Public Disclosure Authorized - World Bankdocuments.worldbank.org/curated/en/450281468311095149/pdf/690510BRI0P... · market prices for cotton fiber – they squeeze farm profits and

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Tajikistan Agriculture Sector: Policy Note 2 Cotton Sector Reform: Increased Competition, Improved Incentives and

Higher Production The Need for Reform The Tajik cotton sector is in crisis. Growth is slow relative to other areas of the agriculture sector, excessive debt has paralyzed attempts to revitalize production, and rural poverty is highest in cotton growing areas. The lynchpin of Tajik agriculture is impeding rather than enhancing agriculture sector growth and rural poverty reduction; and its contribution to export earnings and tax revenue is below potential. A recent analysis of the cotton sector clarified reasons for this crisis, and proposed a series of strategies on how it should be addressed. These findings were based on a comprehensive review of the cotton sector, and lessons drawn from cotton production in other parts of the world. The ensuing policy note summarizes these findings and outlines a coherent set of policy and program measures to intervene in the debt crisis which would result in higher cotton production, and increased farm incomes, export earnings and tax revenue. Constraints to Cotton Sector Recovery There are a number of opinions on the causes of the cotton sector’s predicament, not of all of which are well informed. For instance, there is a widespread belief that weak farm management, low world market prices and low consequent profitability are a major influence. A recent analysis, however, has shown that: first, cotton yields have been improving since 2001, suggesting that farm management is not a prime cause of the crisis; and second, while world prices have declined since 1995, the value of cotton production (at equivalent world prices) has exceeded production costs in every year since 1995, except 2002. Hence, there has been sufficient value in the cotton supply chain to make cotton production profitable throughout this extended period. Moreover, cotton producers in neighboring countries, who achieve similar yields, receive higher returns than Tajik producers. The real constraints to cotton sector recovery lie elsewhere. (1) The Cotton Debt Crisis Unpaid debts incurred by cotton producers are estimated at over $200 million, accumulated since 2001. This debt is a major constraint, for both the cotton sector and for broader agricultural development, yet public perception of the reasons for this debt is poorly informed. Responsibility is widely attributed to producers on the grounds that their borrowing has been excessive and inappropriate, and that cotton is unprofitable (as claimed above). Comprehensive analyses by the World Bank and Asian Development Bank show that this view is misleading. In fact, much of the current cotton debt is attributable to the exploitation of producers by investors. The contractual relationship between farmers, lenders and investors allows investors to manipulate prices of both farm inputs and cotton output, and, as a result, manipulates the income due to producers. This lowers producer returns and their ability to meet loan repayments, and has caused many producers to default on their loans. Once in default, producers become tied clients of the investors – who then exploit them further – resulting in the accumulation of debt. This situation has been aggravated by a small core of producers who refuse to repay their loans, despite having the means to do so. Thus, the cotton debt crisis is largely the result of illicit profit-taking by investors, and voluntary default by a small core of producers. This debt impedes cotton production because investors are refusing to provide further credit to indebted farmers, depriving them of the inputs they need for production. Other financial institutions are reluctant to lend to indebted cotton producers because they are unsure of the actual level of their debt. Cotton debt has also become a constraint to land reform. Farmers who would like to establish individual dehqon farms are unwilling to proceed because they risk being assigned a crippling share of debt, which they would be unable to repay. Uncertain of their future, cotton farmers are also reluctant to invest in the rehabilitation of irrigation and drainage systems in order to control the salinization which is reducing yields.

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A debt resolution process, that was recently initiated, will address the immediate debt problem, and allow the cotton sector to move forward, but it will not resolve the underlying problems which caused it in the first place. As discussed below, the underlying causes of the debt crisis and the real constraints to cotton production are the lack of competition in processing, marketing and credit; the low consequent incentives for producers to raise output; inappropriate government intervention; and the lack of political will to remedy these problems. Simple debt resolution, without solving these larger issues, could easily lead to a further accumulation of debt. (2) Inadequate Competition

Inadequate competition among the enterprises responsible for ginning, marketing and credit is the fundamental constraint to cotton sector development. In theory, the private sector gins and investors who process and market cotton provide an appropriate base for competition in the cotton sector. They are numerous and well dispersed and no single operator dominates the market. In practice, local governments coerce producers to work with specific gins and investors, based on their ability to appropriate land in the event that it is “misused.” This creates a system of local and regional monopsonies. Local government control of the movement of cotton further enhances their ability to support these monopsonies. The resultant structure lowers producer incomes, reduces sector revenue and deprives government of much needed tax revenue.

