such limitations, it is therefore
assumed that the results obtained from the branch will be used to generalize the broader
spectrum of the entire Agricultural Finance Corporation branch network.

1.8 Conceptual framework

In view of existing literature on agricultural finance three hypotheses will be tested.
Lending procedures have no effect on availability of agricultural finance to SMEs, lack of
finance does not hinder growth of SMEs and government policies have no influence on
growth performance of SMEs (Namusonge, 1999).

Two main theoretical paradigms have been advanced to explain the existence of this
fragmentation: the policy-based explanation and the structural-institutional explanations
(Aryeetey et al., 1997). According to the policy-based explanation, fragmented credit
markets (in which favoured borrowers obtain funds at subsidized interest rates, while
others seek funds from expensive informal markets) develop due to repressive policies
that raise the demand for funds. Unsatisfied demand for investible funds forces credit
rationing using non interest rate criteria, while an informal market develops at
uncontrolled interest rates.

According to the structural-institutional explanations, imperfect information on

creditworthiness, as well as cost of screening, monitoring and contract enforcement

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among lenders, results in market failure due to adverse selection and moral hazard, which
undermines the operation of financial markets. As a result, lenders may resort to credit
rationing in the face of excess demand, thus establishing equilibrium even in the absence
of interest rate ceilings and direct allocations. Market segmentation then results. Market
segments that are avoided by the formal institutions due to institutional and structural
factors are served by informal agents who use personal relationships, social sanctions and
collateral substitutes to ensure repayment. An extended view of this explanation is that
structural barriers result in monopoly power, which perpetuates segmentation.

Independent variables Dependent Variable

INSTITUTIONAL
LENDING PROCEDURES

TYPE AND SOURCE OF SME GROWTH

AGRICULTURAL FINANCE

GOVERNMENT LENDING
POLICIES

Figure 1: Conceptual framework

The following variables have influence on MSE growth.
(a)Institutional lending procedures
Institutional lending procedures determine ease of access of finance. Where the
procedures are cumbersome borrowers are not able to meet the requirements of the
institution and shy away from the institution. The procedures also may determine the time
from application to disbursement and since most of the activities have a time frame.
Clients want to deal with institutions that disburse funds in the shortest time possible.
Funds are also required for purchase of new equipment, hiring of extra labour and

8
purchase of extra stock .All these requires to be done quickly hence simplicity in terms of
institutional lending procedures is critical.
(b) Type and source of agricultural finance
This determines the rate of SME growth in that some agricultural finance service
providers provide both cash credit and credit in form of stocks and inputs. This has an
effect in that the client has no control on the cost of inputs this affects the profitability of
the enterprise. Credit source is also important in that government organizations may offer
cheaper credit as well as NGOs depending on the cost of the finances. Empirical evidence
however indicates that a commercial, market-based approach is most likely to reach large
numbers of clients on a sustained basis (Kibaara, 2005).
(c)Government lending policies
Agricultural financial services are part of an interactive system of financial institutions,
financial infrastructure, legal and regulatory frameworks, and social and cultural norms.
Government has a role to play in establishing a favourable or “enabling” policy
environment, infrastructure and information systems, and supervisory structures to
facilitate markets, but it should play a more limited role in direct interactions. Lending
policies therefore determine the growth rate of SMEs as this determines the cost of doing
business.

1.9 Summary
The chapter provides the background and statement of the problem. The research
problem being investigated is the effect of agricultural finance on small and medium
enterprises and the factors that affect the availability of agricultural finance. Research
questions are generated from the problem and the study seeks to answer these questions.
The study is of significance to policy makers, donor agencies, civil society organizations,
financial institutions, development agencies, entrepreneurs and other stakeholders.

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 CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction
This chapter reviews both empirical and theoretical literature concerning agricultural
finance with specific in-depth focus on its role in SME growth. The role of agriculture in
economic growth is analyzed, the entrepreneurial finance needs at various stages of
business growth and constraints facing the agriculture sector in Kenya. We also examine
the typology of financial institutions offering agricultural finance in Kenya and in Africa.
The chapter also looks at the constraints facing agricultural finance institutions as a
source of entrepreneurial finance.

2.2 Role of agriculture in national development

Kenya’s economy is heavily dependent on agriculture. The agricultural sector directly
contributes 25 per cent of the gross domestic product (GDP) and indirectly an additional
27 per cent through linkages with manufacturing, distribution and the service sector.
(GOK, 2007) Evidence shows that there is a direct and positive relationship between
growth of the agricultural sector and the entire economy. Wherever the agricultural sector
has performed well, the economy has invariably performed well. This could be due to
several factors, including the relatively large share of the sector in the gross domestic
product. A large proportion of the population is thus trapped in a vicious circle of low
income and low assets. This persists from generation to generation, rendering a low GDP
per capita inevitable. The situation is exacerbated by a physical infrastructure that
impedes the effective distribution and marketing of agricultural goods, by degraded soil
fertility, by uncertain land tenure, by lack of access to credit, and by limited irrigation
possibilities, worsened still further by growing competition for scarce water and the
threat of climate change. These are compounded by the disastrous effect of HIV/AIDS on
the adult community in rural populations (McDonald and Roberts, 2006; Corrigan et al.,
2005; Misselhorn, 2005).

Agricultural investment provides the catalyst for the development of essential

infrastructure, including transport, communication, education and health services
(Turnock, 2001). Agriculture and food production is a high-volume, low-cost enterprise

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that demands transport and a functioning infrastructure (Fan and Zhang, 2004). Raising
agricultural productivity beyond subsistence levels is therefore critical to initiating a
broader economic momentum and agricultural finance is critical to this. (Kibaara, 2005)

2.2 Agricultural finance as a source of entrepreneurial finance

Agricultural finance is very critical in the various phases of business growth for
entrepreneurs as depicted in the various phases
2.2.1 Start up Phase
During the very earliest (‘start-up’) stages of their development, entrepreneurs usually
need a full range of support services, ranging from start-up finance. This is typically
made available in the form of small grants, own savings and soft loans and is used for the
provision of suitable and affordable premises and purchase of initial stock(Burns,1988)
2.2.2 Growth Phase
This refers the transition from being a micro-business to a small firm employing more
than 5-10 people - depicted as the growth a critical stage in SME development and one
where many businesses fail (on average, 50 per cent of SMEs cease trading within five
years of start-up). During this growth phase support needs typically focus on areas such
as helping entrepreneurs raise larger amounts of finance for investment and working
capital to fund expansion, developing their markets, improving management skills and
helping them to cope with organizational change. Many start-ups do not have the capacity
to grow beyond the stage of providing self-employment for the founder; likewise, some
SME owner manager may not wish to expand their enterprise beyond being a micro-
business (Burns, 1988)

2.2.3 Maturity Phase

The third stage this is where a small firm achieves a sustainable growth rate and
successfully makes the transition to being a medium-sized enterprise. At this stage,
support needs become more complex and, for example, may involve advice on a stock
market floatation, exporting, help with the development of supply chains and integration
into knowledge networks. In the human resources field there are likely to be increasingly
specialist skills development requirements. (Norman, 2003)

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2.3 Constraints to agriculture sector growth in Kenya
Several constraints have been identified as hindering growth of SMEs in the agricultural
sector. The main constraints identified include:

2.3.1 Unfavorable macro-economic environment

Stable macro-economic environment is vital for sustained growth and investment.
Although in the recent past the government has made considerable progress in stabilizing
the macro-economic environment, persistent large public sector borrowing requirements,
high lending interest rates, and overvalued and volatile shilling exchange rates has
discouraged investment in the agricultural sector. Many farmers have been impoverished
by the high debt service and non-performing loans. This has made agricultural finance
unavailable to institutions such as the AFC and other farmer organizations .The lack of
finance hampers growth of the agri-based SMEs (GOK, 2004)

2.3.2 Unfavourable external environment. Deterioration in terms of trade due to a

decline in the world commodity prices has particularly impacted negatively on the
incomes from coffee, tea, sisal and pyrethrum farming. Tariffs and non-tariffs barriers
imposed by developed countries have made it difficult for developing countries to access
their markets. SMEs that rely on these commodities are not able to expand due to limited
markets and lack of finances for value addition and supporting entrepreneurs.

