THE WORLD BANK THE WORLD BANK Washington, D.C. The Dynamics of Vertical Coordination in Agrifood Chains in Eastern Europe and Central Asia Environmentally and Socially Sustainable Development (ECSSD) Europe and Central Asia Region The Dynamics of Vertical Coordination in Agrifood Chains in Eastern Europe and Central Asia edited by Johan F. M. Swinnen CASE STUDIES Working Paper No. 42 0615783cov.qxd 3/15/06 5:29 PM Page 1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized
Transcript
THE WORLD BANK
THE WORLD BANKWashington, D.C.
The D
ynam
icsof Vertical C
oordination
in A
grifood Ch
ains
in Eastern
Europe and C
entral A
sia
Environmentally and Socially Sustainable Development (ECSSD)Europe and Central Asia Region
The Dynamics of Vertical Coordination
in Agrifood Chains in Eastern Europe
and Central Asia
edited by Johan F. M. Swinnen
C A S E S T U D I E S
Working Paper No. 42
0615783cov.qxd 3/15/06 5:29 PM Page 1
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
Pub
lic D
iscl
osur
e A
utho
rized
THE WORLD BANK
Environmentally and Socially Sustainable Development (ECSSD)Europe and Central Asia Region
The Dynamics of Vertical Coordination
in Agrifood Chains in Eastern Europe
and Central Asia
edited by Johan F. M. Swinnen
C A S E S T U D I E S
Working Paper No. 42
37050
This volume is a product of the staff of the International Bank for Reconstruction andDevelopment/The World Bank. The findings, interpretations, and conclusionsexpressed in this paper do not necessarily reflect the views of the Executive Directorsof The World Bank or the governments they represent. The World Bank does notguarantee the accuracy of the data included in this work. The boundaries, colors,denominations, and other information shown on any map in this work do not implyany judgment on the part of The World Bank concerning the legal status of anyterritory or the endorsement or acceptance of such boundaries.
The material in this publication is copyrighted. Copying and/or transmitting portionsor all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development/The World Bankencourages dissemination of its work and will normally grant permission to repro-duce portions of the work promptly.
For permission to photocopy or reprint any part of this work, please send a requestwith complete information to the Copyright Clearance Center, Inc., 22 RosewoodDrive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470,http://www.copyright.com/.
All other queries on rights and licenses, including subsidiary rights, should beaddressed to the Office of the Publisher, The World Bank, 1818 H Street NW,Washington, DC 20433, USA, fax 202-522-2422, e-mail [email protected].
Acknowledgments v
Acronyms and Abbreviations vii
C H A P T E R
1 Introduction 1Johan F. M. Swinnen
2 A Comparative Study of Agrifood Chains in Moldova,Armenia, Georgia, Russia, and Ukraine 5John White and Matthew Gorton
3 Vertical Integration in an Agroindustrial Complex: Agrofirms and Agroholdings in Russia 45Ekaterina A. Gataulina, Vasiliy Y. Uzun, Alexander V. Petrikov,and Renata G. Yanbykh
4 Vertical Coordination in the Cotton Supply Chains in Central Asia 73Marc Sadler
5 Foreign Investment and Vertical Coordination in Supply Chains in Europe and Central Asia: Lessons from Dutch Agrifood Companies 115Siemen van Berkum and Jos Bijman
iii
Contents
6 A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia 135 Liesbeth Dries and Nivelin Noev
7 Restructuring and Vertical Coordination in the Dairy Sector in Romania 167 Siemen van Berkum
Contents
iv
Acknowledgments
v
The case studies were financially supported by the World Bank under theESW “The Dynamics of Vertical Coordination in ECA Agrifood Chains:Implications for Policy and Bank Operations”; and by the Bank-Netherlands Partnership Program (BNPP) with the grant “VerticalCoordination in ECA Agrifood Chains as an Engine of Private SectorDevelopment: Implications for Policy and Bank Operations.”
Steven Jaffee, Richard Henry, Csaba Csaki, and Ali Mansoor reviewed thestudy proposal and provided very useful comments and suggestions.William Sutton, Maria Amelina, and Maurizio Guadagni advised on thepreparation of the study. Mark Ludwick, Karin Rosskopf, Gail Lee, andMaria Gabitan provided editorial assistance. Benoit Blarel, sector man-ager, and Laura Tuck, ECSSD director, provided much appreciated en-couragement and critical guidance throughout the duration of the study.
Acronyms and Abbreviations
vii
ADB Asian Development BankAFER Agency for Foreign Economic RelationsAIB AgroinvestbankBNPP Bank-Netherlands Partnership ProgramCARs Central Asian RepublicsCEE Central and Eastern European CountriesCIS Commonwealth of Independent StatesECA Europe and Central AsiaEU European UnionFAO Food and Agriculture OrganizationFBC Foreign Business CompaniesFDI Foreign Direct InvestmentFIP Farm Improvement PlanFSU Former Soviet UnionHVI High Volume InstrumentationIFDC International Fertilizer Development CenterIFI International Financial InstitutionIMF International Monetary FundISPA Instrument for Structural Policies for Pre-AccessionNYCE New York Cotton ExchangeRAS Rural Advisory ServicesRF Russian FederationSAPARD Special Accession Programme for Agriculture and Rural
DevelopmentSIPU Swedish Institute for Public AdministrationTUGE Tajik commodities exchangeUPS UzPakhtaSanoatishUSDA United States Department of AgricultureVC Vertical CoordinationWB World Bank
IntroductionJ O H A N F. M . S W I N N E N
1
A major problem in the Europe and Central Asia (ECA) agricultural sectorand rural areas during the transition was the breakdown of the relation-ships of farms with input suppliers and output markets. The simultane-ous privatization and restructuring of the farms and of the up- anddownstream companies in the agrifood chain have caused major disrup-tions. The result is that many farms and rural households face seriousconstraints in accessing essential inputs (feed, fertilizer, seeds, capital,etc.) and in selling their products. The problems are worsened by the lackof public institutions necessary to support market-based transactions,such as for enforcing property rights and contractual agreements.
In the absence of appropriate public institutions, private contractualinitiatives, often from large food and agribusiness companies, are emerg-ing to overcome these obstacles. Large traders, agribusinesses, and foodprocessing companies, often as part of their own restructuring or follow-ing foreign investment, start contracting with the farms and rural house-holds and provide basic inputs in return for guaranteed and qualitysupplies. This process of interlinked contracting is growing rapidly inECA agriculture and rural areas.
These private contract initiatives can be quite substantial. Empirical evi-dence indicates that they include farm management assistance, extensionservices, quality controls, farm input assistance programs, trade credit, andeven bank loan guarantees. The programs generate important improve-ments in the credit situation of the farms, as they contribute directly to
1
WP 42 Case Studies
2
improved access to finance (e.g., through trade credit), and indirectly asthey improve contracting farms’ access to loans from banks or externalfinancial institutions (through loan guarantees, enhanced farm profitabil-ity, and improved future cash flows). Arguably, the transition disruptionsand contract enforcement problems have been even more severe in therural credit markets than in other markets. In combination, the direct andindirect effects of the farm assistance programs create important benefitsfor the farms and households supplying to these companies; they lead toimproved input access, productivity, product quality, and market access.
There is increasing evidence that these processes have been growingand have been an engine of productivity growth in the agrifood supplychains of ECA countries. Yet, several important issues are unresolved onthis process of vertical coordination. Specifically, related to the efficiencyimplications, remaining questions include: Under which conditions doessuch a process emerge spontaneously? Which are the key policy factors inthis process? What is the role of foreign direct investment (FDI) in thisprocess? What triggers beneficial spillover effects to other companies andsuppliers? How general are these developments? Are they limited to cer-tain subsectors? In which sectors is this process more likely to emerge?Does an optimal model of contracting exist? Are there ECA specific fea-tures of these vertical coordination programs?
Concerning equity implications, key questions include: Does this processof vertical contracting lead to the exclusion of small farms? Does theemergence of contracting with downstream companies lead to rentextraction of farmers by creating dependency?
Finally, several policy issues need to be addressed. Is it sufficient for thegovernment to create the right environment for private investments inthe food industry and agribusiness in order to set this process in motion?If so, which are the key policy factors in this process? How can governmentpolicies or interventions contribute to the emergence of these institutionsand to desirable efficiency and equity effects?
These questions were the focus of a major study organized by theWorld Bank. The objective of the study was to analyze vertical coordina-tion (VC) in agrifood supply chains in ECA and to identify options forimproved policies, institutions, and investments which Governmentscould make, and which the World Bank could support, in order to improvelinks in the agricultural marketing and processing chain and increaseaccess of farmers to input and output markets. This is especially impor-tant in those countries where contractual arrangements are slow to develop.It is also important if farmers are to be lifted out of subsistence farmingand into a modern agrifood economy.
An important input into this study and its conclusions is a series ofempirical case studies, implemented in 2003 and 2004 in ECA countries,that considered a variety of sectors. The case studies analyze vertical coor-dination in dairy, cotton, fruits and vegetables, sugar, wine, and so forthand analyze impacts of investments by processors, retailers, and financialand industrial groups in the food chain in Central Europe, South EasternEurope, Russia, Ukraine, the Caucasus, and Central Asia. In addition, the case studies include interviews with managers of international com-panies who have invested in this region.
This report presents several of these case studies and survey reportsimplemented across countries and (sub)sectors of the agrifood supplychains in ECA. The case studies provide detailed information and analy-sis and are a rich source of insights in the processes of vertical coordina-tion that are taking place in the ECA region and their effects. The mainreport of the study is published separately under the title “The Dynamicsof Vertical Coordination in the Agrifood Supply Chains of the TransitionCountries of Eastern Europe and Central Asia: Implications for GovernmentPolicy and Bank Operations.”
Introduction
3
A Comparative Study of Agrifood Chains in
Moldova, Armenia, Georgia,Russia, and Ukraine
J O H N W H I T E * A N D M A T T H E W G O R T O N †
5
EXECUTIVE SUMMARY
Senior executives from agrifood enterprises in five countries that belongto the Commonwealth of Independent States (CIS) were surveyed con-cerning their use of contracting, contract support measures, enterpriseperformance, and the quality of the raw materials sourced from farmers.The study was designed to provide greater insight into the use andimpacts of contracting and contract support measures. The design of thestudy was governed by a World Bank concept note that identified a num-ber of unresolved issues surrounding the conditions under which con-tracting emerges, its impacts, linkages with foreign direct investment(FDI), and whether it leads to the marginalization of small farms.
2
*Faculty of Social Science and Business, University of Plymouth, UK. E-mail:[email protected].
† School of Agriculture, Food and Rural Development, University of Newcastle,UK. E-mail: [email protected].
Report prepared for The World Bank (ECSSD) project on “Vertical Coordinationin ECA Agrifood Chains as an Engine of Private Sector Development: Implicationsfor Policy and Bank Operations” (Contract No. 7615040/7620016).
The authors would like to acknowledge the efforts of country experts who col-lected the data for this research. Grateful thanks are therefore extended to NairaMkrtchyan and Vahe Heboyan (Armenia), Alexander Didebulidze (Georgia), MikhailDumitrashko and Anatolie Ignat (Moldova), Alexander Yermolov (Russia), andAlexander Skripnik (Ukraine).
A total of 60 enterprises were interviewed, 12 in each country. Purposivesampling was used to ensure that respondents met certain criteria,namely, that they were senior executives of agrifood industry enterprises,their enterprises had made recent capital investments in the sector, andthey were involved in contracting with farmers. The sampled firms hadan average turnover and employment of US$3.6 million and 309 full-time equivalents, respectively. The findings of the study are summarizedbelow with reference made to the relevant tables in the main body of thereport.
Contracting between processors and farmers became more prevalentover the period 1997–2003 in the cases studied. The use of contracts withboth small and large farmers grew, but growth in the latter case has beengreater. By 2003, more enterprises had contracts with larger farms thansmaller farms, but the reverse was true for sourcing from spot markets whererelationships with small farmers are more prevalent. The use of other agents,such as traders and intermediaries, as a source of supply has also increased.
As part of a contract, a processor may provide support measures, suchas credit, physical inputs, and technical advice, to farmers. In the sample,38.3 percent of processors offer credit to at least some of the farms thatsupply them. The corresponding figure for physical inputs is 33 percent.On average the processors that offer credit and physical inputs do so toapproximately one half of the farms that supply them and around 60 per-cent of processors have a minimum size of farm below which they do notoffer such support. Investment loans and machinery are far less com-monly granted to farms and, when they occur, are offered on a moreselective basis. Processors report that they rarely discriminate againstsmaller farmers in providing agronomic support, guaranteed prices, orprompt payments.
While several contract support measures are provided on a selectivebasis, overall their use is spreading to a larger number of farms. Only in aminority of cases is the mean percentage of farms to which a contract sup-port measure is currently offered lower than in the first year that the mea-sure was introduced by the processor. The measures that are now moreselectively offered are investment loans, harvesting and handling support,and prompt payments. The impact of the first two measures has not beenas successful as often hoped and the change in the number of farms withaccess to the latter two support measures has been small.
Interviewees were asked to assess the mean impact of each contractsupport measure employed on farm yields and quality of output (mea-sured as the percentage change in farm output reaching higher and basicstandards as a result of the contract support measure). The mean impactacross all contract support measures employed was a rise in farm yields
WP 42 Case Studies
6
by 9.1 percent and an average increase of 9.5 percent in the amount offarm level output reaching higher [extra class / premium class] standards.The impact on the amount of farm level output reaching basic standardswas less because most agricultural output was judged to be reaching thislevel prior to the implementation of contract support. The measures withthe greatest impact on yields were veterinary support, physical inputs,and specialist storage (especially cooling equipment in the dairy sector)and a set of market measures (prompt payments, guaranteed prices, andmarket access). In terms of raising quality, quality control support, vet-erinary support, physical inputs, market access, and prompt paymentshave had the greatest impact. The returns to investment loans andmachinery have been relatively poor.
The majority of contract support measures have been introduced since1999 and for proactive reasons. Proactive reasons were classified as a moti-vation to enhance product quality, improve competitive offerings, andmeet consumer demand. There is no relationship between year of intro-duction and the impact on yields or farm level quality. However, the meanimpact of contract support measures introduced for proactive reasons hasbeen significantly greater than where measures have been introduced reac-tively (matching the support of competitors, protecting supply base). Thissuggests that the impact of contracting is not uniform or related to specifictime periods but is greatest for first movers.