Assured of adequate raw material, the ginneries have no need to compete by raising outturn rates or improving efficiency. They also appropriate most of the byproducts of cotton processing, which should either be paid for or returned to the producer, further reducing producer incomes. Forced to supply a specified ginnery and unable to take their seed cotton elsewhere, producers have no choice but to accept this situation. Investors have an even tighter hold on cotton producers, and an even bigger impact on sector output. By charging above market prices on farm inputs and paying below market prices for cotton fiber – they squeeze farm profits and limit the ability of farmers to generate working capital from their own resources and/or from other lenders. Loss-making farmers, unable to repay their debts, become tied clients of the investors because their debts are secured by crop liens. Even those producers without debt find it difficult to escape the local investor’s monopsony, first because of local government pressure to transact with local investors’; and second because other financial institutions have yet to establish themselves as significant, alternative sources of working capital. (3) Low Producer Incentives

Incentives for producers to raise output are low. Not only do they lack the resources to optimize production, they also receive an inadequate share of world market prices. The monopsony position of investors and cotton gins, as described above, is the prime cause of low producer incentives as it leads to the following problems:

• Poor access to farm inputs as a result of above-market prices, low input quality, and late input delivery by the investors.

• Low ginning efficiency, poor storage facilities and inappropriate baling and parceling procedures1; and the failure of cotton gins to compensate producers for the by-products of cotton processing all significantly reduce both producer prices and farmer share of total income from the cotton value chain.

• Lack of transparent marketing procedures by investors.

Even where producers are willing and able to pay above market prices for additional (low quality) fertilizer, their ability to use it effectively is limited when it arrives too late. They are also aware that the practices of ginneries and investors provide little incentive to raise quality and preclude a fair price for seed cotton.

1 Poor storage facilities for seed cotton lead to undue mixing of different quality offerings, mixed qualities of cotton fiber are aggregated into shipment parcels, and low quality bale bands lead to discoloration. These practices reduce farmer incentives to improve seed cotton quality.

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Better prices for seed cotton would certainly improve producer incentives to raise output, but they are in a weak bargaining position to change this situation. While tacit government support for monopsony practices precludes immediate change, few producers would currently be able to take advantage of a more open production, processing and marketing environment. Their management skills are weak; they have little or no accurate information on the quality of their cotton, equivalent world prices at the time of sale, outturn rates, input prices etc; and they have limited capacity to improve their access to this information and/or ensure that it is accurate. Current systems for grading, weighing and certifying cotton further reduce producer prices and production incentives. • Grading is based on the old Soviet system which adjusts solely for color, with no discounts for

trash or nep content. Trash and nep content are key pricing parameters for international traders, however, and a critical element of international (USDA) grading systems. Current quality and market prices are lower as a result, because producers have little direct incentive to raise quality; and the inability to classify according to international systems precludes access to higher value grades. Export returns and so producer prices are compromised as a result.

• Weighing and grading are performed by licensed inspectors employed by the ginneries and exporters themselves, with minimal transparency and no independent monitoring. This further increases their opportunities to exploit producers.

Official policies and mechanisms for pricing cotton, and levying export taxes also reduce returns, not only for producers but also for exporters. • Comparison of the official pricing formula with similar formulas used in other countries shows

that the adjustments used to convert the export (CIF) price back to a FOB price are too high, depriving the sector of legitimate revenue.

• Moreover, government applies this formula as a maximum, set price – depriving exporters of the ability to sell at higher prices when buyers are prepared to pay more.

• There is inadequate flexibility in the terms of sale and delivery. Exporters must fix their prices at the date of receipt of pre-payments, which prevents them from hedging their price risks, and/or taking advantage of favorable changes in market prices.

• An inflated base is used for levying export taxes (export returns, plus associated processing and marketing costs); further depriving exporters of legitimate revenue and the opportunity to pass this revenue back to producers. Processing and transport costs should be excluded from this base.

Finally, producer incentives to raise output are further compromised by the following broader issues: • An inadequate supply of high performing seed varieties, due to the breakdown of state seed farms

on the one hand and excessive restrictions on the use of imported seeds on the other. Many farmers have received no new seed since independence and are obliged to use seed from the previous harvest. Genetic potential, and the capacity to increase yields, has declined as a result. Cross-contamination of medium and long staple varieties is also reducing the uniformity of baled cotton fiber, thus reducing quality and price.

• Increasing salinization of arable land due to the general deterioration of irrigation and drainage infrastructure and unclear designation of responsibility for the maintenance of secondary irrigation and drainage canals.

(4) Inappropriate Government Intervention The following elements of current government intervention in the cotton sector inhibit sustainable growth. • Cotton production quotas are still applied unofficially, despite having been officially terminated.

In cotton growing areas, local government authorities continue to coerce producers to use 70% of their irrigated, arable land for cotton on the basis of official annual production plans. Output falls as a result, because farmers produce in response to coercion rather than the positive incentive created by favorable prices and the prospect of favorable returns.

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• This coercion also distorts land use patterns and resource use, precludes the use of crop rotations which would raise soil fertility and cotton yields, and limits the production of other profitable crop and livestock enterprises.

• Local government control of cotton movement reinforces the monopsony position of local ginneries and investors, and severely reduces the opportunities for competition.