2.3.3 Inappropriate legal and regulatory framework.

This is seen in outdated legal and regulatory framework that has served only to constrain
agricultural development, trade and effective competition. Outdated business laws inhibit
growth of entrepreneurs.

2.3.4 Lack of capital and access to affordable credit.

The main factor which farmers, particularly small farmers, points out as causing low
productivity in agriculture is inadequate credit to finance inputs and capital investment in
the past, the government through the AFC, the cooperative bank of Kenya and the
cooperative movement, provided affordable credit to farmers. Due to mismanagement

12
and political patronage and interference, most of these institutions have collapsed or
failed to provide the services, thus leaving farmers without source of affordable credit. A
number of micro-finance institutions are however operating in some areas, but they reach
only a small proportion of smallholder farmers, provide very short-term credit and their
effective lending rates are very high. The formal banking system is yet to develop credit
facilities that particularly suit small scale farming business.

2.3.4 Frequent droughts and floods.

Most crop and livestock farming in Kenya is rain-fed, and therefore, is susceptible to
weather fluctuations. Over the last three decades the frequency of droughts and floods has
increased, resulting in crop failures and loss of livestock. Furthermore, with increasing
land degradation, land resilience has been reduced and the effects of drought and floods
exacerbated.

2.4 Typology of financial institutions offering agricultural credit in Kenya

The supply of agricultural finance is dominated by commodity based credit providers and
companies that promote tea, Sugarcane and horticultural crops production. Provision of credit
by the commodity based credit providers has increased from 53.5 per cent in 2000 to 62.7 per
cent in 2004 (Table 1). This shows that the role of contracted farming in provision of
embedded services such as credit for agricultural inputs has become increasingly important.
The savings and credit co-operatives (SACCOs) remain a significant supplier of agricultural
credit and especially in the Central Highlands and Western Transitional zones. However, the
SACCOs market share has slightly declined from 25 per cent in 2000 to 20.6 per cent in 2004
partly because of spillover effect of wrangles and mismanagement of SACCOs.
Table 1: Sources of agricultural financing

Source of credit 2000 2004

Commodity based credit providers 53.5 per cent 62.7 per cent
SACCOs 26.0 20.6
Informal moneylenders 12.1 9.9
Local trader/input stockists 6.8 3.9
AFC 0.4 1.3
Commercial banks 0.6 1.0
MFIs/NGOs 0.6 0.5
TOTAL 100 100
Source: Tegemeo Survey 2000 and 2004

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Jointly, the informal money lenders and local traders/input stockists are more important
than the formal commercial banking institutions, providing 20 per cent of the agricultural
credit to the rural households in Kenya. The government owned Agricultural Finance
Corporation has increased its agricultural credit provision from 0.4 per cent in 2000 to 1.3
per cent in 2004. This gain is partly attributed to financial revamp by the government and
the current restructuring of the institution. (AFC, 2007)

Provision of agricultural credit through the mainstream commercial banks has increased
slightly as a result of recent innovative products associated with retail banking such as
loans to tea and dairy farmers. In addition, there is reduced bureaucracy, excess liquidity
as investment opportunities are thinned following the reduction of government/treasury
bills which was estimated to contribute 50 per cent of the bank’s income. However, the
commercial bank’s contribution to agricultural credit is insignificant. The Micro Finance
Institutions (MFIs) provide agricultural credit to a mere 0.6 per cent of the rural
households. MFIs have been in existence for the last 20 years, focusing on the
economically active but poor entrepreneurs and have played a pivotal role in helping the
low-income earners access non-agricultural loans. (Kibaara, 2005)

2.5 The Equity Bank model

Equity Bank Limited provides retail Banking and microfinance services in various parts
of the country. The bank has a total branch network of 50 branches and 200 ATMs.The
bank has been instrumental in the provision of agricultural finance products .The bank
offers credit to entrepreneurs engaged in agricultural activities such as milk production
maize, coffee, tea, horticulture, and SMEs engaged in trade and service activities. In
order to increase outreach the bank provides mobile banking services with 44 village
mobile banks. The bank as has flexible security requirements and loan appraisals are
based on the ability to pay vis-à-vis collateral based. The bank has also ensured quick
disbursement of loan with crop advance loans taking less than a day to disburse (Equity,
2006).

Due to the above innovative products including catering for the financial needs of women
the bank in partnership with UNDP recently launched the women enterprise fund that

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caters for the specific needs of women entrepreneurs, Equity controls more than a third of
all bank accounts in Kenya with deposits of Ksh 23.6 billion in 1,347,578 accounts. The
bank also disbursed loans totaling Ksh 15 billion with 40 per cent of these being
agricultural loans (Equity, 2007)

2.6 Lending policies and their impact on SME financing

The lending policies used by the main credit institutions in Kenya do not ensure efficient
and profitable use of credit funds, especially by farmers, and also result in a disparity
between credit demand and supply (Atieno, 1994). This view is further supported by a
1995 Kenya Rural Enterprise Programme (KREP) survey showing that whereas credit is
an important factor in enterprise expansion, it will most likely lead to enterprise
contraction when not given in adequate amounts (Daniels et al., 1995). Hence, despite the
existence of a sophisticated financial system, it has not guaranteed the access to credit by
small-scale enterprises.

Although not much is known about the informal financial sector in the country, there is a
consensus that it is an important source of finance to the small-scale entrepreneurs in the
country (Aleke Dondo, 1994, Ouma, 1991) found that 72 per cent of the sample surveyed
saved with and borrowed from informal sources. Whereas in the formal credit market
only a selected few qualify for the predetermined loan portfolios, in the informal market
the diversified credit needs of borrowers are better satisfied. The problems of formal
financial institutions, especially security, loan processing, inadequate loans given, unclear
procedures in loan disbursement and high interest rates, all underscore the importance of
informal credit and the need to investigate the dynamics of its operations, especially with
respect to how these factors determine the access to and the use of credit facilities.
Informal credit sources in Kenya comprise traders, relatives and friends, ROSCAs,
welfare associations, and moneylenders (GOK, 2005)

2.7 Access to financial services by SMEs in Kenya

Access to financial services by smallholders is normally seen as one of the constraints
limiting their benefits from credit facilities. However, in most cases the access problem,
especially among formal financial institutions, is one created by the institutions mainly

15
through their lending policies. This is displayed in the form of prescribed minimum loan
amounts, complicated application procedures and restrictions on credit for specific
purposes (Schmidt and Kropp, 2003). For small-scale enterprises, reliable access to short-
term and small amounts of credit is more valuable, and emphasizing it may be more
appropriate in credit programmes aimed at such enterprises.

Schmidt and Kropp, (2003) further argue that the type of financial institution and its
policy will often determine the access problem. Where credit duration, terms of payment,
required security and the provision of supplementary services do not fit the needs of the
target group, potential borrowers will not apply for credit even where it exists and when
they do, they will be denied access.