By analyzing changes in the proportion of agricultural raw materialssupplied to processors that fell into premium, acceptable, and rejected/unusable categories, changes over time in the quality of farm level outputcan be assessed. The majority of processors (61.7 percent) saw an improve-ment in quality over the period 1997–2003; 11.7 and 26.7 percent saw nochange or worse farm product quality, respectively. Those that saw anincrease in product quality procured a significantly greater proportion ofagricultural raw materials using contracts and also employed a significantlygreater number of contract support measures.
Many have expressed a concern that the spread of contracting leads tothe marginalization of small farms. Marginalization can be viewed in twomain ways: the number of small farms dealt with and the terms andconditions of those relationships. Regarding the first aspect, from the sur-vey data there is little systematic evidence of marginalization: only justover one in five processors (21.7 percent) reported that they were deal-ing with fewer small farms (defined as less than 1 hectare or five cows inthe dairy sector) in 2003 than 1997. In contrast, 55 percent are dealingwith more small farms, although the share of total raw materials sourcedfrom small farms has fallen in just over one third of processors sampled.As demand has stabilized and increased in the CIS, processors have looked
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
7
to source more agricultural raw materials, and small farms have not, inthe vast majority of cases, been excluded. However, their terms and con-ditions as evidenced by the selective granting of contract support mea-sures may be worse.
The results highlight more positive impacts of FDI than negative. FDIfirms have made significantly greater capital investment (both as a totaland per employee). Most of this investment has been in upgrading pro-cessing facilities. Western FDI firms also employ a significantly greaternumber of contract support measures and, maybe somewhat surprisingly,source a significantly greater proportion of agricultural inputs from smallfarms. All but one of the 13 firms that have reduced the number of smallfarm suppliers are owned by domestic private investors.
Exporting is associated strongly with FDI. As a result there is a highdegree of overlap between the characteristics of exporters and FDI firms.Exporters have made greater capital investments and source a greater pro-portion of the agricultural raw materials from small farms and signifi-cantly less from other agents. Exporters do employ a greater number ofcontract support measures.
Few processors have specific plans to reduce the number of farmerswith whom they deal. About one third expect to be dealing with fewerfarmers in the future, but this is largely accounted for by farmer-led ini-tiatives (switching to different agricultural activities and exiting fromsmall-scale agriculture as macroeconomic prospects recover).
The most widespread problems faced by processors are ineffective orinappropriate market governance, problems with procuring agriculturalraw materials, and meeting the challenge of the greater internationaliza-tion of markets. Supporting internationalization was identified as aninvestment and policy priority, particularly because currently exportingis, with a few notable exceptions, largely limited to FDI firms. Internationaltechnical assistance and advice on exporting were seen as particularlyimportant given that such specialist support typically cannot be obtainedfrom local educational establishments.
A breakdown of results by country and sector is provided in theannexes. When interpreting the results, the small size of subsamplesshould be noted. The number of contract support measures offered issignificantly higher in Armenia, Georgia, and Moldova than in Russiaand Ukraine. This may reflect the greater level of FDI in the Armenian,Georgian, and Moldovan samples, given the previously found linkbetween FDI and contract support. Moldova also has the most frag-mented supply base, although some consolidation was witnessed in theperiod 2001–3.
WP 42 Case Studies
8
Bearing in mind the small size of some subsamples, contract supportmeasures are most widely used in the sugar sector (mean of 5.75 measuresemployed per processor) and for wine/brandy. This may reflect how (a) sugar processors and wineries are procuring directly from farmersrather than agents/distributors, (b) FDI has been more significant in thesesectors, and (c) quality requirements are more acute in these sectors. Anoticeably low proportion of supply comes from small farms in the sugarsector (6.3 percent), although sugar refineries do deal with a large num-ber of small farms (mean of 1,275 in 2003). In the wine/brandy sectorover three-quarters of grapes come from small farms and this may reflectwhy so many wineries in the FSU wish to purchase vineyards to provide amore stable supply of grapes that meets their quality requirements.
By analyzing only companies engaged in the dairy sector, it is evidentthat contracting is most extensively developed in Moldova and Armenia.This can be discerned both in terms of the share of raw materialssourced using contracts with farms and the mean number of contractsupport measures employed. In Moldova this may reflect the higherlevel of Western FDI and in Armenia a relatively high proportion ofdairy output is exported. These findings are in line with the relation-ships between both Western FDI and exporting with contracting foundfor the full sample.
INTRODUCTION
Restructuring and privatization in Central and Eastern Europe and theFormer Soviet Union (FSU) has led to the separation of many previouslyhorizontally and vertically integrated enterprises together with the emer-gence of de novo businesses. Enterprises have had to forge their own rela-tionships with buyers and suppliers in an environment of both weakpublic institutions for enforcing contractual obligations and propertyrights and a high level of macroeconomic instability. These problemshave been identified as impediments to growth with the dislocation to,and failure of, interenterprise relationships being a causal factor in thefalls in output witnessed in the early years of transition (Blanchard andKremer 1997; Gow and Swinnen 2001).
With the breakup of former state and collective farms, established foodprocessors in the FSU have lost guaranteed, state-directed supplies anddemand. Food processors have had to establish their own relation-ships to effectively procure agricultural raw materials. In meeting thischallenge processing enterprises can source farm level output throughthree main mechanisms: spot markets, vertical ownership integration, orcontracting. Contracting appears to be the favored mechanism of many
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
9
large food and agribusiness companies in the region and the introduc-tion of contracting has been linked to significant improvements in pro-ductivity (Gow et al. 2000).
However, while case study evidence points to the potential role of con-tracting as an engine for growth in agrifood supply chains, there is a lackof systematic evidence on its impact. Unresolved issues concerning theimpact of contracting and vertical integration on the CIS agrifood sectorwere identified in a recent World Bank concept paper on this topic. Theconcept paper, which defined the parameters for this report, identifiesfive main unresolved issues:
� Under what conditions do contract relationships emerge and whatrole does government play?
� What is the role of foreign direct investment (FDI)?� What triggers beneficial spillover effects of foreign investment and
how general are such developments?� Is there an optimal model of contracting or should contractual relation-
ships vary according to differences in markets and stages of transition?� What are the key equity issues and does the process of vertical con-
tracting lead to the exclusion of small farms?
This study sought to collect and analyze data from the CIS to helpanswer these questions, providing a basis for identifying options forimproved policies and investments.
METHODOLOGY
To investigate the issues outlined in the concept note, a standardized sur-vey instrument was designed to obtain data from agribusiness enter-prises. As the survey was concerned with contracting and investment,purposive sampling (Lincoln and Guba 1985) was employed. Purposivesampling can be defined as the selection of cases “from which the mostcan be learned” (Merriam 1998, p. 61). Under this method, “sample ele-ments are handpicked because it is believed they can serve the researchpurpose” (Churchill 1999, p. 503). In this case, only interviewees whomet certain criteria were selected. The criteria chosen were:
� Senior executives of agrifood industry enterprises (excluding micro-enterprises and those that had just been established);
� Enterprises that had made recent capital investments in the agrifoodsector;
� Enterprises that were engaged in contracting with farmers.
WP 42 Case Studies
10
These criteria were designed to ensure that the sample contained com-panies that were engaged in activities that the study sought to understandand evaluate. A quota of 12 companies per country was drawn up byresearchers in each state, who checked that potential interviewees met thecriteria. For each country a target of four milk processors, four plant-basedenterprises (sugar, milling, fruits, etc.), and four value-added companies(reflecting products of national importance that varied between statessuch as wine, brandy, and speciality cheeses/ice cream) was set. This divi-sion was designed to pick up on subsector differences and reflect thebroad balance of the agrifood sectors in the FSU.
The survey instrument contains both open and closed questions.Numerical data were obtained on firm performance and backgroundcharacteristics, the value of capital investments, contract relationshipswith farmers, the impact of contracting, quality standards, and contractbreaches. Open-ended questions were designed to obtain qualitativeinformation on the rationale for investments, contract decisions, andfuture prospects. Interviews were conducted in relevant national lan-guages with responses translated into English for cross-national analysis.
The sample of 60 enterprises collectively accounted for 18,556 employ-ees in 2003 and had a combined turnover of US$215.6 million. Themean level of employment for the sample was 309 full-time equivalentswith an average turnover of just under US$3.6 million per annum (table2.1). The sample therefore incorporates some major players in the FSUagrifood sector.
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
11
TABLE 2.1 Sample Characteristics by Country
Country Sample Size Mean Employment (2003) Mean Turnover (2003)
Table 2.2 details the different sources of supply utilized by processors infour years (1997, 1999, 2001, and 2003). Small farms were defined asproducers with less than 1 hectare of land or, for the dairy sector, less than
five animals. Table 2.2 presents the number of enterprises using a partic-ular potential relationship to source farm-level output and the valid per-centage figure corrects for missing data for earlier years in a small numberof cases.
Table 2.2 reveals that the use of all potential means for sourcing agri-cultural raw materials increased over the period 1997 to 2003. Thisreflects the impact of macroeconomic recovery and the overall growth inprocessor level output during this period and a requirement to sourcemore raw materials. The greatest growth has been recorded for contract-ing with larger farmers (from 42.3 to 75 percent of the sample), usingother agents and own farms, albeit the latter is from a low base. Moreenterprises have contracts with larger farms than with small farms, butthe reverse is true for sourcing from spot markets, where relationshipswith small farms are more prevalent. Between 1999 and 2003, there wasrelatively little change in the number of enterprises using spot markets asa source of supply, with a slight decline in the number of processors usingspot markets with larger farms in 2003 compared to 2001. These figureswould suggest that significant reforms are occurring in farmer–processorrelationships: contracting is becoming more prevalent, especially withlarger farmers; the use of spot markets as a source of supply is stagnating;and the use of other agents such as intermediaries and traders is increas-ing. One quarter of the sample was also engaged in farming in 2003 andmost of this vertical ownership integration has occurred recently: in 1997only four interviewees reported that their enterprise also had farmingoperations.
WP 42 Case Studies
12
TABLE 2.2 Use of Potential Supply Relationships in Sourcing Agricultural RawMaterials (1997–2003)
Table 2.3 details the distribution and mean impact of contract supportmeasures on farm performance. Measures are listed in descending orderof frequency, with the most popular measures applied being prompt pay-ments, transportation, and monetary credit. One third of the sample alsoprovides physical inputs to at least some of the farms which supply them.Investment loans from processors to farmers are infrequent. Regardingthose firms that apply a specific measure, the mean percentage of farmsthat received that measure in the first year of operation and the currentmean percentage of farms that have access to the measure are detailed,alongside the percentage of processors that operate a minimum size pol-icy for applying a particular measure. These figures give an insight into thediffusion of measures and whether small farms are being excluded.Measures such as agronomic support, guaranteed prices, and prompt pay-ments are typically applied to the vast majority of farms with which aprocessor deals. Only one processor that offered prompt paymentsreported that it discriminated against small farms in applying the mea-sure. Support measures such as investment loans and the provision ofmachinery are more selectively applied—the majority of processors thatoffer these supports do so selectively. Around 60 percent of processors thatoffer credit and physical inputs also have a minimum farm size belowwhich they do not offer these supports. Regarding diffusion, out of the 15possible support measures listed in table 2.3, in only three cases is themean percentage of farms to which the measure is offered currently lowerthan in the first year in which the measure was introduced by the processor.This suggests that measures tend to be offered to more farms over timerather than assistance becoming more selective. The three cases in whichthe mean has fallen are: investment loans, harvesting and handling support,and prompt payments. The first two are capital intensive measures and thefall in the percentage of farms to which prompt payments are offered issmall.
The last three columns of table 2.3 assess the mean percentage changein farm level yields, percentage of output that reaches higher standards,and the percentage change in the amount of output meeting basic stan-dards. The support measures with the largest impact on yields are the pro-vision of specialist storage, veterinary support, and physical inputs,followed by a set of market measures (prompt payments, guaranteedprices, and market access). Each of these measures is credited with increas-ing yields by over 10 percent. Specialist storage in the form of on-farmcooling tanks has been particularly important in raising yields and qual-ity in the dairy sector, a trend also noted by Dries and Swinnen (2002,2004). The impact of investment loans has been modest and this may
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
13
14
TAB
LE 2
.3D
istr
ibut
ion
and
Impa
ct o
f Con
trac
t Sup
port
Mea
sure
s
Dis
trib
utio
n of
Sup
port
Mea
sure
to F
arm
sIm
pact
s of
Spe
cific
Con
trac
t Sup
port
Mea
sure
on
Farm
s
% C
hang
e in
% C
hang
e in
N
o. o
f Fir
ms
% o
f Sam
ple
Mea
n %
of
Mea
n %
of
% o
f Fir
ms
Ope
rate
Ave
. % C
hang
e Fa
rm O
utpu
t Fa
rm O
utpu
t O
fferi
ng S
uppo
rtO
fferi
ng
Farm
s O
ffere
dFa
rms
Offe
red
Min
imum
Far
m
in F
arm
Yie
lds
Reac
hing
Re
achi
ng
Mea
sure
Mea
sure
Supp
ort
to in
1st
Yea
rto
Cur
rent
lySi
ze fo
r Mea
sure
Due
to M
easu
reH
ighe
r Sta
ndar
dB
asic
Sta
ndar
d
Prom
pt p
aym
ents
2846
.788
.084
.53.
711
.412
.02.
1Tr
ansp
orta
tion
2745
.064
.269
.646
.26.
85.
73.
5Cr
edit
2338
.339
.850
.960
.89.
38.
83.
0Ph
ysic
al in
puts
2033
.348
.251
.257
.912
.414
.23.
5Qu
ality
con
trol
1931
.776
.879
.415
.87.
617
.25.
6Gu
aran
teed
pric
es14
23.3
86.7
91.7
14.3
11.1
8.9
1.1
Agro
nom
ic s
uppo
rt13
21.7
82.0
84.5
8.3
6.5
5.0
1.4
Farm
loan
gua
rant
ees
1118
.37.
015
.127
.36.
86.
00.
0M
achi
nery
1016
.719
.430
.560
.05.
04.
05.