• The Government has tacitly accepted the local monopsonies established by ginneries and investors, rather than promoting competition between them.

• The Government also tacitly supports the current certifying mechanism, which allows ginneries and exporters to self-certify the weighing and grading of cotton fiber; rather than introducing a transparent, independent certification mechanism.

• Government unwillingness to reform the seed industry further prejudices cotton production, by depriving farmers of high potential imported seed varieties.

These interventions serve to distort a market economy, and reflect a continued reluctance to move away from the institutions of command economic systems. Sustainable increases in cotton production will only come from measures that encourage farmers to increase output, rather than through coercion, and which lead to more sustainable patterns of land use for Tajikistan’s limited arable land. Given higher producer prices and the freedom to choose how much land to allocate to cotton, farmers are more likely to allocate their land, labor and capital in a manner which improves both incomes and the sustainability of land use. Policy and Program Responses Revitalization of the cotton sector requires direct responses to the constraints described above. Some of these measures require non-contentious, technical changes to existing policies and procedures, but will need strong donor support to ensure that appropriate new institutions are created to implement them. Others, such as increased competition, require significant changes to existing policy and will not succeed without strong political will to overcome deep-seated vested interests. (1) Resolution of the Debt Crisis Government and donors have now established an Independent Commission to review outstanding cotton debts on a case by case basis, in order to determine: (i) how much is actually owed; (ii) the assignment of this debt to farms and/or land parcels, and (iii) the oversight of eventual debt resolution. Once agreement between producers and investors has been reached, producers should be free to contract with any enterprise they choose in order to finance, process and market their cotton. Strong leadership is needed to ensure that this commission acts independently, beyond the influence of powerful vested interests in both the public and private sectors. Effective leadership is also needed to balance the need for rapid implementation of the debt resolution process against the pressure to support quick but inappropriate solutions. (2) More Appropriate Government Intervention Rationalization of the policies and institutions which regulate the cotton sector is essential, not only to raise cotton production and profitability, but also to realize sector-wide benefits from other elements of reform. More appropriate roles for government are outlined below, starting with a the following activities: • Halt the use of production targets, however defined, and terminate local government control of

producer decisions on how they use their land. • Terminate local government control of where producers obtain credit and gin their cotton. • Terminate local government control over the movement of cotton. • Terminate the ability of local government to appropriate land for “misuse,” and limit public

powers of appropriation to land required for public works, accompanied by full compensation. • Privatize state supported seed farms.

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These policies are instruments of central planning, which have no place in a market economy. Government has different responsibilities in a market economy. In this context its involvement in the following issues should be modernized and strengthened: • Introduce a new cotton grading system based on the USDA classification system; • Establish an independent, internationally certified grading agency which operates with full

transparency in the interests of producers, processors and buyers. • Reform existing seed regulations to allow the import of improved varieties of seedcotton, and

establish appropriate mechanisms for monitoring the quality of this seed and providing adequate information to users.

Together these measures are designed to increase competition rather than suppress it, and to rationalize and support government provision of legitimate public services. (3) Increase Sector Competition and Efficiency and Raise Producer Returns Reform of the policies which protect local monopsonies and restrict competition will lead to a dramatic change in sector efficiency and output. The gins will need to improve their outturn rates and general efficiency in order to offer higher prices to producers, and remain competitive. Investors will also have to compete, by improving the price and timeliness of input supply and providing more favorable credit terms. More can be done to increase competition, however, further increasing sector efficiency and producer returns. • Encourage the growth of commercial input suppliers and other sources of credit. New forms of

contractual relationships between producers and lenders should also be developed, which employ collateral substitutes other than crop liens, and allow producers to repay their loans with cash (after selling the cotton themselves).

• Introduce regular auctions of baled cotton by the Tajik Universal Goods Exchange (TUGE) as an

additional sales outlet for producers and processors, not only to increase competition among potential buyers, but also to provide timely information on current market prices. The issue of independently certified quality certificates will encourage participation by international buyers in the TUGE auctions, further increasing competition.

• The increased transparency of the new grading system and the price information provided by the

TUGE auctions will also reduce the ability of ginneries and exporters to widen operating margins by paying below market prices.

• Train producer groups to manage their own input supply, processing and marketing, as an

alternative to reliance on the investors. Producer returns and incentives to raise output will also be improved by the following changes to the current mechanisms for setting prices and levying export taxes: • Revise the current official price formula by reducing the current parameters which adjust CIF

prices to FOB prices, and using this formula to set minimum rather than maximum prices; • Allow exporters more flexibility to determine prices and terms of sale, including the ability to

hedge price risk. • Levy export taxes on an ex-works price for cotton fiber, excluding the costs of processing and

transport for export. Government, farmers, processors and exporters will all benefit from these reforms, through higher prices and profits for farmers and exporters, higher tax revenue for government and higher export revenue.