The Grameen Bank experience shows that most of the conditions imposed by formal
credit institutions like collateral requirements should not actually stand in the way of
smallholders and the poor in obtaining credit. The poor can use the loans and repay if
effective procedures for disbursement, supervision and repayment have been established.

Notable disadvantages of the formal financial institutions are their restriction of finance
to specific activities, making it difficult to compensate for losses through other forms of
enterprises, and their use of traditional collateral like land. There is need for a broad
concept of rural finance to encompass the financial decisions and options of rural
economic units, to consider the kind of financial services needed by households, and
which institutions are best suited to provide them.

2.8 Characteristics of financial markets in Africa

Credit markets in Africa have mainly been characterized by the inability to satisfy the
existing demand for credit in rural areas. However, whereas for the informal sector the
main reason for this inability is the small size of the resources it controls, for the formal
sector it is not an inadequate lending base that is the reason (Aryeetey, 1996).Rather, the
reasons are difficulties in loan administration like screening and monitoring, high
transaction costs, and the risk of default. Credit markets are characterized by information

16
asymmetry, agency problems and poor contract enforcement mechanisms (Nissanke and
Aryeetey, 1995). They are mainly fragmented because different segments serve clients
with distinct characteristics. Because of this, lending units are unable to meet the needs of
borrowers interested in certain types of credit. The result is a credit gap that captures
those borrowers, who cannot get what they want from the informal market, yet they
cannot gain access to the formal sources. Enterprises that want to expand beyond the
limits of self-finance but lack access to bank credit demand external finance, which the
informal sector is unable to satisfy.

2.9 Financial institutions in Kenya

The Banking industry in Kenya is governed by the Companies Act, the Banking Act, the
Central Bank of Kenya Act and the various prudential guidelines issued by the Central
Bank of Kenya (CBK). The CBK, which falls under the Minister for Finance’s docket, is
responsible for formulating and implementing monetary policy and fostering the
liquidity, solvency and proper functioning of the financial system. The CBK publishes
information on Kenya’s commercial banks and non-banking financial institutions, interest
rates and other publications and guidelines.

There are 50 bank and non-bank financial institutions, 15 micro finance institutions and
48 foreign exchange bureaus. Thirty-five of the banks, most of which are small to
medium sized, are locally-owned. The industry is dominated by a few large banks most
of which are foreign-owned, though some have local shareholders. Nine of the major
banks are listed on the Nairobi Stock Exchange. (CBK, 2007)

MSEs have traditionally not relied on the mainstream/conventional sources of capital

because SMEs lack tangible securities that are demanded by mainstream financial
institutions and also the operations of financial institutions are tailored to offer credit
services to the formal businesses. SMEs are also seen as high risk and also the policy and
regulatory framework for financial services is less supportive of small clients. Traditional
sources of agricultural finance are discussed below.

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Commercial banks
Commercial Banks are the very heart of the financial market, providing the greatest
number and variety of loans To SMEs. Banks tend to be conservative in their lending
practices and prefer to make to established small businesses than to high risk startups.
They have stringent application procedures, high interest rates and elitist lending target
portfolio. The major banks include Kenya Commercial Bank, Barclays Bank, Standard
Chartered Bank, and Equity Bank which has experienced phenomenal growth and is
currently controlling more than a third of all bank accounts in Kenya with 1,347,578
active bank accounts (CBK, 2007)

Savings and credit cooperative societies (SACCOS):

The SACCOS rely on members’ savings to provide loans and other services. Members
are provided with loans based on share contribution as well as guarantors’ shares.
Members can borrow up to specific number of times of the value of share contribution
with a repayment period of up to 36 months. Loan repayment and interest are deducted
from the salary or from the marketed produce. SACCOs are an important source of
agricultural finance where there are guaranteed markets for farm produce.

Development Finance Institutions (DFIs)

Other than commercial banks another set of financial institutions that have historically
been the most active in financing SMEs in Kenya, are DFIs. By 1995, the total number of
DFIs in the country was nine, all operating in the industrial and commercial sector. The
GOK started DFIs to promote industrial development. Some key DFIs include the
Industrial and Commercial Development Corporation (ICDC), the Development
Financial Corporation of Kenya (DFCK), the Kenya Industrial Estates (KIE) and
Industrial Development Bank (IDB). DFIs provide long-term finance of up to 10 years
with grace period of up to two years. Unlike commercial banks and NBFIs that insist on
100per cent security, DFIs lending is based on the viability of projects being funded and
security is based on the fixed asset being financed. They also provide non-financial

18
services, such as appraisal, implementation, monitoring of projects and training of
entrepreneurs. (Namusonge, 2004)
Micro finance institutions (MFIs)
Micro finance institutions use the group pressure model where members interested in
financing arrangements form solidarity groups that serve as security for the money
borrowed. Group pressure is critical in ensuring loan repayments through imposition of
sanctions. The MFIs are an important source of entrepreneurial finance and funding new
ventures. Examples include Kenya Women Finance Trust., K-REP BIMAS, Sunlink and
FAULU KENYA

2.9 The role of AFC in the provision of entrepreneurial finance

The Agricultural Finance Corporation (AFC) is a wholly owned state corporation
established through an act of parliament (Cap 323 of the Laws of Kenya).Its mandate is
to support the development of agriculture and agricultural industries by making loans to
farmers, co-operative societies, incorporated group representatives, private companies,
public bodies, local authorities and any other persons engaging in agriculture or
agricultural industries.

The Agricultural Finance Corporation (AFC) has traditionally been the single largest
agricultural credit institution in the country and has been instrumental in the development
of agriculture by providing an average of the total credit to the sector sine independence.
The organization has developed a strong physical presence countrywide with a branch
network of 31 branches country wide. The corporation has been instrumental in the
implementing many government and donor supported programs such as mechanization of
the agricultural sector, livestock development programs, the Guarantee Minimum Return,
the Seasonal Crop Credit and the Emergency Livestock Off-take Program. Since early
1990’s, the corporation started experiencing operational difficulties due to poor
governance, political interference and effects of economic liberalization that led to
subsequent collapse of some agricultural marketing bodies. By 1992, the non-performing
loan portfolio reached 89 per cent (AFC, 2005). The government and other donors
stopped funding AFC and the recovered money was used for recurrent expenditure. AFC
officially stopped lending from 1997 to 2001(AFC, 2007)

19
The National Rainbow Coalition (NARC) government pledged to improve access to rural
credit and financial services from 2003. Since then, the government has implemented
some of its pledges as stated in the Strategy for Revitalizing Agriculture (SRA). The
government has restructured AFC by writing off bad debts and refinancing. The
corporation has resumed lending for seasonal crop credit and value addition loans at
10per cent and 15per cent respectively. As at 2004/2005, the corporation had advanced a
total of one billion Kenya shillings to 5253 farmers. Seasonal loans account for 52per
cent of the total loans, while development accounts for 48 per cent (AFC, 2007)

Kenya has however not developed a comprehensive rural financial services strategy. The
rural financial sector is governed by the Banking Act, Building Society Act and the Post
Bank Act. The proposed SACCO Societies Regulatory Bill 2004 is still to be debated in
parliament. Through the Economic Recovery Strategy for Wealth and Employment
Creation (ERSWC) the government has identified poor access to farm credit and financial
services as a contributing factor to the decline in agricultural productivity. The Strategy
for Revitalizing Agriculture (SRA) proposes to encourage an orderly development of
micro-finance institutions through the enactment of facilitative legislation, encourage
commercial banks to set up operations in the rural areas by providing appropriate
incentives, encourage banks to lend to agriculture by reviewing and repealing legal
provisions that have undermined lending to the sector, recapitalize and streamline the
management of Agricultural Finance Corporation so that it can perform its function of
providing affordable credit to farmers ( GOK, 2004). As a follow up on SRA, the
Agricultural Sector Co-ordination Unit (ASCU) has fast-tracked the rural financial
services by establishing a thematic group on inputs and rural financial services with an
overall objective of developing an Integrated Farm Input Strategy.