2Sp
ecia
list s
tora
ge9
15.0
32.8
32.9
33.0
10.0
8.3
4.4
Harv
est /
han
dlin
g7
11.8
30.6
18.6
71.4
9.3
5.4
2.6
Mar
ket a
cces
s6
10.0
68.3
69.7
0.0
11.2
14.2
2.0
Busi
ness
/ 6
10.0
45.8
47.5
50.0
6.2
4.2
2.5
fin. m
anag
emen
tVe
terin
ary
supp
ort
58.
358
.066
.040
.017
.017
.00.
0In
vest
men
t loa
ns4
6.7
4.0
0.3
75.0
5.5
5.0
2.5
Aver
age
58.2
60.4
35.2
9.1
9.5
2.9
explain why the number of farms to which this support is offered hasbeen falling. The provision of machinery is also credited with having alow impact on farm level yields.
In terms of raising the quality of output, particularly the percentage ofoutput reaching higher standards, the most beneficial measures havebeen quality control support, veterinary support, physical inputs, marketaccess, and prompt payments. The link between quality control, veteri-nary support, and higher quality farm level output appears reasonable.Machinery, financial and business support, and, rather surprisingly, agro-nomic support have had the lowest mean impact. Support measures havehad less impact on the amount of farm-level output that reaches basicstandards, as most farm output already passes this threshold. For thelatter, the most significant measures have been quality control, specialiststorage, and machinery.
Foreign Investment
Fourteen companies in the sample of 60 have received FDI. Of the 14FDI firms, 11 have Western foreign investors and in three cases theinvestment has come from another FSU state. In a comparison withdomestically owned firms, this distinction between Western FDI and FSUFDI is maintained. Regarding mean turnover and employment, there areno significant differences between three groups (table 2.4). The meanturnover per employee, which is often used as a measure of productivity,is higher for the Western FDI firms but the difference is not statistically sig-nificant. However, significant differences are apparent regarding theamount of capital investment. Over the previous six years, the mean levelof capital investment in those enterprises that had received Western andFSU FDI was approximately US$1.7 and US$2.8 million, respectively,compared with a mean of US$0.73 million for those entirely domesti-cally owned. A similar significant difference is observed when comparingthe amount of capital investment per employee.
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
15
TABLE 2.4 Characteristics of Foreign Investment Enterprises
Mean for Mean forWestern Foreign Mean for DomesticallyInvestors’ Firms FSU FDI Firms Owned Firms
To investigate whether small farms are being excluded from food supplychains, the survey solicited information on the share of agricultural rawmaterials procured from small farms by each processor in four years(1997, 1999, 2001, and 2003). Similar data were collected regarding thetotal number of small farms that each processor dealt with in the samefour years. Small farms, as discussed above, were defined as producerswith less than 1 hectare of land or, for the dairy sector, fewer than fiveanimals. From these questions it is possible to analyze how the share oftotal agricultural raw materials sourced by processors from small farmshas changed since 1997, together with an assessment of the number ofsmall farms with which they have a relationship (table 2.5). If data werenot available for 1997, the assessment was made on the differencebetween the least recent year for which information was available and thefigures for 2003. A comparison is also drawn for 2001–3 only, to iden-tify the most recent trends.
WP 42 Case Studies
16
TABLE 2.5 Change in Share of Agricultural Raw Materials Sourced from Small Farms and Number of Small Farm Suppliers
Change in Share of Agricultural Raw Change in Number of Material Sourced from Small Farms Small Farm Suppliers
small farmersTotal 60 100.0 60 100.0 60 100.0 60 100.0
For the period 1997–2003, table 2.5 indicates that in just over onethird of enterprises, the share of agricultural raw materials sourced fromsmall farms declined with an increase registered in about a quarter ofinterviewees’ businesses. Twelve firms report no change and 11 havenever dealt with small farmers. In terms of the number of small farm sup-pliers, however, a majority of firms report an increase. This increase inthe number of small farms in many cases was due to political reforms(land reform and decollectivization) rather than processors’ strategies.For example, 10 out of 12 companies in Moldova reported an increase inthe number of small farm suppliers over the period 1997–2003. Duringthis era, Moldova implemented a radical National Land Program that
saw the break up of former state and collective farms with distribution ofland and physical assets to members.
Only 13 of the enterprises interviewed reported that they dealt with fewersmall farms in 2003 than in 1997 and 3 indicated no change over this timeperiod. This implies that there are a number of processors that, even thoughthe share of agricultural raw materials sourced from small farms isdeclining, are nonetheless dealing with more small farms. For the2001–3 period slightly fewer processors recorded a growth in the num-ber of small farm suppliers and this may reflect some consolidation.Overall, there is a lack of evidence of small farms being systematicallyexcluded.
The characteristics of the 13 enterprises that reduced the number ofsmall farm suppliers between 1997 and 2003 are presented in table 2.6.Of the 13 enterprises, 6 are located in Russia, 3 in Georgia, 2 in Armenia,and 1 each in Ukraine and Moldova. Compared with the rest of the sam-ple, those firms which have reduced the number of small farm suppliersare larger when measured by the total number of employees, but this issignificant only at the 10 percent level. There are no significant differ-ences between the two groups regarding their turnover, percentage ofsales to the domestic market, and foreign investment. On this measure,there is no evidence of a linkage between FDI and the exclusion of smallfarms.
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
17
TABLE 2.6 Comparison of the Characteristics of Firms That Have Reduced theNumber of Small Farm Suppliers with Those of the Rest of the Sample
Mean for FirmsThat Have ReducedNo. of Small Farm Mean for Rest of Suppliers (n�13) Sample (n�47) t-test
No. of employees (2003) 602 228 −1.788*Turnover (2003) 2,566,883 3,876,673 .686% of sales to domestic market 80.40 71.2 −.813% of enterprise shares owned 86.20 80.2 −.560
by domestic private investors% of enterprise shares owned 6.15 13.4 .842
by Western foreign investors
*Significant at the 10% level
Product Quality
For the years 1997, 1999, 2001, and 2003, dairies were asked to indicatethe percentage of milk delivered to them that was extra class, first class,second class, and rejected/unusable. Enterprises without dairy operationswere asked, for the same years, to indicate the percentage of agricultural
raw materials supplied to them that was of premium quality, acceptablequality, and rejected/unusable. From these figures it is possible to assesschanges in the quality of farm produce supplied to processors. An improve-ment indicates that a greater proportion of produce fell into premium/extra class categories with less being deemed unusable or rejected.1
Table 2.7 reveals that the majority of firms report an improvement in thequality of farm level produce supplied to them. Sixteen reported thatquality worsened and seven enterprises indicated no change.
WP 42 Case Studies
18
TABLE 2.7 Overall Change in the Quality of FarmProduce Supplied to Processors (1997–2003)
A breakdown of changes in quality by country (table 2.8) reveals thatseven of the 12 companies in the Russian sample indicate that qualitydecreased over the assessed period. The three companies in Moldova thathad suffered from a decrease in product quality were all engaged in fruitand vegetable processing. In 2003, Moldova suffered from a particularlycold winter and dry spring and this was seen as the main explanation forfailing yields and quality in these cases (FAO 2003). Similar reasons weregiven by the interviewees for the two cases of worsening product qualityin Armenia. In Russia and Ukraine there is no clear link with a particularsector or factor.
Product Quality and Contracting
It is possible to look at the linkage between the product quality datareported above and contracting in two ways. First, are there significant
TABLE 2.8 Overall Change in the Quality of Farm Produce Supplied toProcessors by Country
differences between the firms that report improving, no change, andworsening product quality and the percentage of agricultural rawmaterials procured using contracts? Second, one would expect that animprovement in product quality is associated with the use of the contractassistance measures detailed in table 2.3. Table 2.9 reveals that there aresignificant differences between firms that report worse, no change, andimproved product quality on both these measures. Those firms thatreport an improvement in the quality of agricultural raw materials sup-plied to them procure a greater proportion using contracts. On averagethose that have witnessed an improvement in farm level product quality,procure 56.5 percent of agricultural raw materials using contracts com-pared with only 30.3 percent for those that have suffered from worsen-ing product quality. A significant difference is also apparent regarding themean number of contract assistance measures employed (based on the15 possible assistance measures listed in table 2.3) and product quality.The mean number of contract assistance measures employed by firmsthat have witnessed improved product quality is 4.24 compared against2.00 and 1.86 for those registering a worsening situation and no change,respectively.
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
19
TABLE 2.9 Relationship Between Contracting and Product Quality
Change in Product Quality Percentage of Raw Material Mean Number of Contract Supplied Bought Using Contracts in 2003 Support Measures Used
***1% level of significance; *10% level of significance
First Mover Advantage and the Impact of Contracting
For each contract support measure employed, information was elicitedfrom interviewees on their motivation for introducing the measure.Motivations were divided into proactive reasons (improve product quality,gain a competitive advantage, meet customer needs) or reactive (defendsupply base against competition, survival, etc.). Although not all explana-tions could be divided into proactive or reactive reasons, in about 190cases motivations could be categorized in this manner. The mean impactof contract support measures when employed for proactive or reactivereasons is compared in table 2.10.
WP 42 Case Studies
20
TABLE 2.10 Mean Impact of Contract Support Measures Introduced forProactive or Reactive Reasons
Motivation No. Mean SD t -test
Mean % change in yields Reactive 44 5.07 8.98Proactive 150 10.33 11.45 −2.803***
Mean % change in output Reactive 43 3.17 8.41meeting highest grade Proactive 150 11.35 13.29 −3.812***
Mean % change in output Reactive 43 1.67 4.83reaching basic standards Proactive 148 3.22 6.03 −1.546
***Significant at 0.01 level
Table 2.10 reveals that the mean impact on yields and on the per-centage of output reaching highest grade standards was significantlylarger for measures introduced for proactive reasons. For the percent-age of output reaching basic standards, where impacts overall are moremodest, no significant differences are evident. For the other two mea-sures the differences between the proactive and reactive groups arestriking: the mean impact on yields is twice as great for the proactivegroup and the differential for the percentage change in output reach-ing highest grade standards is even higher. This suggests that theimpact of contracting is not uniform but depends on the nature of themarket and the degree to which other firms also offer contract assis-tance measures. First movers in offering contract assistance measuresappear to reap the greatest rewards. Where contracting is introduced toprotect the supply base of a processor which is under threat from others,contracting still has a positive effect on yields and quality but the ben-efits are far smaller.
While there are significant differences between the impact of contractsupport measures introduced for proactive and reactive reasons, there areno significant relationships with year of introduction (table 2.11). Thesurvey recorded the year in which each contract support measure wasintroduced and they have been coded into four categories: up to andincluding 1996, 1997–99, 2000–1, and 2002–3. The mean impact onyields and percentage change in farm output reaching the highest stan-dards was highest for measures introduced in the period 2000–1, but dif-ferences between year groups are not significant. This would suggest theimpact of contracting is related more to market conditions such as thecontract relationships of competitors rather than the specific year ofintroduction.
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
21
TABLE 2.11 Comparison of Impact of Contract Support Measures by Year Introduced
Mean % Mean % Change in Mean % Change inChange Output Meeting Output Reaching
Year Groups in Yields Highest Grade Basic Standards
When comparing firms that have received FSU or Western FDI with therest of the sample regarding contracting and product quality, significantdifferences are apparent (table 2.12). First, Western FDI enterprises use asignificantly greater number of contract support measures (as listed intable 2.3) than the other two groups. Western FDI firms use an average of4.91 contract support measures compared with means of 1.67 and 3.12 forFSU FDI firms and wholly domestically owned companies, respectively.Second, and somewhat surprisingly, both Western and FSU FDI firmssource a significantly greater proportion of agricultural raw materialsfrom small farms. Enterprises with Western and FSU foreign investmentsource on average 57.3 and 63.3 percent of their agricultural raw materi-als from small farms (both spot markets and contracts), respectively, com-pared with 30.9 percent for domestically owned companies. Domesticallyowned companies source a significantly greater proportion from otheragents (30.2 percent of total supplies) compared with a mean of 5.7 percent
WP 42 Case Studies
22
for Western FDI firms (table 2.12). Both Western and FSU FDI firms arealso engaged in far greater levels of exporting. While about four fifthsof the output of wholly domestically owned firms is sold on the domes-tic market, the respective figures for Western and FSU FDI firms are only47.9 and 55.7 percent.
Exporting and Relationships with Investment and Contracting
From the 60 enterprises in the dataset, 32 are engaged in exporting(53.3 percent). About one quarter of the sample export more than 50 percent of their total output and as detailed in table 2.12; bothWestern FDI and FSU FDI firms export a significantly greater proportionof their output. Examining other associations, table 2.13 presents a cor-relation coefficient matrix detailing the relationships between the per-centage of sales to the domestic market and the key variables oncontracting, use of contract support measures, and investment.
TABLE 2.12 Characteristics of Foreign Investment Enterprises Regarding Contracting
t-test Mean for Mean for Mean for F-test Comparing
Western Foreign FSU FDI Domestically Between Western FDI Investors’ Firms Firms Owned Firms Three and Domestic
(n�11) (n�3) (n�46) Groups Owned Only
Total number of 4.91 1.67 3.12 2.857* −2.059**contract support measures used
% of supplies 73.30 3.66 44.00 5.256*** −2.382**bought usingcontracts (2003)
% of supplies 17.50 66.70 21.80 2.8836* 0.402bought from spot markets (2003)
% of supply from 57.30 63.30 30.90 3.685** −2.417**small farms (both spot markets and contract) 2003
% of supply from 33.60 7.00 34.90 1.206 0.125large farms (both spot markets and contract) 2003
% of supply bought 5.70 11.30 30.20 2.852* 2.244**from other agents
% of output sold on 47.90 55.70 80.20 4.272** 2.809***domestic market
*Significant at the 10% level; **significant at the 5% level; ***significant at the 1% level
The correlations between the percentage of total sales accounted for bythe domestic market and other variables are marked in bold font. Thereare significant, negative correlations between the percentage of sales to thedomestic market and total investment, capital investment per employee,the proportion of total supply from small farms, and the total number ofcontract support measures. In other words, exporting is associated withgreater capital investment and exporters source proportionally more fromsmall farms and employ a higher number of contract support measures.Given the linkage between exporting and FDI, the similarity between thesupply relationships with exporting (table 2.13) and the supply charac-teristics of FDI firms (table 2.12) is understandable.
Future Developments
As part of the survey, interviewees were asked how and why the number ofsuppliers to their enterprise would change in the future. From theseresponses, predicted changes in the number of suppliers were categorizedas likely to decrease, likely not to change, or likely to increase (table 2.14).
