Early contracting: the solution to coffee farmers’ credit issues?

  • In certain coffee-producing countries, interest rates for agroindustrial loans can exceed 30% per annum
  • Early contracts can give lending institutions the assurances they need to provide more favourable borrowing terms
  • However, early contracts entail a commitment before coffee is harvested, exposing both buyers and sellers to risk

FOR MANY smallholder coffee farmers, an inability to access affordable credit has reached a breaking point, and minimal cash flow support from other actors in the supply chain is leaving them with limited options.

Cash flow is crucial for farmers as it allows them to reinvest in their farms, maintain or improve crop quality, and generally navigate the cyclical nature of coffee production. It’s essential for both short-term survival and long-term business viability. Without pre-financing options, they may struggle to meet these needs and could accumulate debt.

Coffee producers struggle to access affordable financing for several reasons. Persistently high interest rates have made formal lending institutions expensive and almost untenable for small-scale farmers; only a small number of traders will assist with cash flow issues; and a lack of roaster pre-payment arrangements leaves them with nowhere else to turn.

At the same time, when foreign currency depreciates against the US dollar and foreign reserves decline, it leads to higher borrowing costs. According to William, this can sometimes exceed 5% of what we see in the West. This makes financing their crop more expensive for producers.

“Credit is becoming more expensive for everyone – not just producers,” says William Hobby, founder and manager of Maverick Coffee Trading. “Government central banks are hiking interest rates as a knee-jerk response to bring down the rising rate of inflation we are seeing globally.

“However, coffee farmers see their rates rise even further because of some perceived risks on the part of the financiers, such as corruption and political instability.”

What is early contracting?

To address these challenges, some contractors advocate for early contracting. This involves coffee buyers and sellers entering into contracts for the purchase and sale of coffee well in advance of its actual harvest and delivery; and agreeing on purchase terms such as price, quality, and quantity.

It’s important to note that this is different to pre-financing – where traders or roasters actually pay for their coffee early to help liquidate the process for farmers. Early contracting, sometimes called “forward booking”, essentially “locks in” a price ahead of harvest and reserves a certain amount of coffee for a roaster, without advance payment.

This approach can be good for roasters because they can secure a low price if the market dips. It can also benefit them because they will know what price they are paying for coffee ahead of time, stabilising their costs and helping them to establish a more realistic budget. Additionally, reserving coffee potentially gives roasters access to fresh crop – essentially helping them acquire better-quality lots.

At a time when roasters’ operating costs are high and traders are battling liquidity problems, the ability to secure coffee at a known price but delay payment of it is understandably appealing – which is why it’s becoming a favoured option above pre-financing for some.

Better borrowing terms for farmers

Crucially, early contracting also helps farmers access more affordable finance with better borrowing terms because they can show the forward purchase agreement to their lender, and that can act as collateral for credit.

“It’s a commitment between a buyer and seller of coffee for a specific quality, quantity and shipment period at a predetermined price either fixed outright, or ‘floating’ as a differential above or below the NYC terminal market,” says William. “With these contracts in hand, the possibility of having them financed by a classic, or coffee-specific financial institution increases considerably.”

“Early contracting gives the lender forward visibility into a producer’s business, and that visibility translates into less risk,” says Florian Schaffner, CFO and head of data at Algrano. “The earlier you contract, the earlier you can use it as collateral.”

By securing a loan against a contract, producers alleviate liquidity constraints, reducing the need to quickly sell coffee at lower prices. Even if their entire crop isn’t included in the agreement, early contracting gives them the time and resources needed to find buyers who will pay higher prices – most likely on the international market.

Coffee farmers could benefit from early contracting

Locked in

But if early contracting has so many advantages, why isn’t everyone doing it?

Early contracting carries an inherent risk for buyers. As it typically occurs before coffee is harvested and evaluated for quality, there’s a chance it may not meet their expectations or requirements, leading to potential disputes, renegotiations, and supply chain disruptions. However, this is no different to pre-financing.

It can also carry risk for producers. Crop failure is becoming more common in the face of climate change and increased frequency of diseases, and this has the potential to impact the ability of farmers to fulfil their obligations.

Committing to an early contract could also mean that producers miss out on selling their coffee at higher prices if the market takes a sudden upturn.

This situation can also impact buyers, possibly resulting in “strategic defaulting.” This is where a producer who has entered into an early contract deliberately fails to meet their contractual obligations – typically driven by the expectation of securing a higher price for their coffee elsewhere due to changing market conditions.

And at a time of significant market price fluctuations, this risk becomes more immediate.

As an alternative, early contracts can commit buyers and sellers to a volume of coffee, leaving the price to be decided at a later date. However, this approach still carries a level of risk.

“You can contract on a differential basis where you commit to a volume today where both sellers and buyers have time to lock in a price,” says Florian. “But uncertainty remains on what the final price will be because it’s not fixed. And if you fix the price, you run the risk of strategic defaulting – it’s a fine balancing act.”

Trusting trading relationships

In spite of the risks, early contracting can clearly bring benefits to both buyers and sellers. It’s an approach that requires each side to have a level of trust, which is why an established long-term trading relationship between buyer and seller can be beneficial. Not only can buyers build up a familiarity with the producer’s coffee and have a level of quality assurance, but a relationship based on trust reduces the risk of a strategic default.

This is why it’s often importers who have an established footprint at origin who advocate for early contracting, rather than roasters whose focus is understandably often elsewhere other than building trust with producers.

Ultimately, as interest rates are expected to remain high and roasters continue to battle rising costs, early contracting can offer a real solution to introduce liquidity into the system and help mitigate producers’ credit issues. All it requires is what the coffee industry needs a few more of – long-term trading relationships built on trust.

Coffee Intelligence

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