3.0 Constraints of agricultural finance institutions

Commercial banks and other formal institutions fail to cater for the credit needs of
smallholders, due to their lending terms and conditions. It is generally the rules and
regulations of the formal financial institutions that have created the myth that the poor are

20
not bankable, and since they can’t afford the required collateral, they are considered
uncreditworthy (Adera, 1995).

In the recent past, there has been an increased tendency to fund credit programmes in the
developing countries aimed at small-scale enterprises. In Kenya, despite emphasis on
increasing the availability of credit to small and micro enterprises (SMEs), access to
credit by such enterprises remains one of the major constraints they face. A 1995 survey
of small and micro enterprises found that up to 32.7per cent of the entrepreneurs
surveyed mentioned lack of capital as their principal problem, while only about 10per
cent had ever received credit (Daniels et al., 1995). Although causality cannot be inferred
a priori from the relationship between credit and enterprise growth, it is an indicator of
the importance of credit in enterprise development. The failure of specialized financial
institutions to meet the credit needs of such enterprises has underlined the importance of
a needs oriented financial system for rural development.

Experience from informal finance shows that the rural poor, especially women, often
have greater access to informal credit facilities than from formal sources (Schrieder and
Cuevas, 1992; Adams, 1992). The same case has also been reported by surveys of credit
markets in Kenya (Raikes, 1989; Alila, 1991; Daniels et al., 1995). A relevant question
then becomes: Why do informal financial institutions often succeed even where formal
institutions have failed? Lack of an empirical analysis of the relationship between lending
policies and the problem of access makes it difficult to answer such a question. This
study is aimed at empirically analyzing the credit policies in the agricultural finance
sector with the view of establishing their role in determining the access of small-scale
enterprises to financial services with the role of AFC coming under sharp focus given its
mandated role in funding the thriving agriculture sector.

The lending policies used by the main credit institutions in Kenya do not ensure efficient
and profitable use of credit funds, especially by farmers, and also result in a disparity
between credit demand and supply (Atieno, 1994). This view is further supported by a
1995 KREP survey showing that whereas credit is an important factor in enterprise

21
expansion, it will most likely lead to enterprise contraction when not given in adequate
amounts (Daniels et al., 1995). Hence, despite the existence of a sophisticated financial
system, it has not guaranteed the access to credit by small-scale enterprises.

Although not much is known about the informal financial sector in the country, there is a
consensus that it is an important source of finance to the small-scale entrepreneurs in the
country (Aleke Dondo, 1994). (Ouma, 1991) found that 72 per cent of the sample
surveyed saved with and borrowed from informal sources. Whereas in the formal credit
market only a selected few qualify for the predetermined loan portfolios, in the informal
market the diversified credit needs of borrowers are better satisfied. The problems of
formal financial institutions, especially security, loan processing, inadequate loans given,
unclear procedures in loan disbursement and high interest rates, all underscore the
importance of informal credit and the need to investigate the dynamics of its operations,
especially with respect to how these factors determine the access to and the use of credit
facilities. Informal credit sources in Kenya comprise traders, relatives and friends,
ROSCAs, welfare associations, and moneylenders.

3.11 Supply and demand of entrepreneurial finance

The 1993 baseline survey indicated that only 9per cent of the MSME had accessed
microfinance and only 4per cent of this finance was obtained from formalized financial
channels. The survey noted that the bulk of the SME credit(69.1per cent) come from the
informal credit and savings associations, mainly rotating savings and credit
associations(ROSCAS), friends and relatives. These findings compare favourably with
the 1995 baseline survey which showed that 10.8 of the SMEs had accessed microfinance
and that only 3.4 per cent of those received credit from formal financial sources
(Namusonge 2006).Thus the supply of entrepreneurial finance which includes
agricultural finance is very low compared to the aggregate demand.

3.12 Impact of entrepreneurial finance

Entrepreneurial finance is critical in creating a source of business capital for persons
excluded from the formal banking sector and this fosters their self determination and
economic self-reliance. Support for capital formation through savings schemes managed

22
by people themselves enables the beneficiaries to raise capital for growth of businesses.
This leads to growth and expansion of the enterprises and hence overall economic
growth.

3.13 Summary
This literature review has attempted to analyze the role of agricultural credit and its effect
on SME growth. The role of agriculture is critically examined as well as constraints
facing the agricultural sector. The review also analyses the typology of financial
institutions and the issue of access to finance. It also critically examines the role of AFC
in the provision of agricultural finance. An understanding of the role of finance in growth
of SMEs is critical to development to small-scale enterprises.

23
 CHAPTER THREE: RESEARCH METHODOLOGY

3.1 Introduction
This section highlights the research design, target population and sample size, methods of
data collection, and data analysis.

3.2 Research design

The research design used in the study would be exploratory-descriptive research design.
It is exploratory in that the major emphasis would be on the discovery ad trying to get
more insight on the effect of agricultural finance on SME growth. The design would also
be descriptive as the effect of the finance on the growth of SMEs would be explained.

3.3Target population
The study targeted entrepreneurs engaged in farming, wholesale and retail trade, and
primary processing of agricultural products. The sample size was 120 respondents drawn
from six administrative divisions of Machakos district.
3.4 Geographical scope
The study was carried out in March 2008 in six divisions of Machakos district where the
clients are located. Machakos district has 9840 registered businesses (GOK, 2007). The
A.F.C. branch here is one of the oldest branches offering agricultural finance and the
impact of the organization is also focus of the study.

3.4 Sampling and sample size

This includes both credit and noncredit users. The researcher selected 120 small-scale.
The entrepreneurs identified the available formal and informal sources of credit from
which they had benefited. There are six administrative divisions in Machakos district
.Each administrative division was allocated 20 respondents giving a total number as 120.
Purposive sampling was then applied in the selection of respondents who were willing
and satisfied the set criteria of being in business for more than 18 months with 1-50
employees. The required sample size was selected using the proportionate stratified
sampling and judgmental sampling respectively.

3. 5 Data collection methods

Data collection methods include the use of questionnaires, observation and discussions.

24
3.5.1 Primary Data collection

The main data collection instrument used in the study was a questionnaire. Respondents
who are literate were asked to fill tone or the same was used as an interview
schedule for illiterate respondents. This was administered in Kiswahili for ease of
understanding.

Pre-testing the questionnaire was done to five respondents to remove ambiguous and
confusing questions and make the necessary amendments. Data was then collected by the
researcher assisted by six research assistants over a period of four days.

The researcher also used observation method to complement data generated from the
questionnaire. This data from the observation was used for correlation purposes to
enhance data reliability.
3.5.2 Secondary data collection
This was mainly done using data from the Central bureau of statistics and ministry of
trade and industry data on registered businesses in Machakos district.