The largest single category (40.7 percent) predicts that their enterprisewill increase its number of suppliers in the future and the main reason forthis is an expected expansion in demand. While just under one third pre-dict a decrease in the number of suppliers, this does not imply that themajority within this group have a policy of deliberately excluding certainfarms. Out of the 19 cases, 12 cite principally farmer-led reasons for theirpredictions of a future fall in the number of suppliers. The two mainfarmer-led reasons cited were a movement into different agriculturalactivities (for example, milk farmers slaughtering their dairy cows becauseof high current meat prices) and an exit of small farmers as a result of anupturn in fortunes in the rest of the economy which will make the lowreturns to small-scale agriculture less attractive. The latter pattern hasbeen witnessed in many Central European states and should not be inter-preted as a deliberate marginalization of small farms. Only seven inter-viewees cited that they have specific initiatives for reducing the numberof farmers with whom they deal and in three cases this was linked tobackward integration into farming.
While noting the small size of subsamples, comparisons can be drawnbetween current supply practices and predicted future changes in suppli-ers (table 2.15). There are no significant differences, in the size of enter-prises predicting increases, decreases, or no change in the number ofsuppliers. However, those that are predicting a future rise in the numberof suppliers currently deal with a small number of large farms (mean of19 compared with averages of 113 and 223 for the decrease and no changegroups, respectively). It may be that they are operating in regions with a
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
23
24
TAB
LE 2
.13
Corr
elat
ion
Coef
ficie
nt M
atri
x fo
r Rel
atio
nshi
ps B
etw
een
Expo
rtin
g, C
ontr
actin
g, a
nd In
vest
men
t
% o
f Sup
ply
from
% o
f Raw
Ca
pita
l Sm
all F
arm
sTo
tal N
umbe
r of
% o
f Sal
es to
%
of A
g. S
uppl
y M
ater
ial B
ough
tIn
vest
men
t To
tal
Valu
e of
Tot
al(b
oth
spot
mar
kets
Cont
ract
Sup
port
D
omes
tic
from
Oth
erU
sing
Con
trac
ts
per E
mpl
oyee
Em
ploy
men
t In
vest
men
ts&
con
trac
t) (2
003)
Mea
sure
s U
sed
Mar
ket
Age
nts
(200
3)(2
003)
(200
3)(2
003)
Valu
e of
tota
l inv
estm
ents
1.2
32*
.210
�.3
13**
−.29
8**
−.01
5.5
63**
*.1
51%
of s
uppl
y fro
m s
mal
l 1
−.02
3�
.353
***
�.5
76**
*.0
96.3
73**
*−.
128
farm
s (b
oth
spot
mar
kets
an
d co
ntra
ct) (
2003
)To
tal n
umbe
r of c
ontra
ct
1�
.322
**−.
303*
*.3
93**
*.0
42.1
04su
ppor
t mea
sure
s us
ed%
of s
ales
to d
omes
tic m
arke
t1
.295
**.0
48�
.232
*.2
27*
% o
f ag.
sup
ply
from
oth
er
1−.
512*
**−.
278*
*−.
063
agen
ts (2
003)
% o
f raw
mat
eria
l bou
ght u
sing
1
.188
−.08
4co
ntra
cts
(200
3)Ca
pita
l inv
estm
ent p
er
1−.
153
empl
oyee
(200
3)To
tal e
mpl
oym
ent (
2003
)1
***C
orre
latio
n is
sig
nific
ant a
t the
0.0
1 le
vel;
**co
rrel
atio
n is
sig
nific
ant a
t the
0.0
5 le
vel;
*cor
rela
tion
is s
igni
fican
t at t
he 1
0% le
vel
dearth of large farms and thus to meet rises in demand they require anincreasing number of suppliers. The firms predicting a future growth inthe number of suppliers also deal with substantial numbers of smallfarms (mean of 883), although differences among the three groups arenot statistically significant.
There are no significant differences among the predicted increase,decrease, and no change groups in terms of the amount supplied via spotmarkets or contracts with large farms. However, regarding contracts withsmall farms there are significant differences with those predicting a fall inthe number of suppliers sourcing a high proportion of total supply from
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
25
TABLE 2.14 Predicted Change in Number of Suppliers
a. One interviewee did not feel able to make a prediction.
TABLE 2.15 Comparison Between Current Supply Practices and PredictedFuture Changes in Number of Suppliers
Practices / Figures Means for Predict Means for No Means forfor 2003 Decrease Group Change Group Increase Group F-test
Total employment 171 315 424 0.712Share of supply from 31.8 1.9 19.6 5.288***
contracts with small farms
Share of supply from 28.4 36.3 23.5 0.932contracts with large farms
Share of supply from 19.9 13.0 20.8 0.325spot markets with small farms
Share of supply from 7.7 5.1 1.3 1.534spot markets with large farms
Share of supply from 8.2 39.3 28.9 4.750**other agents
Number of small 351.4 600.9 883.0 0.535farm suppliers
Number of large 112.5 222.9 19.0 2.292farms suppliers
***Significant at the 0.01 level; **significant at the 0.05 level
small farms via contracts (31.8 percent compared to just 1.9 percent of theno change group). This may suggest that small farms could be squeezedin the future, although other questions have indicated that the fall insmall farms is more likely to be farmer led than as a result of specificplans to exclude them by processors.
QUALITATIVE FINDINGS ON BUSINESS CONSTRAINTS ANDNATIONAL GOVERNMENT AND WORLD BANK PRIORITIES
In addition to collecting numerical data, respondents were asked severalopen-ended questions. They were asked to identify the key constraintsthat their business faced, the impact of national government decisionmaking on their enterprise, and the role they saw for international agen-cies such as the World Bank. These questions generated a rich set ofanswers, some of which were specific to particular states and markets.This section summarizes the most widespread opinions on these issues.
Regarding business constraints, the most commonly cited problemwas a lack of effective market governance. This has two main elements:first, the continued operation of “shadow/black” economy producersthat avoid taxes and social security obligations and have engaged incounterfeiting brands and smuggling. Such producers, by avoidingthese obligations, have a lower cost structure and are able to undercutother producers. For example, one cheese manufacturer in Armenia sug-gested that differences in tax payments accounted for a 25 percent varia-tion in producers’ costs and a winemaker in Moldova indicated thatexcise duties on alcohol were equal to 50 percent of the cost of rawmaterials. Counterfeiting has undermined the value of nationally wellknown brands, particularly in the wine and spirits sector. One Georgianwine producer indicated that counterfeiters were falsifying one of theirpremium brands and were selling it at a price lower than what the com-pany was paying for its raw materials. Clearly, from a marketing per-spective it is difficult to develop premium brands and added-valueproducts in a business environment characterized by weak governanceand legal protection. Second, demands for bribes by inspection agenciesand state officials were reported as still being widespread. For example,one Moldovan fruit and vegetable processor reported that about 20 dif-ferent state controls were introduced in their industry on a yearly basiswith little benefit to consumers or producers, only those administratingthem. This point was echoed by most interviewees in Georgia. The cultureof national state administrations was seen as a major impediment to theeffective implementation of loans and aid from international agencies.
WP 42 Case Studies
26
The most frequently cited resource issue was problems with procuringraw materials. As final demand in the region has increased, and in somecases farm production has been severely disrupted by land reform, theprocurement of supplies of sufficient quantity and quality has becomemore challenging and this has motivated the increased diversity ofsources (table 2.2) and the investment in contracting and contract sup-port measures (table 2.3). This has been particularly noticeable in thedairy sector but not limited to it; respondents from wineries and thefruit and vegetable sector reported similar difficulties. While the surveydid not explicitly collect data on prices, real increases in both raw mate-rial and final product prices were reported by many.
Internationalization is perceived as the main marketing challenge,both in terms of coping with growing imports and also effectively serv-ing a wider geographical market either at the national or internationallevel. The main barriers to exporting are perceived as harmonizing pro-duction with international standards, establishing effective distribution,and poor bargaining terms as a result of the strong negotiating positionsof intermediaries (in particular supermarkets). Distributors often defaulton exclusivity agreements, carrying competitors’ lines, despite the existenceof contracts which prohibit such actions. Helping meet the challenge of theinternationalization of markets was identified as an investment/policy pri-ority. As identified in table 2.12, export experience is largely confined,with a few notable exceptions, to FDI firms. For wholly domestically ownedfirms, international assistance to aid harmonization with internationalstandards and provide technical advice on exporting was seen as partic-ularly important because, as one respondent remarked, such specialistadvice typically cannot be obtained from local universities, colleges, andother educational agencies.
To conclude, the most widespread problems faced by processors areineffective or inappropriate market governance, problems with procuringagricultural raw materials, and meeting the challenge of the greaterinternationalization of markets. These challenges are common across thestates surveyed and should form the basis of any policy initiatives.
CONCLUSIONS AND POLICY RECOMMENDATIONS
Overall, the Spread of Contracting Has Been Beneficial
Based on survey findings, farm–processor contracting has become moreprevalent in the FSU region, contract support measures have stimulatedimprovement in yields and the quality of output, and such supports havebeen introduced in the majority of cases for proactive reasons. There is a
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
27
significant association between improvements in product quality and thepercentage of output bought using contracts and the mean number ofcontract support measures employed.
Improving Yields and Output
Investment loans and machinery grants have been mainstays of manydevelopment projects, yet the impact on yields and improvements inproduct quality of these two measures in the FSU has been modest.Specialist storage (especially cooling tanks in the dairy sector), veterinarysupport, prompt payments, guaranteed prices, and physical inputs havehad bigger effects on average yields. Improving the proportion of outputreaching higher standards has been achieved most successfully throughquality control, market access, veterinary support, and physical inputs.This suggests that improvements to yields and quality are linked to fivemain factors:
� Preserving the quality of what is already produced. A major problem in theFSU has been the storage of production prior to processing. In the dairysector, the lack of effective cooling facilities rapidly decreases the valueof milk produced and in the arable sector, postharvest losses throughinappropriate storage have eroded competitiveness (Striewe 1999).Investments in farm level production will generate poor returns if theeffective means to store output prior to processing are absent.
� The impact of veterinary support on yields and product quality has alsobeen significant. While returns to agronomic support have been mod-est, interviewees repeatedly stressed that a willingness to learn, take onboard advice, and have a professional attitude was as, if not, more impor-tant than size in establishing a fruitful farm–processor relationship. Landreform programs have created a more diverse and fragmented agricul-tural base in most FSU states. Disseminating technical advice to farmsbecomes more difficult under these conditions and attention needs tobe given to how this can be best achieved. While farm–processor con-tracting is one mechanism for the dissemination of technical advice, withprocessors rarely discriminating against small farms on such measures, aquestion remains as to whether such private support mechanisms aresufficient in all areas.
� Premiums are an important element in stimulating improvements inquality at the farm level. This underpins why market access, as a poten-tial contract support measure, is linked to above average improve-ments in yields and quality. The availability of financial premiums forhigher quality is linked to both final demand on the domestic marketand export opportunities. While poverty is still endemic in the FSU, a
WP 42 Case Studies
28
new middle class is emerging and there is an important opportunityfor domestic firms to meet the demand for value-added products bothnationally and internationally.
� The provision of physical inputs has had an above-average (compared withother contract support measures) impact on yields and quality. Themean impact of the provision of physical inputs has been greater thancredit. This may reflect how credit can be more easily diverted to other,nonfarm activities and be difficult to monitor (Gow et al. 2000). Bothpublic and private sector support in the region have suffered fromresources being diverted from the intended programs, particularlywhere the use of resources has been difficult to monitor. Programs thatimprove market access and the dissemination of veterinary andquality control advice are likely to have beneficial effects on yieldsand quality, and offer an additional advantage in that they should beeasier to monitor and thus less likely to suffer from diversion ofresources. Given interviewees’ discussion of inappropriate market gov-ernance, evaluating support measures in terms of the ease with whichresources can be diverted to alternative uses should be one criterionused in assessing any future policy choices.
� Improvements in yields and quality are also linked to a set of market mea-sures, particularly prompt payments and guaranteed prices. Cash flowis a major concern and the linkage between delayed payments and fallsin output has been discussed elsewhere (Gow and Swinnen 2001).
The Positive Benefits of FDI Are Apparent and FDI Should Be Encouraged
Although not significantly different in terms of their size, both Westernand FSU FDI firms have made significantly greater capital investments,particularly in upgrading processing faculties. Upgrading processing facili-ties, particularly so that they can access export markets, has been identi-fied as a major challenge for the FSU successor states. Western FDIfirms offer significantly more contract support measures which are linkedto improving yields and increasing farm-level quality. One oftenexpressed concern of FDI is that it can lead to the marginalization of smallfarms (Escobal et al. 2000). To date there is no evidence of this—onlyone FDI firm has reduced the number of small farm suppliers and resultspresented indicate that FDI firms actually source a significantly greaterproportion of supplies from small farms.
In dealing with the debate on the marginalization of small farms, twosets of distinctions should be noted. First, marginalization can be definedin terms of (a) an exclusion of small farms from formal food supplychains and (b) small farms being offered significantly worse terms andconditions. There is little evidence that small farms are being excluded
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
29
but they may receive poorer terms and access to contract support mea-sures (for example, around 60 percent of processors that offer credit andphysical inputs to farmers do have a minimum farm size below whichthis contract support measure is not offered). However, contract supportmeasures have overall become available to an increasing number of farm-ers after their introduction, rather than support becoming progressivelymore selective. There is thus little indication that the introduction of con-tract support measures reduces farm access to inputs and technicaladvice. Second, regarding marginalization, a decrease in the number ofsmall farm suppliers can come from either farm- or processor-level initia-tives. To date, farm-level initiatives such as switching to different agricul-tural activities or exiting small-scale agriculture altogether appear moreimportant than processor-led strategies. As economies recover in the FSU,the exit of labor from small-scale agriculture is inevitable and should notbe taken as an indicator of processor-led exclusion.
The qualitative data collected indicate that the most widespread prob-lems faced by processors are ineffective or inappropriate market gover-nance, problems procuring agricultural raw materials, and meeting thechallenge of the greater internationalization of markets. Helping meetthe challenge of internationalization was identified as an investment andpolicy priority. It is noticeable that exporting is, with a few notable excep-tions, largely limited to FDI firms and most domestically owned firmslack experience in this field. International assistance to aid the harmo-nization of national and international standards and provide technicaladvice on exporting was seen particularly as important, given that suchspecialist advice typically cannot be obtained from local educationalestablishments.