3.6 Data analysis

Data was analyzed using both qualitative and quantitative methods. Data was first coded
and organized into concepts from which generalizations were made fro the entire
population. Data was then tabulated and frequencies calculated on each variable under
study and interpretations made from the collected finding in the field. Measures of central
tendency such as mean, mode and median and measures of dispersion like standard
deviation and percentages were calculated and interpretations made. Data is then
presented in form of tables and pie-charts and graphs.
The analyzed data was then converted into descriptive statements and/inferences about
relationships.

25
 CHAPTER FOUR: RESEARCH FINDINGS

4.1 Introduction
The data for this research was collected in Machakos district in March 2008.the
respondents were reached through a sample frame provided by the ministry of industry
which has a database of registered businesses in the district. The researchers took four
days to collect data in the six (6) divisions and two days to analyze the data and one week
to write the report. Data was collected on background of the entrepreneurs, business
profile of the enterprises information on agricultural finance and the role of A.F.C. on the
provision of agricultural credit. Suggestions on the role of the government in the
provision of agricultural finance was provided .The research targeted business that had
been in operation for more than 18 months and in rural areas.

4.2 Demographic characteristics of the respondents

This section deals with the demographic and educational factors that may determine the
entrepreneurs’ choice of agricultural finance. The factors are gender, age, educational
background and level of training and experience in business.
4.1.1 Distribution by gender
Respondents were asked to indicate their gender. Out of the 120 respondents interviewed
78 respondents (representing 65per cent) were male and 42 respondents (representing
35per cent were female. This indicates a generally higher frequency of male
entrepreneurs in the study. This can be attributed to the fact that females face more
hurdles in starting the businesses and are not able to access seed capital. Further, women
tend to concentrate on maternal responsibilities and business concerns come second.
These cultural beliefs which have been internalized by women have made them poor
competitors against stronger (men) forces in the society.

26
 Distribution of respondents by
gender

35%
male
female
65%

Fig 2 Distribution of respondents by gender

4.1.2 Distribution by age
Respondents were asked to indicate their age. The highest frequency of the respondents is
in the age brackets of over 44 years with a mean age of 39 years. This is an indicator that
entrepreneurs engaging in agro-based SMEs have pursued other interests before engaging
in the present activity such as formal employment. Further for entrepreneurs engaging in
commercial production ownership of productive land is essential and this age bracket has
inherited the land from the parents or mobilized resources for purchase of land.

Age is critical in business performance in that it takes time to acquire the necessary skills
and startup capital for the business. Further, where self-employment is not taken as a first
option many of the respondents had either been previously employed.

27
The distribution of respondents by age is analyzed in the table 2.
Distribution by age
Age in years Frequency per cent
16-19 1 1
20-25 10 8
26-30 15 13
31-35 18 15
36-40 14 12
41-44 26 22
Over 44 36 30
TOTAL 120 100

Table 2: Distribution by age

4.1.3 Distribution of responses by educational level
The level of education is important as it determines the channels of communication used
by the respondent, degree of confidence and the ease of acquisition of new managerial
skills. The education level also determines the level of confidence in approaching
financial institutions. In order to determine the education levels respondents were asked
to indicate their education levels and the results are tabulated in table 3
Distribution of respondents by educational level
Level of education Frequency per cent
No formal Education 3 3
Primary level 26 22
Secondary level 64 53
Polytechnic level 20 17
College/university 7 6
TOTAL 120 100
Table 3: Distribution of respondents by level of education
The higher education levels are critical in the entrepreneurs’ understanding of the effect
of agricultural finance on the growth of their individual enterprises hence better
opportunities for business growth. The frequencies indicate that over 76 per cent of the
respondents have received education beyond secondary school level. This shows that
entrepreneurship is increasingly becoming a choice of many Kenyans in the absence of
formal employment.

28
4.2 Business profile of the SMEs
The research was geared to finding out the role of agricultural finance on SME growth.
Understanding the legal status of the business the type of business activities the
entrepreneur is undertaking and the age of the business is critical to the analysis of the
role of finance on performance of the firm.
4.2.1 Type of SMEs
The various types of SMEs were categorized into various classes mainly production of
crops or livestock enterprises transportation of agricultural produce, value addition
including processing, packaging and distribution. Other categories included specialized
SMEs such as tree nurseries. The table below shows the relative distribution of the
various SMEs under study
Business profile of the SMEs
Type of SME Frequency per cent
Production 26 22
Transportation 5 4
Value addition/Processing 13 11
Wholesaler/distributor 66 55
Any other (commercial tree nurseries) 10 8
TOTAL 120 100

Table 4: Distribution of SMEs

Majority of the respondents (55 per cent) are engage in distribution and wholesaling. The
entrepreneurs who purchase farm and livestock produce at farm level .These include
grain stores, milk bars and livestock merchants who buy livestock from the farmers and
sell at a profit. The entrepreneurs purchase the produce during harvest season and store
and sell at a profit. Very few entrepreneurs are engage in transportation owing to high
cost of transport and increased competition from other sectors such as the construction
sector. Further most of the agricultural activities are seasonal in nature. The high numbers
of entrepreneurs in the wholesale sector also indicates a weak value chain for most of the
agricultural commodities that provides numerous business opportunities.

4.2.2 Distribution of respondents by ownership

29
Entrepreneurs found at the business were asked to indicate the nature of the ownership of
the business. This was defined as sole proprietorship, partnership, limited company and
any other form of ownership. No responses were received from any other form of
ownership. Overwhelmingly most of the businesses are sole proprietorship. The
frequency is indicated in the chart below.

Business ownership

Partnership
ownership form

Limited company

Sole propreitership

0 10 20 30 40 50 60 70
percentage

Fig 3: Business ownership

Majority of the businesses (63 per cent) are sole proprietorship while the 33 per cent of
the other business are partnership between family members or relatives. Many of the
business are capital intensive and entrepreneurs obtain seed capital from personal savings
accumulated over time. The entrepreneurs found other forms of businesses ownership
cumbersome and expensive or were unaware of their existence.

4.3 Effect of agricultural finance on SMEs growth

Agricultural finance is critical for SME growth. Finance is required for purchase of
additional stock, acquisition of new production facilities and tools, purchase of raw
materials and hiring of more employees. In an effort to establish the availability of other
sources of agricultural finance that businesses may use for growth and expansion the
researcher sought to know whether the business had experienced any growth and the
effect of any agricultural finance on business growth and performance. Agricultural

30
finance impact was best reflected through increase in sales volume (40 per cent), increase
in profit (10 per cent) and increase in number of employees at 12 per cent, increase in
production levels is at 25 per cent. The results are shown on the figure 4 below:

Major areas of business growth

others
New businesses
increase in stock
new employees
profits
production
sales volume

0 10 20 30 40 50
Frequency

Figure 4: Major areas of business growth experienced

The entrepreneurs also indicated the entrepreneurial finance had an overall impact on the
growth of the business (73 per cent of the respondents) while 20 per cent of the
businesses had declined as a result of the agricultural finance obtained. Only 7 per cent of
the respondents indicated that the business had remained the same even after obtaining
the credit

4.3.1. Sources of seed capital

The study sought to find out the sources of finance for starting their businesses. Most of
the respondents had multiple sources of seed capital for the business. However the main
source as most tallied frequently by the respondents is personal savings. Loans from
relatives and from the Agricultural Finance Corporation which is a body specializing in
agricultural finance was listed as a minor source of agricultural finance. This is
summarized on figure 5 below:

31
 Sources of starting capital

Others

Sale of personal assets

A.F.C.
Source

Commercial Bank

Loans from relatives

Personal savings

0 10 20 30 40 50 60 70
Frequency

Figure 5: Sources of starting capital

4.4 Perception of adequacy of business financing

Adequate finances are critical for growth of enterprises. Finances are required for
expansion of the businesses, purchase of new stock, hiring of new employees, and for
graduation into bigger enterprises. Respondents were asked to indicate whether they had
adequate agricultural finance for their business operations and whether the capital
resources they had were adequate for their needs.87 respondents representing 72 per cent
of the total considered their capital resources inadequate while 23 respondents
representing 28 per cent of the total considered their resources adequate.
The frequency of these responses is illustrated in figure 6.