WP 42 Case Studies
30
31
Table 2.16 summaries cross-country comparisons for mean values andANOVA F-tests relating to market structure, firm characteristics, supplybase, and contracting.
From table 2.16, the discussion presented here is limited to those find-ings which are most noteworthy. The percentage of sales accounted forby the domestic market varies significantly between countries. In Russiaand Ukraine most sales are made within national boundaries, while forArmenia, Georgia, and Moldova a greater proportion of sales are exported.The greater proportion of exports for Armenia, Georgia, and Moldovareflects the smaller size of their domestic market and limited nationalopportunities for growth. On closer examination it is revealed that themajority of exports go to other Central and East European Countries(CEECs)/FSU. No statistically significant differences are recorded forexport sales to the EU-15 or the rest of the world.
Although differences exist between countries in terms of firm size asmeasured by the mean number of employees (the mean figure forArmenia being nearly four times that for Georgia), these differences werenot found to be statistically significant. By contrast, differences in meanturnover between countries were statistically significant at the 10 percentlevel, with Georgian and Russian firms reporting the lowest turnovers,and Ukraine the highest. Given the number of comments made relatingto high taxation rates and the shadow economy, one must be careful ininterpreting turnover data—it is not always clear whether data reflect gen-uine differences in terms of the performance of firms, or rather a differ-ence in terms of willingness to divulge accurate financial data.
The mean values of capital investments are significantly higher inMoldova and Ukraine than in Armenia, Georgia and Russia. When ana-lyzing the amount of capital investment per employee, the highest fig-ures are recorded for Moldova and Armenia. Capital investment inboth absolute terms and relative to firm size has been modest in theGeorgian and Russian samples. The Moldovan results reflect the higherlevel of foreign direct investment which is linked significantly with capi-tal investment (see table 2.4).
No statistically significant differences were recorded between countriesin relation to firms’ supply bases. While recognizing this, it is interesting tonote the extent to which supplier numbers vary from country to country.For example, Ukrainian firms utilized nearly 10 times as many suppliers
A N N E X 1
COUNTRY COMPARISONS
32
TAB
LE 2
.16
Com
pari
son
of M
arke
t Str
uctu
re, F
irm
Cha
ract
eris
tics,
Sup
ply
Bas
e, a
nd C
ontr
actin
g by
Cou
ntry
Arm
enia
Geo
rgia
Mol
dova
Russ
iaU
krai
neF-
test
Mar
ket S
truc
ture
% o
f sal
es to
dom
estic
mar
ket
63.9
253
.86
51.5
896
.25
99.8
36.
827*
**%
of s
ales
to o
ther
CEE
Cs /
FSU
27.5
029
.88
39.4
21.
500.
105.
709*
**%
of s
ales
to E
U-15
0.42
6.82
6.83
1.25
0.00
1.83
1%
of s
ales
to re
st o
f wor
ld8.
179.
443.
001.
000.
071.
870
Firm
Cha
ract
eris
tics
Empl
oym
ent (
2003
)13
3.92
526.
5825
9.00
218.
0840
8.75
0.62
3Tu
rnov
er (2
003)
3,30
5,60
31,
460,
057
3,67
8,05
71,
808,
042
7,71
2,66
72.
184*
Valu
e of
inve
stm
ents
(USD
)60
7,25
065
1,90
82,
009,
909
409,
667
1,52
0,50
02.
861*
*Ca
pita
l inv
estm
ent (
USD)
per
em
ploy
ee (2
003)
8,06
43,
290
9,87
83,
610
3,97
82.
245*
% o
f cap
. priv
atel
y ow
ned
80.5
870
.26
61.8
894
.92
100.
003.
188*
*%
of c
ap. f
orei
gn o
wne
d 19
.42
21.4
137
.54
0.00
0.00
3.66
7***
Supp
ly B
ase
No.
of s
uppl
iers
(200
3)67
3.00
388.
6072
8.70
184.
701,
650.
901.
261
No.
of s
uppl
iers
(200
1)53
4.50
252.
8055
0.70
155.
8087
9.30
0.67
5N
o. o
f sup
plie
rs p
er e
mpl
oyee
(200
3)4.
606.
202.
908.
3010
.50
0.30
1N
o. o
f sup
plie
rs p
er e
mpl
oyee
(200
1)6.
005.
703.
306.
701.
500.
327
Cont
ract
ing
% o
f raw
mat
eria
l bou
ght u
sing
farm
con
tract
s (2
003)
59.2
532
.42
64.9
646
.42
33.7
51.
834
Mea
n nu
mbe
r of c
ontra
ct s
uppo
rt m
easu
res
empl
oyed
4.00
3.67
5.33
1.50
2.33
4.75
8***
% o
f sup
ply
from
sm
all f
arm
s (b
oth
spot
& c
ont.)
42.6
740
.58
55.6
725
.89
22.0
81.
919
% o
f sup
ply
from
larg
e fa
rms
(bot
h sp
ot &
con
t.)33
.25
30.5
837
.46
26.6
138
.33
0.29
6N
umbe
r of s
mal
l far
ms
deal
t with
(200
3)60
5.64
338.
1763
9.64
165.
001,
409.
090.
982
Num
ber o
f lar
ge fa
rms
deal
with
(200
3)18
6.42
17.5
879
.92
14.6
721
6.00
1.19
5
*Sig
nific
ant a
t the
10%
leve
l; **
sign
ifica
nt a
t the
5%
leve
l; **
*sig
nific
ant a
t the
1%
leve
l
33
as their Russian counterparts in 2003. In part, this reflects differences infirm size; differences are far less apparent when considering the numberof suppliers per employee. The number of suppliers per employee can betaken as an indication of the degree of fragmentation of the supply base.The lowest supplier–employee ratio was recorded for Moldova, whichalong with Armenia was the only country to see a reduction in the supplier–employee ratio between 2001 and 2003. The fall in Moldovamay reflect a degree of consolidation in land management following landreform and radical decollectivization in the late 1990s.
Only one statistically significant relationship was identified for contract-ing, namely the mean number of contract support measures employed. Thenumber of support measures offered is significantly higher in Armenia,Georgia, and Moldova than in Russia and Ukraine. This may reflect thegreater level of FDI in the Armenian, Georgian, and Moldovan samples,given the previously found link between FDI and contract support(table 2.12).
Table 2.17 details the use of contract support measures by country.Contract support appears to be most well developed in Moldova andleast prevalent in Russia and Ukraine. The figure for Moldova may reflectthe importance of export markets, the importance of wine/brandy, fruit
TABLE 2.17 Percentage of Firms in Each Country Offering Particular SupportMeasure to at Least Some of the Small Farm Suppliers
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
and vegetable and sugar production (see annex 2), and the influence ofFDI. Credit is widely given in Moldova and a majority of firms also pro-vide prompt payments and transportation. In Russia, by contrast, apartfrom transportation and machinery, other support measures are offeredby processors in 25 percent or less cases. It is noticeable that not a singleprocessor in Russia reports that they offer prompt payments or guaran-teed prices. The Russian sample is overwhelmingly domestically ownedand it may be that if FDI occurred and foreign investors started provid-ing better farm-level support, domestically owned processors would beforced to improve their offerings.
WP 42 Case Studies
34
35
The main characteristics of firms in each sector and their contracting andsupply relationships are summarized in table 2.18.
A comparison of the six sectors shows that liquid milk, sugar, and the“other category” are most oriented to the domestic market. Exporting issignificant in the wine/brandy and fruit and vegetable sectors, where inboth cases most exports go to other CEECs and FSU states. Little isexported to the EU-15 or the rest of the world. Developing export mar-kets outside of the FSU remains a major challenge.
The largest companies by employment are in the sugar and “other”industries. By turnover, sugar, wine/brandy, and liquid milk processinghave the largest mean sizes. The highest mean capital investments havebeen recorded in the sugar, wine/brandy, and fruit and vegetable sectors.In each subsector, the majority of firms are privately owned but foreigninvestment has been highest in wine/brandy, and sugar processing.
There are significant differences between sectors in terms of their sup-ply bases. Table 2.18 records the mean number of suppliers (sum of farmsdealt with via spot markets and contracts and other agents/distributors).In most sectors, processors deal with a large number of suppliers: themeans for the sugar and wine/brandy sectors in 2003 were 1,979 and 1,639,respectively. Comparing the number of suppliers in 2001 and 2003, in allsectors except sugar, the total number of suppliers increased between thetwo dates. In the sugar industry, the mean number of suppliers fell from2,299 in 2001 to 1,979 in 2003, although one should remember thatonly four companies are included in this sector. The mean number of sup-pliers per employee in the processing plant gives an indication of thedegree of fragmentation of the supply base. The highest fragmentation isrecorded in the fruit and vegetable sector with, in 2003, a mean of 13.6suppliers per employee in processing. This may reflect how fruit and veg-etable production has low entry barriers. The most concentrated supplybases using this measure are recorded in the speciality dairy (cheese, icecream, kefir, etc.) and sugar sectors.
By analyzing the use of contracts and the balance between small andlarge farm suppliers, it is evident that a greater proportion of raw materialsare bought using contracts with farmers in the liquid milk, fruit and veg-etables, and sugar sectors. In the speciality dairy sector, the use of otheragents and wholesalers is more prominent and this probably reflects adegree of specialization in farm relationships (see annex 3). A noticeably
A N N E X 2
SECTOR COMPARISONS
36
TAB
LE 2
.18
Com
pari
son
of M
eans
for M
arke
t Str
uctu
re, F
irm
Cha
ract
eris
tics,
Sup
ply
Bas
e, a
nd C
ontr
actin
g by
Sec
tor
Liqu
id M
ilkSp
ecia
lty D
airy
Win
e / B
rand
yFr
uit a
nd V
eg.
Suga
rO
ther
Tota
l
No.
of c
ompa
nies
2010
108
48
60
Mar
ket S
truc
ture
% o
f sal
es to
dom
estic
mar
ket
96.8
78.5
24.0
46.2
95.0
84.4
73.1
% o
f sal
es to
oth
er C
EECs
/ FS
U2.
116
.062
.335
.35.
06.
819
.7%
of s
ales
to E
U-15
0.8
0.0
2.6
12.2
0.0
5.6
3.1
% o
f sal
es to
rest
of w
orld
0.4
5.5
11.1
7.6
0.0
3.3
4.3
Firm
Cha
ract
eris
tics
Empl
oym
ent (
2003
)28
3.9
94.1
245.
219
3.5
462.
576
0.9
309.
3Tu
rnov
er (2
003)
3,73
9,08
91,
914,
178
5,86
7,10
12,
498,
179
8,02
2,50
01,
362,
887
3,59
2,88
5Va
lue
of in
vest
men
ts (U
SD)
530,
167
446,
333
1,83
1,11
91,
322,
125
2,85
0,00
043
6,46
31,
005,
963
Capi
tal i
nves
t (US
D) p
er e
mpl
oyee
(200
3)2,
743.
69,
221.
27,
231.
210
,303
.76,
140.
42,
040.
35,
754.
4%
of c
apita
l priv
atel
y ow
ned
85.9
91.5
67.7
70.6
74.4
90.0
81.5
% o
f cap
ital f
orei
gn o
wne
d11
.08.
032
.316
.925
.610
.015
.7
37
Supp
ly B
ase
No.
of s
uppl
iers
(200
3)68
9.9
75.0
1,63
8.8
484.
81,
979.
354
.171
5.5
No.
of s
uppl
iers
(200
1)18
5.5
61.7
1,19
6.4
399.
02,
298.
547
.045
7.7
No.
of s
uppl
iers
per
em
ploy
ee (2
003)
6.28
2.90
11.2
413
.64
3.52
0.47
6.55
No.
of s
uppl
iers
per
em
ploy
ee (2
001)
1.45
3.33
12.7
611
.71
3.37
0.57
4.82
Cont
ract
ing
% o
f raw
mat
eria
l bou
ght u
sing
farm
con
tract
s (2
003)
58.8
38.5
47.8
51.3
52.4
22.9
47.4
Tota
l num
ber o
f con
tract
sup
port
mea
sure
s em
ploy
ed3.
253.
504.
203.
635.
751.
003.
37%
of s
uppl
y fro
m s
mal
l far
ms
(bot
h sp
ot &
con
t.)33
.828
.779
.141
.46.
316
.737
.4%
of s
uppl
y fro
m la
rge
farm
s (b
oth
spot
& c
ont.)
39.7
19.8
12.0
57.4
61.1
22.5
33.2
Num
ber o
f sm
all f
arm
s de
al w
ith (2
003)
635
301,
604
382
1,27
539
618
Num
ber o
f lar
ge fa
rms
deal
with
(200
3)88
3930
103
704
1010
3
low proportion of supply comes from small farms in the sugar sector(6.3 percent), although sugar refineries do deal with a large number of smallfarms (1,275 in 2003). In the wine/brandy sector, over three quarters ofgrapes come from small farms and this may reflect why so many winer-ies in the FSU wish to purchase vineyards to provide a more stable sup-ply of grapes that meets their quality requirements. In the other category,the use of other agents/distributors is also significant and in this sub-sectorthe use of contract support measures is limited.
Contract support measures are most widely used in the sugar sector(mean of 5.75 measures employed per processor) and for wine/brandy.This may reflect how (a) processors are procuring directly from farmersrather than agents/distributors, (b) FDI has been more significant in thesesectors, and (c) quality requirements are more acute in these sectors.
Table 2.19 provides a more detailed guide to the use of particular sup-port measures in each sector. While noting the small number of responses,credit, agronomic support, harvest/handling support, and farm loanguarantees are offered by three out of the four sugar refineries. All four of
38
TABLE 2.19 Percentage of Firms in Each Sector Offering Particular SupportMeasure to at Least Some of the Small Farm Suppliers
Liquid Specialty Wine / Fruit and Milk Dairy Brandy Veg. Sugar Other
Mean number 3.25 3.50 4.20 3.63 5.75 1.00of contract support measures
WP 42 Case Studies
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
39
the sugar processors offer physical inputs to at least some of the farmerswith whom they deal. Most wineries offer transportation and agronomicsupport. Veterinary support is less prevalent than agronomic support andinvestment loans are not common in any industry. Prompt paymentsappear to be more common in the wine/brandy, fruit and vegetables, andspeciality dairy sectors. In these cases many deals are based on cash trans-actions. Two out of the four sugar refineries offer guaranteed prices, incontrast to the liquid milk sector where only two out of the 20 dairiesoffer such support.
The largest subsector in the sample is firms that have some involvementin dairy processing (30 companies). This group is, however, quite diversewith two distinct product groups: liquid milk pasteurizers and specialtydairies for which value-added ice cream, dairy, and/or cheese productsare their most important lines. In a few cases dairy processing is not themain activity of the enterprise, but their activities in monitoring milkquality were noted (section 4 of the questionnaire), with the questionsset drawing on previous survey work by Dries and Swinnen (2002).Considering procedures for testing milk quality and adjusting paymentsaccordingly (table 2.20), all processors test for fat content and the over-whelming majority also assess consistency, residiums, and germ content.While all but two dairies modify payments based on fat content, adjust-ments for other dimensions of quality such as cell, protein, and germcontent are less common.
40
A N N E X 3
DAIRY INDUSTRY
TABLE 2.20 Testing and Adjustment of Payments for Milk
Number of % of Number of % of Dairies Dairies Dairies Dairies Adjusting Adjusting Testing Testing Payments Payments Milk on Milk on Based on Based on
Broadly speaking, dairies are procuring milk in two main ways depend-ing on the nature of their operations (table 2.21). Plants that principallypasteurize liquid milk have contracts with large and small farmers as theircore supply line and source additional supplies through spot markets andfrom other agents (wholesalers, intermediaries). Dairy plants that havemuch smaller volumes, such as niche ice cream and cheese producers, usewholesalers, other dairies, and intermediaries as their most importantsource of liquid milk (mean of 46.6 percent) and some no longer havedirect connections with farmers (table 2.21).
This suggests some form of specialization in contracting. It is rationalfor most of those that are using relatively small amounts of milk on aninfrequent basis not to invest in contract support measures and directlinkages with farmers where they can form a stable relationship with asuitable wholesaler or other dairy.
By analyzing both liquid milk processors and specialty dairies bycountry (table 2.22), it is evident that contracting is most extensivelydeveloped in Moldova and Armenia. This can be discerned both in termsof the share of raw materials sourced using contracts and the mean num-
TABLE 2.21 Differences in Sourcing of Milk Depending on Type of Dairy
Type of Dairy Number Mean Std. Deviation
Total percentage of raw material liquid milk 20 58.80 36.3bought using contracts in 2003
ice cream, cheese, 20 38.50 43.6and specialist
Share of total raw materials liquid milk 20 24.10 26.2from other agents in 2003
ice cream, cheese, 10 46.60 44.2and specialist
TABLE 2.22 Comparison of Ownership and Contracting in Dairy Sector Only(Both Liquid Milk and Specialty Dairies) by Country
Armenia Georgia Moldova Russia Ukraine Total
Ownership and Exports
% of cap. privately owned 100.00 80.00 43.30 91.30 100.00 87.70% of capital owned by 0.00 20.00 55.00 0.00 0.00 10.00
Western foreign investors
% of output sold on the 64.20 100.00 92.50 95.40 99.70 90.70domestic market
Contracting% of raw material 69.20 42.50 81.30 58.00 27.20 52.00
bought using farm contracts (2003)
Mean number of 5.67 3.50 5.25 2.43 1.56 3.33contract support measures employed
% of supply from small 23.66 17.50 71.25 29.29 28.89 32.07farms (both spot & cont.)
41
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
ber of contract support measures employed. In Moldova, this may reflectthe higher level of Western FDI and the previously discussed linkagebetween Western FDI and contracting (table 2.12). In Armenia, the rela-tively high level of contracting cannot be linked directly to FDI becauseall of the dairies in this country are owned by domestic investors. However,a relatively high proportion of Armenian output is exported and a sig-nificant correlation between exporting and the mean number of contractsupport measures was found for the full sample (table 2.13).
WP 42 Case Studies
42
A Comparative Study of Agrifood Chains in Moldova, Armenia, Georgia, Russia, and Ukraine
43
NOTE1. The comparison was made for 1997–2003. If data for 1997 were not available,
the comparison was made for 1999 with 2003.
REFERENCESBlanchard, O., and M. Kremer. 1997. “Disorganization.” Quarterly Journal of Economics
112(4): 1091–1126.Churchill, G. A. 1999. Marketing Research: Methodological Foundations. Orlando, FL:
Dryden Press.Dries, L., and J. F. M. Swinnen. 2002. Finance, Investments, and Restructuring in Polish
Agriculture. Research Group on Food Policy, Transition & Development, KatholiekeUniversiteit Leuven, mimeo.
——. 2004. “Foreign Direct Investment, Vertical Integration and Local Suppliers:Evidence from the Polish Dairy Sector.” World Development 32(9): 1525–44.
Escobal, J., V. Agreda, and T. Reardon. 2000. “Endogenous Institutional Innovationand Agroindustrialization on the Peruvian Coast.” Agricultural Economics 23: 267–77.
FAO (Food and Agriculture Organization). 2003. “Moldova: Tight Food SupplyEnvisaged Following a Severely Cold Winter and Exceptionally Dry Spring.” FAOGlobal Information and Early Warning System on Agriculture and Food, July 22,http://www.fao.org/docrep/005/y9985e/y9985e00.htm.
Gow, H. R., D. H. Streeter, and J. F. M. Swinnen. 2000. “How Private ContractEnforcement Mechanisms Can Succeed Where Public Institutions Fail: The Caseof Juhocukor a.s.” Agricultural Economics 23(3): 253–65.
Gow, H. R., and J. F. M. Swinnen. 2001. “Private Enforcement Capital and ContractEnforcement in Transitional Economies.” American Journal of Agricultural Economics83(3): 686–90.
Lincoln, Y. S., and E. G. Guba. 1985. Naturalistic Inquiry. Beverly Hills, CA: Sage.Merriam, S. 1998. Qualitative Research and Case Study Applications in Education. San
Francisco: Jossey-Bass.Striewe, L. 1999. Grain and Oilseed Marketing in Ukraine. Iowa State University
Ukraine Agricultural Policy Project (UAPP), Kiev.
Vertical Integration in anAgroindustrial Complex
Agrofirms and Agroholdings in Russia
E K A T E R I N A A . G A T A U L I N A , * VA S I L I Y Y. U Z U N , †
A L E X A N D E R V. P E T R I K O V, ‡ A N D R E N ATA G . YA N B Y K H §
45
EXECUTIVE SUMMARY
After 1998, large integrated agroindustrial organizations emerged inRussian agriculture. The objective was to restore the broken ties betweenagriculture and processing, as well as to rehabilitate financially agricul-tural enterprises with large debts. The devaluation of 1998 increased theinterest in processing and trading enterprises in domestic farms.
Two main forms of integration exist. Agroholdings consist of a parent anddaughter companies, with the parent company holding a controlling blockof stock of the daughter companies. Agroholdings usually include agricul-tural, processing, and servicing enterprises which remain legal entities.Agrofirms incorporate agricultural, processing, and servicing enterprises, notas separate legal entities, but as production departments of the agrofirm.
The creation of integrated agrofirms and agroholdings was stronglysupported by Russian authorities. Integration is regarded as a way to
3
* Senior Scientist and Professor, Department of Reformation of Agriculture, All-Russian Institute for Agrarian Problems and Informatics named after A. A. Nikonov.
† Head, Department of Reformation of Agriculture, All-Russian Institute for AgrarianProblems and Informatics named after A. A. Nikonov.
‡ Russian Academy of Agricultural Science and the Director of the All-RussianInstitute for Agrarian Problems and Informatics named after A. A. Nikonov.
§ Director of the Foundation for Support of Agrarian Reform and Rural Development(RosAgroFond).
increase the effectiveness of the agroindustrial complex, to rehabilitatefinancially insolvent agricultural enterprises, and to attract investmentsto agriculture. Regional and district authorities usually exercise a stronginfluence on the agrofirms and agroholdings. The integrated structuresneed to accept other functions apart from profit maximization, such asthe rehabilitation of insolvent businesses. In return, they are granted cer-tain privileges by the authorities.
Through the integrated companies, agricultural enterprises receivecredit. For enterprises that have no other access to bank loans, this creditis important. In turn, they sell their products to the regional fund at pricesregulated in the region.
In several regions, authorities actively support the creation of suchlarge integrated companies. For example, in Orel region both the stateand private agricultural enterprises participate in the integrated struc-tures. During 1995–2001, four very large agroholdings and 37 large agro-firms were created. Significant budget resources were directed to theintegrated companies. They attracted foreign credits with a guarantee ofloan repayment from the authorities for the delivery of tools andmachines. By 2003 about one half of the resources and sales volumes oflarge and medium enterprises was concentrated in these companies. Theyproduced about 20 percent of the agricultural produce of the region.
The impacts of the vertical integration were mixed. The creation ofthese large integrated companies coincided with a recovery in crop area,including grain crops. Further, starting with the 2000 crop, yieldsincreased. However, a comparative analysis of the efficiency of the agro-holdings and the nonintegrated businesses in Orel region shows that themost efficient organizations are the large independent agrofirms. Non-integrated businesses are more efficient than agrofirms which are part ofthe agroholdings.
The integrated companies increased investments in agriculture andaccess for agricultural enterprises to new tools and machines and to otherresources and credits. This led to an increase in production and sales,crop yield, and productivity. However, at the same time profitability andprofit declined, and debts increased. The main cause is the conflict ofinterests of the persons and structures involved in large integrated com-panies. Constant interference by the authorities is also a problem.
The agrofirms and agroholdings work with the small-scale sector(subsidiary farms of households), because they produce a significant partof milk and meat. There is now strong competition for their products inthe region. The integrated companies often include a special departmentfor purchasing these commodities. However, private subpurchasers drivenby their own interest are more mobile and successful than integrated
WP 42 Case Studies
46
companies, despite the fact that agricultural enterprises provide moreassistance to the owners of subsidiary plots, who most often areemployed by the enterprises.
INTRODUCTION
Outside of Russia agricultural producers usually form cooperatives whichare responsible for provision of resources, storage, processing, and saleof agricultural products. Contractual interactions between agriculturalcompanies and agricultural manufacturers has also become widespread.
Neither cooperatives, nor integration based on contractual relation-ship have become widespread in Russia because of the weakness and lackof organization of private agricultural manufacturers, high transactioncosts of contract execution, and poor legislation.
Further, agricultural production is either unprofitable or brings lowprofit, whereas processing of agricultural raw products and trade aremore profitable. Low profitability of agriculture is a consequence of bothinterindustry price disparities and incomplete reforms in this sector.
In these conditions many politicians and practical specialists see thesolution to the problem in setting up integrated organizations—agrofirmsand agroholdings, which should include agricultural, processing, and ser-vicing enterprises. Such organizations within a firm are supposed to solvethe price problems for agricultural products and also result in cuts in trans-action costs. The integrated organizations receive the status of an agri-cultural producer and enjoy tax privileges.
Agrofirms and agroholdings present a common form of integrationin Russia. Agrofirms incorporate agricultural, processing, and servicingenterprises. Enterprises incorporated into an agrofirm cease to be a legalentity and become production departments of the agrofirm. Agroholdingsconsist of a parent and daughter companies. The controlling block of stockof daughter companies belongs to the parent company. Agroholdings usu-ally include agricultural, processing, and servicing enterprises which, asa rule, remain legal entities.
The creation of agrofirms and agroholdings is actively supported byauthorities in Russia. They regard integration not only as a method ofimproving agroindustrial complex effectiveness, but, most of all, as a wayto financially rehabilitate bankrupt agricultural enterprises and as a toolto attract investments to agriculture.
This study analyzes the motivation and mechanisms for the creationand operation of agrofirms and agroholdings in Russia, and the eco-nomic and social consequences of the formation of these integratedentities.
Vertical Integration in an Agroindustrial Complex
47
The case study in this report focused on the agroholding Orel Agro-complex, agrofirm Soskovo, which is incorporated in this holding, andthree agricultural enterprises that used to be independent entities butnow, as a result of the integration, form part of the above-mentionedagrofirm. Interviews were conducted with workers of the holding and ofthe agrofirm.
The data sources are statistical and accounting reports of Orel Agro-complex and Soskovo agrofirm and its departments (the former agricul-tural entities); analytical materials provided by the economics departmentof the agrofirm; information from the database of State Committee ofthe Russian Federation (RF) on Statistics (Goskomstat) on large andmedium enterprises of RF covering a number of years; materials ofConsultantPlus information and legal services system; publications onthe topic of study; and results of interviews with workers of the agrofirmand of the holding.
AGROINDUSTRIAL VERTICAL INTEGRATION IN RUSSIA
Motivation for Vertical Integration in the Agroindustrial Complex
After the 1998 crises, when the national currency suffered a fourfold deval-uation, domestic production replaced imported goods. Trading and pro-cessing companies faced an acute problem of raw materials provision. Thesituation was made worse by large overdue debts of agricultural manu-facturers, by aging of tools and machines, and by low quality of the work-force. The state of affairs in agriculture and, as a consequence, the growingsocial tension made local authorities concerned with the situation andprompted them to look for a solution to the crisis. At the same time therewere a number of nonagricultural successful companies in Russia, which,provided they received certain privileges from regional authorities, couldinvest in agriculture. Agriculture, because of its low profitability and highrisks, compared to other domains, needed extra guarantees and extra sup-port from authorities in order to attract such investments.
A number of large nonagricultural companies regarded agricultureeither as a possible area for investment for diversification of their activi-ties (Stoylensk ore mining and processing plant, Norilsk Nickel) or as a“subsidiary farm” (Gazprom). Also, acquiring land property became astrong incentive for such companies to invest in agriculture in recent yearsbecause land is considered a good investment, not susceptible to infla-tion. Improvement of the market climate due to the devaluation of theruble led to increased profitability of a number of branches of agriculture.For example, after 1996 the production of sunflower seeds, small-graincrops, and eggs has been profitable. The combination of these factors
WP 42 Case Studies
48
provided the incentive for vertical integration in agriculture in differentregions of the Russian Federation.