32
 Adequacy of business finance

Business has
No adequate
Finance

Business has
Adequate
Finance
0
20 40 60 80
Per cent%

Figure 6: Respondents’ perception of adequacy of current business finances

The above indicates that the respondents who consider their enterprises to be
undercapitalized will most likely to actively seek credit or alternative sources of finance
to grow their businesses.

4.4.1 Knowledge of credit availability

Agricultural finance remains a major constraint to the growth of enterprises. Respondents
were asked whether they were aware of any sources of credit for their businesses.
Majority of the respondents (98 per cent) were aware of sources or availability of
agricultural finance while only 2 per cent were unaware. This is an indicator that credit
awareness is high due to a well developed financial system but the intended beneficiaries
are not able to access it.

4.4.2 Borrowing patterns

The bulk of the SMEs obtain credit for business growth and expansion and only a few
can do without borrowing from formal and informal sources. Most clients indicated (78
per cent) that they prefer credit in form of cash which is not linked to one enterprise but
the whole family as an economic unit. Respondents were asked whether they had ever
borrowed for business growth. The survey indicated that 89 per cent of the respondents
had borrowed from one source or another in order to grow their businesses. Only 11 per

33
cent of the respondents had never borrowed from any institution to support their
businesses.

4.5 Effect of lending procedures

Lending procedure determine the ease of access to agricultural finance from application
to disbursement of the funds. Complicated lending procedure and tiresome bureaucratic
requirements deter potential borrowers from accessing the much needed funds.
Agricultural finance thrives on the principles that more cash is preferred to less, cash
sooner is preferred to cash later and that less risky cash is preferred to more risky cash.
Respondents were interviewed on issues related to amounts borrowed sources of
borrowed funds in the study area and characteristics of lending institutions.
4.5.1 Amounts borrowed from financial institutions
Many of the respondents interviewed had borrowed severally from different financial
institutions and different loan amounts depending on the cash flow needs of the business.
The average amount obtained from financial institution was Ksh 30,000.However some
respondents had obtained as much as Ksh 300,000 from the Agricultural Finance
corporation and KREP Bank. Equity Bank emerged as an upcoming lender to small
enterprises having loaned 28 respondents out of the sample of 120 respondents
interviewed.
Equity bank was mentioned by the respondents as reliable lender due to its flexible
collateral requirements ease of disbursement and assessment of the owner as an economic
unit and not the individual enterprise. There is need therefore to develop agricultural
finance products that meet the needs of the clients. The Agricultural Finance Corporation
still remains an important lender to agro based enterprises disbursing large amounts for
enterprise expansion.
Table 5 shows the tally of the average amounts borrowed and the source.

34
Average amounts borrowed and sources
Bank Name Average loan Frequenc
taken in Ksh y
Equity Bank 50,000.00 28
Krep Bank 8,000.00 20
AFC 150,000.00 3
Masaku Farmers Sacco 30,000.00 21
Barclays Bank 150,000.00 9
KCB 100,000.00 6
Standard Chartered 250,000.00 1
Family Bank 25,000.00 8
Others 10,000.00 4
Average loan 42,000 100
Table 5: Average amounts borrowed and sources

4.5.2 Characteristics of lending institutions

The lending institutions terms and conditions determine the borrowers’ ability to access
funds from it. Respondents were asked to rate the most important characteristic of
lending institutions that made them to approach these institutions for agricultural finance.
Most respondents gave multiple reasons for choosing a particular financial institution.
Easy loan security system was cited as the main reason for choosing a certain lending
institution (43 per cent) while no restrictions on loan use was also cited as an important
factor (36 per cent).Simple application procedures is also a critical factor (35 per
cent).Fast processing of loan applications was also cited by 30 per cent of the respondents
as an important factor in choosing a financial institution to cater for the financial needs of
the borrower.

35
Characteristics of lending institutions affecting loan applicants

Any other

No restrictions on loan use

Loan size appropiriate to my needs

Easy loan security system

Simple application procedures

Fast processing of loan

Proximity to lender offices

0 5 10 15 20 25 30 35 40 45

Figure 6: Characteristics of lending institutions affecting loan applicants

4.6 Effect on lending procedures of AFC

The agricultural finance corporation as a government parastatal is mandated to provide
affordable agricultural finance to the farmers in the lower eastern districts of Machakos
Makueni and Kitui. The researcher sought to find out whether AFC has been fulfilling its
mandate. The results indicate that very few of the respondents have obtained credit from
AFC due to various reasons mostly based on lending procedures which are too complex
and the strict collateral requirements. Majority of the respondents (89 per cent) of the
respondents had not obtained credit from the organization. Out of the three who had
received financing from AFC each had received an average of Ksh 200,000 each with the
highest having received Ksh 300,000 from the organization.

The major reasons for not receiving financing from AFC was the requirement of land as
collateral which many do not have as the land they own is held communally. Further
many respondents were unhappy with the restriction on loan use as there was the
requirement that the applicant must have 25 per cent contribution in either cash or kind
which deterred many would be applicants. Respondents further indicated that there was
high competition for the loans and that there were too many cumbersome procedures
which discouraged borrowers. Secondary data obtained from the Agricultural Finance

36
Corporation shows that out of the 5000 loan applications made in 2007 they had only
managed to process 1235 applications out of which only 1100 were disbursed due to
technicalities such as the entrepreneurs ability to raise the 25 per cent required in cash or
kind for the applications made.

4.7 Policy suggestions regarding agricultural finance

Financial services are part of an interactive system of financial institutions, financial

infrastructure, legal land regulatory frameworks, and social and cultural norms.
Government has a role to play in establishing a favourable or policy environment,
infrastructure and information systems, and supervisory structures to facilitate the
availability of cheap agricultural finance.

Respondents felt that there was a need to change policies so that credit that was available
in the market became cheaper. Most entrepreneurs interviewed in the retrospect realized
that the so called cheap credit availed by some Micro finance institutions is actually
expensive as commercial banks loan and that these institutions applied a lot of pressure
on the individuals to pay up regardless of the business performance. Other major policy
changes that they wished made were in regard to flexible repayment plans to enable them
repay their loans in line with business profitability. Respondents also suggested a major
shift allowing payments after the cropping season as in the tea sector where the bulk of
the payments are dome after the final annual payment.

4.8 Summary of the findings

The majority of the respondents interviewed are male with a mean age of 39 years. Many
of the enterprises are sole proprietorship and the average entrepreneur has at least
secondary education. Many of the entrepreneurs had experienced growth as a result of
use of agricultural finance. The most notable increase was in sales volume at 40 per cent.
Business financing was viewed as one of the most challenging factors affecting business
growth with 72 per cent considering their capital resources inadequate.
Lending procedures of financial institutions are critical in determining the availability of
agricultural finance. This is exemplified by looking at the characteristics of the lending

37
institutions. Respondents cited easy loan security system (43 per cent), no restrictions on
loan use (36 per cent) and fast processing of loans (35 per cent) as characteristics that
determine the choice of a lending institution.
The respondents suggested policy changes including increased government role in
making agricultural finance more affordable and flexible repayment plans that take care
of seasonal production patterns.