Main Forms of Integration
Vertical integration followed four directions. The first direction—develop-ment of processing plants and setting up trade within already functioning agri-cultural enterprises—was a widespread trend during the reforms and in thepostreform period in Russia. It was driven by the desire of the heads ofagricultural enterprises to get a higher income, guaranteed by producinghigher added value. This was made possible by the appearance of mini-plants for processing agricultural products. The highest development ofwithin-enterprise processing was of milk, meat, sunflowers, and someother types of products, including fruit and vegetables. Thus, accordingto the annual report of Ministry of Agriculture of Russian Federation,while in 1990 only 1.3 percent of milk sold by agricultural producers,received industrial treatment, in 2002 the figure grew to 5.8 percent.Especially widespread were slaughter and processing of cattle and poul-try by agricultural enterprises. In 2002, of the total of 3.3 million tonnesof cattle and poultry sold, more than 45 percent were slaughtered in theenterprises. Further, 14 percent of meat was processed in plants owned bythe agricultural organizations.
An approximate diagram of such integration, using a sunflower grow-ing farm that also has a livestock breeding branch in its structure as anexample, is shown in figure 3.1.
However, this type of integration led to poorer quality of products.Besides, the financial state of agricultural enterprises with processingplants did not improve either. For example, in Penza region in 2000, 26 percent of all sunflower seed oil produced came from such attachedprocessing plants. Its quality was low, and more than 60 percent of the
Vertical Integration in an Agroindustrial Complex
49
livestock breeding department
crop production department (sunflower seeds,fodder)
crop processing department (sunflower seed oil production)
processing waste (oilcake) used in livestock breeding
fodder
FIGURE 3.1 Diagram of Processing Integration (Sample: sunflower seed-growing enterprise)
product was given to the enterprise’s workers as a way to compensate forthe arrears of wages (Korol’kova 2001).
The situation with sales outlets was also difficult. Own trade impliedadditional costs for opening and maintaining shops and complying withrequirements regarding assortment of products. The shops of agriculturalenterprises could not compete with already existing shops because of theformers’ small turnover (Deryuga et al. 2003).
Hence this form of integration did not solve the problems of social ten-sion in the villages, attracting investments, or improving interindustrialrelations. However, it continues to exist and allows the manufacturersof agricultural products to enjoy certain benefits from receiving a shareof additional surplus produce.
The second direction was integration during privatization. The schemes ofprivatization of processing plants were designed to integrate agricultureand processing. Russian legislature envisaged incorporation of former stateprocessing enterprises by passing 51 or 49 percent of stock to agriculturalorganizations supplying raw material. The remaining stocks were receivedby the workers of the processing enterprise—a wonderful project thatfailed. First, the majority of processing plants were privatized using the sec-ond scheme and 51 percent of stock was given to the workers. As a conse-quence, after privatization the actual control of the agricultural enterpriseover the processing enterprises proved very feeble, and with passage oftime the agricultural organizations lost all control, either because theysold their shares or because additional emissions of shares resulted indepreciation of the shares belonging to the agricultural organization. Also,the processing plants needed investors. Agricultural organizations couldnot be investors as they themselves were in poor financial shape.
The third direction—creation by agricultural enterprises of processing orservicing cooperatives—did not enjoy widespread success because largeagricultural enterprises did not need cooperation, while most smallerfarmers, those who had left collective or state farms, had low volumesand were scattered over the territory and failed to form a critical mass forsetting up a cooperative. They did not trust each other and regarded acooperative as a return to a collective farm.
The most common form of integration in modern Russia is the fourthdirection—the creation of agrofirms and agroholdings. The main structuresof agrofirms and agroholdings are shown in figure 3.2. An agrofirm isone legal entity with lots of departments, while an agroholding uniteslegally independent daughter enterprises. Figure 3.2 provides organizationschemes of existing agrofirms and agrocompanies.
The possibility of using combined property to also consolidate financial-managerial activities, in particular, taxation, budgeting, insurance, account-
WP 42 Case Studies
50
Vertical Integration in an Agroindustrial Complex
51
Agriculturalenterprise
#1
Processingenterprise
Agriculturalenterprise
#2
Servicingenterprise
Agriculturaldepartment
#1
Agriculturaldepartment
#4
Agriculturaldepartment
#2
Agriculturaldepartment
#3
Agroholding
Tradingenterprise
Tradedepartment
Processingdepartment
Servicingdepartment
Constructiondepartment
Agrofirm
FIGURE 3.2 Organizational Structure of Agrofirm and Agroholding
ing, and other schemes, which provide a tight control over the use offunds, is regarded as a positive aspect of agrofirms and agroholdings bythe investor-integrator.
The main problem of the majority of integrated agricultural produc-ers, as part of agrofirms or agroholdings, is their financial and manage-rial weakness which puts them in a dependent position. On the otherhand, the inflow of investments and the resulting possible financial reha-bilitation are positive aspects for weak agricultural producers who, other-wise, would lead a miserable life or go bankrupt.
Agroholdings
The “temporary regulation of holding companies, created in the process ofincorporation of state enterprises,” passed by the Decree of the President ofRussian Federation on November 16, 1992, serves as the legislative basisfor the holdings. Although it is not an easy task to define types of holdings,two types can be singled out: those based mainly on state property andthose based on private property. The first type clearly prevail in Orel region,in which state control of the regional agricultural–industrial complex is
very strong. The second type dominates in Belgorod region and is alsocommon in other regions. Large state agroholdings and agrofirms may bethought of as a transitional institution for financial rehabilitation of agri-cultural enterprises with the help of budget funds. Later on they are trans-ferred to private owners, as is seen from developments in Orel region(such as Orlovschina and Orlov agrocomplex, which are separate agro-firms). The fact that large private agricultural businesses are more appeal-ing to investors as compared to state businesses is illustrated by the datain table 3.1.
WP 42 Case Studies
52
Belgorod region attracted many times more investments in agro-industrial complexes than Orel region. At the same time the budget ofBelgorod region, unlike that of Orel region, virtually stopped investingin agriculture.
Agroholdings are commercial organizations, and making profit istheir objective as stipulated by their charter. On the other hand, we needto take into account the fact that any reorganization of agricultural busi-nesses cannot avoid coordination with local authorities, which set forththeir own provisions. Therefore, holdings of both types have to acceptcertain social obligations, and that can negatively influence their prof-itability (e.g., weak enterprises become part of the structure instead ofstrong ones). In return, authorities grant agroholdings certain privileges.State organizations perform these functions to a greater extent, comparedwith private ones, because the state has more controlling rights. Manystructures in Orel region have been created following direct orders ofregional authorities.
Large private structures usually also work in close cooperation withauthorities. Thus, the initiative to create agroholdings in Belgorod region
TABLE 3.1 Investments to Fixed Assets (rubles per 100 ha of agricultural land inprices effective for corresponding years)
Indicator 1999 2000 2001 2002
Investments into fixed assets in Belgorod region 39.0 51.3 128.3 120.5Investments into fixed assets of agricultural– 17.2 81.0 43.6 35.1
industrial complex in Orel regionInvestments into agricultural–industrial 2.7 0.8 0.1 0.02
complex from the budget of Belgorod regionInvestments in agricultural–industrial complex 1.0 2.6 5.5 0.3
from the budget of Orel region
was exercised by the governor, who issued Decree #710 on December 14,1999: “On measures to economically rehabilitate bankrupt agriculturalenterprises.” According to this Decree together with state investments,which are insufficient, funds of successful enterprises should be directedto villages—and large private agroindustrial holdings need to be created.
The first holding called Stoylenskaya Niva was founded in December2000. According to a press publication, the governor of Belgorod region“asked” the head of Stoylensk ore mining and processing plant FyodorKljuka to enter agricultural business. A key condition for the creation ofthe corporation was the consolidation of funds and farm land shares,which were transferred by the ex-owners to the new owners for manage-ment: 49 percent of shares in the new formations were received by theowners of the land shares, and 51 percent by the investors of agriculturalenterprises. Thus, after the enterprise was registered, the investor becamede facto the owner of the land, giving in return the consent to take part infinancial revitalization of agricultural enterprises in the region.
The transfer of ownership of agricultural enterprises to the holdingcould take various forms: purchase of shares, redemption of stock forarrears to the budget, investment into authorized capital stock, transferof state ownership, or lease. As a result, an integrated structure emerged,with the controlling block of shares both in the head (management)company and in daughter companies belonging to the investor.
The organization and the legal form of agroholdings are designed toprovide the investors with guarantees of protection of the invested funds.The most common are open and closed joint stock companies and lim-ited companies, which better correspond to a classic definition of aholding with head and daughter companies. This is seen in the CentralBlack Earth region as well as in other regions of Russia (Chernyaev et al.2002, p. 18). Out of 19 large agroholdings in Belgorod region, 13 werejoint stock companies in 2002. For example, the large holding Efirnoye,holdings in Orel region, Parnas-M in Leningrad region, and others are alllimited companies.
Holdings are developing in almost all branches of agriculture. Someholdings deal with many crops and livestock products (Orel Niva JSC,Stoylenskaya Niva, Belagrogaz) and others specialize in one commodity(Pshenitsa-2000 Orel [wheat], Siberian milk, Tomilino poultry).
Our research indicated that this process contributed to the emergenceof very large firms, sometimes owning hundreds of thousands of hectaresof land, employing many thousand workers, and having access to multi-million and even multibillion credits. The largest Russian industrialholding Gazprom is at the same time the largest agroholding: 91 enter-prises are in its structure. They are controlled by 25 daughter companies
Vertical Integration in an Agroindustrial Complex
53
of Gazprom, and many of these have their own daughter companies.Some agroholdings were profitable, and others were unprofitable.
The integration processes are most active in Belgorod and Orel regions.In Belgorod region more than two thirds of agricultural enterprises arepart of integrated structures. In 2001–2 almost 80 percent of arable landwas concentrated in integrated structures, whereas less than 25 percent ofland was under cultivation by such formations in other areas of CentralBlack Earth region (Chernyaev et al. 2002, p. 63). In 2002 in Orel, 26 per-cent of all farm workers were employed by the three largest holdings,which also owned 41 percent of arable land. But there are still indepen-dent agrofirms and other integrated formations in the region.
Integration has its positive factors, including concentration of pro-duction, better supply of resources to agricultural enterprises, lower exter-nal transaction costs of each member of the structure, and a moreprominent role in the market played by the integrated structure. Invest-ments usually lead to growth of production indicators, as was the case forthe majority of agricultural enterprises of integrated structures, in partic-ular in Orlov, Belgorod, and Voronezh regions. For example, the increasein output between 2000 and 2002 in Voronezh region for integratedagricultural enterprises was: grain production per 100 ha of arable land,112 percent; sugar beet, 48 percent; milk, 57 percent; cattle gain in weight,111 percent. In 18 large agroholdings in Belgorod region similar indi-cators were: grain, 69 percent; sugar beet, 33 percent; milk, 62 percent(Chernyaev et al. 2002, pp. 63–64).
At the same time the financial results were not always satisfactory. Inintegrated structures in Voronezh region the profitability rate for graindeclined (−17.6 percent), as was the case for milk (−44.9 percent) and forlive weight of cattle (−33.1 percent). The same situation is seen in agro-industrial formations in Belgorod region. In 2002 the profitability ratedeclined: for grain (−1.3 percent), for milk (−8.4 percent), for live weightof cattle (−19.8 percent) (Chernyaev et al. 2002, pp. 70–71). In 2002 therewere 19 large agroholdings in Belgorod region. The number of agriculturalenterprises within these agroholdings showing losses increased from 67 in2001 to 110 in 2002. The number of profitable enterprises decreased from84 to 39. Only 6 agroholdings out of 19 were profitable. In fact, the finan-cial results of nonintegrated agricultural enterprises in Belgorod region in2000–1 were better than in integrated ones. Average wages in agroholdingswere smaller than the corresponding value for the region (2,191 rubles vs.2,300 rubles in the region).
Integration structures have problems of management, increase of inter-nal transaction costs, allocation of resources, and protection of property.Conflicts of interests among various branches and problems with income
WP 42 Case Studies
54
distribution, motivation of workforce, and intercompany relationsremain. Many fail to solve the problems of protection of property andeffective allocation of resources.
AGROINDUSTRIAL FORMATIONS IN OREL REGION
In the early 1990s the region was experiencing a decline in production aswell as in crop yield and productivity. Agriculture and the processingindustry in Orel region faced the same problems of exchange, outdatedtools and machines, and a chronic lack of current assets, as the majorityof Russian enterprises did. This served as an incentive for authorities toact in order to change the situation (see table 3.2).
The causes of vertical integration stated above were common for manyagricultural regions of Russia, but there was another factor in Orel region:the head of the region. In 1993 Yegor Semyonovich Stroyev became headof administration of Orel region. He is a powerful administrator (amonghis titles are Chief of Council of Federation of the Federal Assembly ofRussian Federation, Chair of Interparliamental Assembly of CIS, Chair ofthe Council of the Central Federal Region). Thanks to the influence of thegovernor, access to financial resources was gained; external investmentswere attracted by the security provided by the authorities.
The leading motive for the creation of agrofirms and large regionalholdings in Orel region was the intention of the regional authorities toactively employ methods of state control to preserve and develop theagroindustrial sector of the region, to rehabilitate bankrupt agriculturalenterprises, to provide the enterprises with fixed and current assets, andto restore the broken integration links. Orel region was to become themodel of development of a regional agricultural sector under market con-ditions and with a strong controlling role of the state.
The creation of large agrofirms and agroholdings with state participa-tion in their capital gave the authorities the opportunity to influence pro-duction and financial activities of the integrated formations. Agrofirmsconsisted of agricultural and processing enterprises, and often ownedshops or other trading facilities. In agrofirms, weak, bankrupt enterprisesthat could not survive in market conditions were attached to a strong core(for example, a financially strong processing enterprise).
The creation of agrofirms used various schemes to rehabilitate weakbusinesses that became their new constituents and at the same time notto burden the new formation with the debts of the old enterprises. Forthis purpose new legal entities were created, where most liquid propertyand most of the workforce was transferred, while the old enterprises wereleft with their debts and declared bankrupt. As a result of the reforms,enterprises grew significantly larger in size, while their total number
Vertical Integration in an Agroindustrial Complex
55
56
TAB
LE 3
.2D
ynam
ics
of M
ain
Indi
cato
rs o
f Agr
icul
ture
Dev
elop
men
t in
Ore
l Reg
ion
Indi
cato
rs19
9019
9519
9619
9719
9819
9920
0020
0120
02
Crop
are
a, h
a1,
568.