38
CHAPTER FIVE: SUMMARY, CONCLUSIONS AND RECOMMENDATIONS

5.1 Introduction
The research was carried out to find out whether agricultural finance has played any role
or no role in MSE growth. The researcher obtained data from 120 respondents in six
administrative divisions of Machakos district. Data was analyzed and the findings based
on the study objectives and research questions of the study.

5.2 Summary
The modern entrepreneur has secondary school education. 76 per cent of the respondents
had above secondary school education while 93 per cent of the respondents have at least
primary school education. Only 7 per cent of the respondents had no formal education.
There was no evidence that borrowing is tied to the level of education of the entrepreneur
since almost all the entrepreneurs had ever borrowed finances at one stage or another to
meet their personal or business needs. However the highly educated individuals generally
have a higher access to alternative sources of investment finance due to their ability to
negotiate for alternative sources and the ability to follow the requirements that are needed
to obtain agricultural finance.

There are currently more males than female entrepreneurs in the study area with males
constituting 65 per cent and females taking 35 per cent. The study found that the
entrepreneur borrows largely on personal rather than on business basis. This is because
many entrepreneurs are running businesses that are sole proprietorship in nature with no
formal structures for their businesses. In this respect they have not developed a
comprehensives business plan for their businesses. Formal financial institutions are
currently lending to individuals under the personal loan system without the stringent
application procedures and elaborate collateral system requirements. Accessibility to
agricultural finances is still limited, the application procedures difficult and many
institutions still demand for collateral.

Microfinance institutions are filling this gap by presenting borrowing opportunities under
the group lending approaches. This approach prefers lending to an individual and

39
applying group pressure on the individuals to service their loans regardless of their
business performance. In this respect entrepreneurs continue facing problems of
inadequacy of capital for growing their businesses. The cost of credit is the main
determinant of choice of sourcing for finances for entrepreneurs with 60 per cent of the
entrepreneurs interviewed generally considering the current interest rates charged by
financial institutions as prohibitive and high.

When choosing financial institutions to approach for credit, 56 per cent of potential
borrowers would look at the interest rates charged by the lender from the findings of the
research. On establishing that they are relatively cheap in the market, then they would
consider the following issues in order of priority .30 per cent of the respondents would
first consider whether the lending institution would consider adjusting the repayment
premiums in this respect) therefore they would prefer MFIs which would penalize the
group members to cover for this shortfall rather than sell the individuals assets.32 per
cent of the respondents consider the speed of processing loans third is what collateral the
institutions would ask for then fourth whether the lender might consider rescheduling the
loan in times of misfortunes. Application procedures, proximity to offices or their officers
and size of loan available rank fifth sixth and seventh respectively. A significant minority
of entrepreneurs are happy with the way things are.

5.1Conclusions
The process of transforming traditional and subsistence agricultural production system
into commercial production system through the introduction of improved agricultural
technologies demands the availability agricultural finance. This is quite justified as the
prevailing subsistence agriculture can not produce surplus income beyond family
consumption and social obligations. The gap in time frame between the investment in
agricultural production and acquiring the income is another factor that calls for the
availability of agricultural finance.

40
Financial institutions offering agricultural finance must tailor their products to meet the
needs of their clients. There is need to develop lending policies that recognize that
financial services are part of an interactive system of financial institutions, financial
infrastructure, legal and regulatory framework, social and cultural norms. There is need
to simplify lending procedures and develop unique loan products that cater for the needs
of the entrepreneurs in the agricultural sector.

5.2 Policy Recommendations.

A favorable legal and regulatory framework should be established to facilitate availability
of agricultural finance. The government cannot ignore that MSEs in the agriculture are
crucial plank in meting its employment and development agenda. It should therefore
facilitate the growth of this sector by developing a vibrant lending industry.

5.2.1 Management recommendation

All the stakeholders must build and enhance the business skill of the entrepreneurs in
order to increase their growth potential .When the business capacity of the entrepreneurs
is high, the can visualize the direction which they want their business to grow in the
future. As a result, with increased capacity, they can be able to develop comprehensive
business plans to achieve that vision and as a result increase the demand for credit in the
market , improve productivity and employment and generally assist the government to
meet its development agenda. Treating the farm household as a financial unit integrating
a variety of economic activities, and basing lending decisions on repayment capacity
rather than how funds are utilized is also important to ensure more flow of funds to the
MSEs that require agricultural finance.

5.2.2 Institutional recommendations

Lending institutions must review their policies to focus on the vibrant MSE sector. The
current lending environment favours personal lending rather than business lending. As a
result the entrepreneurs are unable to access agricultural finance in levels that can satisfy
their business needs. This capital is therefore not tied to the performance of the business.

41
It is therefore increasingly evident that lending institutions must focus more on the MSE
sector to enable them achieve their financial needs.

In general terms as the size of the loans demanded by the business increases, there is a
concurrent increase in complexity of application procedures and a greater need for the
lenders to obtain collateral. At this stage, female entrepreneurs become generally
disadvantaged by the patriarchal system existing in the country that denied them
ownership of property. This level then demands that financial institutions that take
cognizance of this facts be encouraged in the policy and practice in order to improve the
lot of female entrepreneurs

5.3 Areas for further research

More research should be conducted on methods of information gathering on the
borrowers to reduce default rates and strengthening capacity of the agricultural finance
institutions in order to enhance credit delivery. Further there is need to carry out research
on how agricultural finance providers can adapt their services to become more flexible in
timing, amounts disbursed and repayment schedules – (bi monthly, quarterly, annual, end
of crop cycle and irregular repayment schedules) in order to provide the much needed
finance to the entrepreneurs

42
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Alila, P.O. (1991) “Informal and formal credit in rural Kenya, A case of Western Kenya
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Alila, P.O. and Rosemary Atieno. (2001). Emerging lessons in agricultural microfinance
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Aleke, D. (1994) “Credit to the informal sector approaches and models experienced in
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Aryeetey, E. (1996a). “Informal financial markets in Africa”. In M. Matthew and G.

Ngola, eds., Forging Links: Economic Research and Policy Making in Sub-Saharan
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Aryeetey, E. (1996b). “Rural finance in Africa: Institutional developments and access for
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April, Washington, D.C. Vol 2 No 6

Aryeetey E., Hettige, H., Nissanke, M. and Steel, W. (1997) “Financial market
integration and reforms in Ghana, Malawi, Nigeria and Tanzania”. World Bank
Economic Review, vol. 11, no. 2: 195–218

Aryeetey, E. and Udry, C. (1997) “The characteristics of informal financial markets in

Sub-Saharan Africa”. Journal of African Economies, supplement to vol. 6. Number1.

Aryeetey, E. and Gockel, F. (1991). “Mobilizing domestic resources for capital formation
in Ghana: The role of informal financial sectors”. AERC Research Paper No. 3.

Atieno, R. (1994) “Institutional credit lending policies and the efficiency of resource use
among small-scale farmers in Kenya”. Studien zür Ländlichen Entwicklung, number 46,
LIT Verlag Münster-Hamburg.

Braun von, Swaminathan, M. S.; Rosegrant, Mark, W. (2004). Agriculture, food security,
nutrition and the Millennium Development Goals (Annual Report Essay) Washington,
D.C.: International Food Policy Research Institute (IFPRI)

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Braverman, A. and Guasch, J.L. (1995). “Rural credit markets and institutions in
developing countries: Lessons for policy analysis from practice and modern theory”.
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Burns, eds (1998) Small Business and Entrepreneurship Hampshire Macmillan Business.

Casson, M. (2005). “Entrepreneurship and the theory of the firm”'. Journal of Economic
Behavior & Organization, Vol58 no 2, pg 327-348

Central Bank of Kenya (1998). Monthly Economic Review, Nairobi

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CGAP, (2005). “Scaling up poverty reduction: Case study for Microfinance”. World
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46
APPENDIX 1 QUESTIONNAIRE
A) BACKGROUND OF THE ENTREPRENEUR

1) Name (Optional)_____________________

2) Sex of the respondent Male ( ) Female ( )

3) Age of the respondent__________________

4) Marital status: Single ( ) Married ( ) Divorced ( )

5) Highest Level of education attained

No formal education ( )

Primary education ( )

Secondary education ( )

Polytechnic ( )

College/University ( )

6) Have you had any business related training?

A) Yes_______ b) No_____________

b) If yes specify the type of training and length of period in training?

B: BUSINESS PROFILE

1) Location____________________________________________________________

7) TYPE OF SME

a) Production ( )

b)Transportation ( )

c) Value addition ( )

47
d)Wholesaler ( )

d) Any other (specify)

8) Nature of business

a) Sole proprietorship__________ b) Partnership ____________

c) Limited Company_____________

d) Other (specify)____________________________________________________

9) When was the business started_______________________________________

C: EFFECT OF AGRICULTURAL FINANCE ON SME GROWTH

10) Has agricultural finance helped the business to change in the following ways
(Tick as appropriate)
A)Grow______________
B)Decline____________
C)remained the same___________
d) Do not know______________
11) If yes complete the table below (Tick as appropriate)
Area of growth At start Present position
Sales volume
Production
Profits
New employees
Increase in stock
New businesses
Others (Specify)
In your own assessment has
the demand for your
products/services increased
for the last 2 years?

48
D INFORMATION ON AGRICULTURAL FINANCE

12) Where did you get your seed capital?

a) Personal savings ( )
b) Loans from relatives ( )
c) Loan from a commercial bank ( )
d) Loan from agricultural finance corporation ( )
e) Sale of personal assets ( )
f) Others(Specify) ( )

13) Do you find yourself with adequate agricultural finance for your business?
A)Yes______________ b)No___________________

14) Are you aware of any other sources of agricultural finance for the business?

a)Yes______________ b)No___________________
15) Have you ever borrowed from any sources to grow and improve your business?
16) If NOT, why have you not borrowed?
a) The has not been a need for borrowing ( )
b) Borrowing is against my faith ( )
c) The borrowing conditions have been too stringent ( )

17) If YES indicate the source of finance and the amount

Source Amount

18) What exactly makes you prefer to borrow from the above institution?
a) Proximity of lender/offices ( )
b) Fast processing of the loan ( )
c) Simple application procedures ( )
d) Easy loan security system ( )
e) Loan size (Appropriate to my needs) ( )
f) No restrictions on loan use ( )
g) Any other (Specify)______________________

19) Have you ever been an unsuccessful loan applicant?

a)Yes______________ b)No___________________

49
20) If YES in above what is the reason for your failure to access these finances
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
__

21) In your opinion which is the most difficult issue regarding sourcing for business
credit?
a) None(am Happy with the way things are) ( )
b) Proximity to offices/officers ( )
c) Speed of processing of loans ( )
d) Application procedures ( )
e) Loan security system(collateral) ( )
f) Size of loan available for the business ( )
g) Inflexibility of loan repayment terms(specify) ( )
h) Interest rates ( )
i) Lender apathy in case of misfortunes/enterprise failure ( )
j) Others______________________________________

22) Have you ever obtained finance from Agricultural Finance Corporation (Machakos
Branch)
Yes_______________ No________________

If yes state amount

10,000-20,000 ( )
20,000-40,000 ( )
40,000-100,000 ( )
100,000-250,000 ( )
Over 250,000 ( )
If not state the reasons for not borrowing from AFC
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
______
22) In your opinion what should be done by the government or the lenders of agricultural
finance to make entrepreneurs access capital for growing and expanding their businesses?
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________

50
_______________________________________________________________________
______

23) What are your expectations from the government as an entrepreneur as regards the
provision of agricultural finance?
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
____

51
APPENDIX 2: WORKPLAN AND BUDGET
Work plan
PERIOD 2007/2008 ACTIVITY
May - September Writing of the project proposal and proposal defense
October. - November Collection of data
Dec – February Compiling of the research project and submission

Budget

ITEMS COST IN KSH.

Typesetting 8,000

Photocopy 4,000

Stationary 10,000

Binding 6,000

Travel and subsistence (90 days @ Ksh. 1000) 90,000

Miscellaneous expenses 15,000

TOTAL 133,000

TABLE OF CONTENTS
Declaration (ii)

52
Dedication
(iii)
Acknowledgements (iv)
Abstract (v)
List of tables (vi)
List of figures (vii)

CHAPTER ONE: INTRODUCTION..............................................................................1

1.1 Background 1
1.2 Statement of the research problem 2
1.3 Research objectives 5
1.5 Importance and justification of the study 5
1.6 Scope of the study 7
1.7 Limitations of the study 7
1.8 Conceptual framework 7
1.9 Summary 9
CHAPTER TWO: LITERATURE REVIEW...............................................................10
2.1 Introduction 10
2.2 Agricultural finance as a source of entrepreneurial finance 11
2.3 Constraints to agriculture sector growth in Kenya 12
2.4 Typology of financial institutions offering agricultural credit in Kenya 13
2.5 The Equity Bank model 14
2.6 Lending policies and their impact on SME financing 15
2.9 Financial institutions in Kenya 17
2.9 The role of AFC in the provision of entrepreneurial finance 19
3.0 Constraints of agricultural finance institutions 20
3.11 Supply and demand of entrepreneurial finance 22
3.12 Impact of entrepreneurial finance 22
3.13 Summary 23
CHAPTER THREE: RESEARCH METHODOLOGY..............................................24
3.1 Introduction 24
3.2 Research design 24
3.3Target population 24
3.4 Sampling and sample size 24
3. 5 Data collection methods 24
The main data collection instrument used in the study was a questionnaire.
Respondents who are literate were asked to fill tone or the same was used as an
interview schedule for illiterate respondents. This was administered in Kiswahili for
ease of understanding. 25
3.6 Data analysis 25
CHAPTER FOUR: RESEARCH FINDINGS..............................................................26
4.1 Introduction 26
4.2 Demographic characteristics of the respondents 26
4.2 Business profile of the SMEs 29
4.3 Effect of agricultural finance on SMEs growth 30
4.3.1. Sources of seed capital 31

53
 4.4 Perception of adequacy of business financing 32
4.5 Effect of lending procedures 34
4.6 Effect on lending procedures of AFC 36
4.7 Policy suggestions regarding agricultural finance 37
4.8 Summary of the findings 37
CHAPTER FIVE: SUMMARY, CONCLUSIONS AND RECOMMENDATIONS. 39
5.1 Introduction 39
5.2 Summary 39
5.1Conclusions 40
5.2 Policy Recommendations. 41
5.3 Areas for further research 42
REFERENCES 43
APPENDIX 1 QUESTIONNAIRE 47
APPENDIX 2: WORKPLAN AND BUDGET 52

54