51,
369.
51,
327.
41,
290.
11,
189.
71,
144.
91,
201.
51,
228.
61,
233.
9In
clud
ing
grai
n cr
ops
907.
981
2.5
787.
778
3.8
752.
970
7.6
752.
179
0.6
790.
1Su
gar b
eet
59.4
32.8
29.3
25.1
17.2
18.9
2019
.116
.5Po
tato
es61
.348
47.7
47.9
46.2
61.1
61.2
61.2
61.5
Vege
tabl
es4.
85.
45.
35.
15
4.9
4.9
4.6
5.4
Gro
ss y
ield
, tho
usan
d to
nsGr
ain
crop
s2,
074.
51,
164
1,17
0.6
1,37
7.7
1,10
4.5
911.
41,
397.
61,
613.
81,
966.
9Su
gar b
eet
926.
248
2.9
367.
719
920
7.8
195.
336
3.7
321.
426
7.5
Pota
toes
632.
267
7.7
685.
250
7.5
622.
145
6.5
924.
772
0.6
589.
1Ve
geta
bles
72.9
83.5
89.3
80.1
9279
.892
.682
.393
.3
Crop
yie
ld, c
entn
er/h
aGr
ain
crop
s23
.914
.615
18.2
18.7
16.7
19.3
22.9
27Su
gar b
eet
162
154
137
111
163
147
202
189
212
Pota
toes
105
141
144
107
135
7515
111
896
Vege
tabl
es15
015
616
515
417
915
818
417
316
9Ch
emic
al fe
rtiliz
atio
n pe
r ha
of c
rops
in a
gric
ultu
ral
181.
119
.3n/
a33
.139
48.9
61.9
54.5
48.4
orga
niza
tions
(rec
alcu
late
d fo
r 100
% o
f nut
rient
), kg
Popu
latio
n of
cat
tle a
t yea
r end
, hea
ds71
8.1
420.
835
3.7
300.
426
8.3
272.
627
0.2
277.
126
8.4
Popu
latio
n of
pig
s, h
eads
498.
932
0.5
282.
125
0.1
256.
329
7.6
269.
730
2.1
325.
3M
ilk y
ield
per
cow
in a
gric
ultu
ral e
nter
pris
es, k
g/an
imal
3,01
82,
079
1,86
21,
926
2,09
52,
123
2,35
52,
585
2,61
7Av
erag
e eg
g-la
ying
cap
acity
per
yea
r per
hen
in
233
191
198
206
205
221
221
239
227
agric
ultu
ral e
nter
pris
es, p
iece
sCa
ttle
and
poul
try p
rodu
ctio
n in
sla
ught
er-w
eigh
t, 11
7.9
6062
.459
.356
.155
.558
.556
.958
.7th
ousa
nd to
nsM
ilk p
rodu
ctio
n, th
ousa
nd to
ns75
4.4
454.
638
0.7
341.
532
5.3
330.
333
833
6.3
324.
5Eg
g pr
oduc
tion,
mill
ion
piec
es36
3.7
287.
929
5.1
286.
126
9.4
267.
925
4.8
260
240.
6
decreased. Thus, from 1999 to 2002 the number of large and mediumagricultural enterprises shrank from 497 to 274 (not all businesses havefinished the liquidation procedure).
Table 3.3 shows the expert evaluation of the scale of operation of inte-grated structures among large and medium agricultural organizations ofthe region. About half of the resources and sales are concentrated in theintegrated structures.
Vertical Integration in an Agroindustrial Complex
57
TABLE 3.3 Evaluation of the Scale of Integration in Large and MediumAgricultural Enterprises in Orel Region in 2002, %a
Share in Indicators for OtherLarge and Medium Agricultural IntegratedAgricultural Enterprises Enterprises of Agricultural Nonintegratedof the Region 4 Holdings Enterprises Businesses
In sales proceeds 30 20 49In cost of fixed assets 38 9 52
of agricultureIn workforce of large 36 15 49
and medium agricultural enterprises
In agricultural arable land 41 15 44In sale of grain (quantity) 34 15 51In sold milk (quantity) 27 13 60In sold pork 49 7 44
a. Rating of enterprises as integrated structures performed by experts.
The integration processes in the region were supported by the localnormative-legal acts (decrees of the head of administration). At the districtlevel, comprehensive Programs for Reforms of Agroindustrial Complex,clearly defining the targets of the process, have been developed. The casestudy in box 3.1 on the Novosilsk district is used to show the process andresults of the creation of an integration formation of a district level.
B O X 3 . 1
The Example of Novosilsk Agrofirm Public Company
To create an agrofirm in Novosilsk region, a decree of the head of administration ofOrel region “On Measures of Reforming Agricultural Sphere of Novosilsk District ofOrel Region” #641 was issued on December 18, 1998. By that time only one out of 18 agricultural organizations finished 1998 without losses. The total overdue debt of
WP 42 Case Studies
58
the region’s agricultural organizations was 41.4 million rubles. Practically all agricul-tural business of the region were specializing in grain growing.a The “comprehensiveprogram of reforming the agricultural sphere” for this region specifically pointed outthe need for “state control of agricultural production at the district level by means ofeconomic influence of local authorities (by way of participating in the structure of theauthorized capital) on production, processing and sales of agricultural products, rawproduce and foodstuffs, as well as on industrial-technical supplies and logistics ofagricultural sphere of the district’s economy.”b It was planned to found the AgrofirmNovosilsk. Its founders were to be the administration of Novosilsk district via the dis-trict committee on control of assets (KUMI), district consumer society (Raypo),Novosilskaya MTS machine and tractor station, Selkhoztekhnika public company,Novosilsk dairy public company, 10 of 18 agricultural organizations of the district,some of which were, in fact, bankrupt, as well as investing firms (Orlovchshina publiccompany, Region-Agro Ltd company). A number of agricultural enterprises-founderwhose financial position was relatively stable did not lose their independence, butbecame shareholders of the agrofirm. The controlling block of shares in the structurebelonged to the state. Technology improvement, both in agriculture and in process-ing, renovation of bakery, reparation of confectionery, and reconstruction ofincubator-poultry plant were envisioned. The appendix to the decree also envisagedprivileges for household subsidiary farms for selling their produce to the newly cre-ated structure, as well as implementation of a program for individual housing con-struction.c The project was executed with immediate participation of consultants fromthe created Foundation for Support of Agricultural Reform, Agromir.
In 1999 the agrofirm started operations. It had at its disposal 15,000 hectares ofarable land and 10 million rubles of industrial assets. It encompassed milk process-ing, grain production, milling and bakery, cattle raising and meat processing, poultryraising, and fruit processing. The agrofirm finished 2002 with 21.7 million rubles inoverdue debt and 4.7 million rubles in losses. According to the Goskomstat data basefor 2002, district agricultural organizations in Novosilsk had a total of 129.7 millionrubles of overdue debt. During this time two more agrofirms were created in the dis-trict, Zarechenskaya and Golitsino Ltd Company (2000), that had, respectively, 11,200and 8,200 hectares of arable land. At the same time the old businesses, on whosebase the new enterprises had been created, still were not closed, although they didnot have either land or workforce, they produced nothing, and had no earnings.Thus, the Goskomstat database for Novosilsk district lists 20 agricultural organiza-tions, of which 12 existed only nominally and still had 53.5 million rubles of overduedebt. In many of these bankrupt enterprises the value of fixed assets was less thatthe sum of their overdue debts. At the same time, the newly created agrofirmsstarted accumulating new debts themselves. By the end of 2002, Zarechenskaya had14.2 million rubles in overdue debt and Golitsino Ltd Company had 6.7 million rublesin overdue debt. The pretax profit of these enterprises was significantly lower thanthe sum of overdue debts.
a. Database of the State Statistics Committee for 1998.b. Zemlya, sobstvennost’, reforma. Orlovschina: puti i opyty agrarnykh preobrazovanij. Kollektivnayamonografiya i sbornik dokumentov po strukturnoj perestrojke agrarnogo sektora. V dvukh tomakh.Tom 1. 1999. Orel: Agromir Foundation, p. 236.c. Zemlya, sobstvennost’, reforma. Orlovschina: puti i opyty agrarnykh preobrazovanij. Kollektivnayamonografiya i sbornik dokumentov po strukturnoj perestrojke agrarnogo sektora. V dvukh tomakh.Tom 2. 1999. Orel: Agromir Foundation, pp. 156–164.
The creation of such agrofirms, as previously described, was quitetypical and was implemented in other districts of Orel region. In 2001,37 agrofirms at district level were already operating in the region; theywere working on 581,000 ha of arable land and consisted of 246 enter-prises, including 173 agricultural, 37 processing, and 36 servicing enter-prises (Zlobin 2001).
Even larger structures were also created in Orel region—agroholdingsthat comprised agrofirms, servicing, trading and processing organizations.Very large formations included the agroindustrial complex Orel Niva,Orlovchshina, Orel Agrocomplex, Orelagropromsnab (program Wheat-2000 Orel) (see map).
Vertical Integration in an Agroindustrial Complex
59
KorsakovoMtsensk
Novosil’
KhomutovoZalegochsh
Krasnayazarya
Bolkhov
Znamenskoye
Khogynets
OREL
Kromy
Shablykino
Soskovo Zmiyevka
Pokrovskoye
Verkhovje
Livny
Dolgoye
Kolpna
Trosna
DmitrovskOrlovskij Glazunovka
Maloarkhangelsk
agrofirms of Orel Nivaagrofirms of Orel Agro-Complex
branches of Pshenitsa-2000
Naryshkino
The state was also among the founders of these structures. Regionaladministration invested in their authorized capital, allocated budgetcredits, or acted as the guarantor of credits. Thus the authorities couldinfluence directly the economy of the regional agroindustrial complex,and the region saw the creation of a single system of state and businesscontrol. An analysis of the creation and operation of the four largest agro-holdings of the region follows.
AgroIndustrial Complex Orel Niva
Among the founders are the Regional Department of Agriculture andFood Supplies and 40 organizations and enterprises from various spheresof the agroindustrial complex, including Orlov dairy combine, three meat
processing combines, Kristall stock company, Livnysakhar public company,Naryshkinskaya poultry plant, Agropromsnab stock company, Orels-elkhozkhimiya stock company, Livnykhleboprodukt stock company, OrelRegional branch of Agroprombank, and Association of Peasants’ Farms andCooperatives. Five directorates (on state purchases, on logistics and techni-cal development, on economics and finance, on commerce, on capitaldevelopment) made part of the structure; each of directorates consists ofdepartments and subdepartments and other sections. Technical service cen-ter Niva-Service, trading center Niva-Torg, and Slavyanskiye Korni founda-tion for private housing development in rural areas were functioning as OrelNiva branches. The foundation provides soft credits, construction servicesto rural builders on account of sold agricultural produce (Zlobin 2000, pp.111–113). More than 4,000 houses have been built during the period of thefoundation’s activities (Zlobin 2003, p. 18).
Orel Niva received initial budget funds, provided agricultural organiza-tions with tied credits and resources, and resold the produce received onaccount of the credits with a profit, thus building up its own assets. In thisway it was largely performing the functions of procuring and servicingorganizations. Later on Orel Niva was using not only budget, but also itsown funds. Apart from organizing its own trade it also purchased sharesand property of other enterprises by creating joint ventures. Every year OrelNiva purchases 200,000–300,000 tons of wheat, tens of thousands oftons of sugar beet, and so forth. Deliveries to the food reserve are around15,000–20,000 tons of meat and processed meat, 400–420 tons of butter,and about 200 tons of milk. Every year supplies of inputs to agriculturalproducers are around 80–100 million rubles (Zlobin 2003, pp. 17–18).
Despite the formal commercial nature of the organization, the head ofthe administration directly intervenes with the allocation of budget fundsas tied credits, specifying which businesses are to receive the aid, andin what volume. Thus, Decree #221 of the head of the regional admin-istration dated April 25, 1997 ordered Orel Niva public company to use3.4 billion rubles of the loan from the regional budget to support reformedbusinesses and business along the route of Orlovskoye Polesye park inthe form of providing them with resources (fuel and lubricants, fertiliz-ers, and spare parts) per attached list of businesses, which also specifiedthe volume of aid per business. At the same time this document statedthat, “in case of failure due to objective causes of the listed businesses torepay the credit,” a mutual clearing of the debt of Orel Niva public com-pany to the regional budget would follow and the charges were to be writ-ten off as agricultural arrangements.
In 1999 Orel Niva was transformed into an agroindustrial holding. Itsmanagerial and business structure is given in figure 3.3. The member
WP 42 Case Studies
60
companies of the organization keep changing; therefore the structure isnot stable.
The management company provides general management and coordi-nation of the activities of the holding. There are a total of 16,000 employ-ees working in all the spheres of the holding’s activities. The main goalsof the structure are production, processing, and sale of agricultural pro-duce. Former functions have also been preserved, but are now limited tothe scale of businesses making part of the formation. More than 150 mil-lion rubles have been invested into production development by theregional administration and Orel Niva. In recent years the volume of newmachines leased to agrofirms at the cost of budget funds and credits equals700 million rubles (Zlobin 2003, p.19).
In 2002, Orel Niva was using 337,000 ha of land (including 277,000 haof arable land) and employed 9,690 people. Virtually all the agrofirmsspecialize in grain production, with the exception of Nivy-Verkhovye (pigfarm) and Otrada Ltd. (fruit and small fruit growing). In 2001 and 2002,profit came from the Niva-Verkhovye pig farm and six agrofirms showedlosses. The increase of overdue debt from 97.8 million rubles to 135 mil-lion rubles is alarming.
Agroholding Orlovchshina Agroindustrial Public Company
This company was created in 1997 with the main goal as the rehabilitationof poultry breeding. It includes the Naryshkin poultry farm, Kromsk mixed-feed plant, Zolegochshinskoye grain storage facility, Pavlovskoye andRzhavetskoye—unprofitable grain-producing enterprises—and Mokhovs-kaya Ltd. machine and tractor station (Zlobin 2003, pp. 13–14). All
Vertical Integration in an Agroindustrial Complex
61
Orlov Niva public company
5 servicingenterprises
15 processingenterprises26 agrofirms 6 trade
enterprises
4 enterprises directlyreporting to the head
company
102 agriculturalenterprises
13 processingplants
96 tradeorganizations
27 servicingenterprises
FIGURE 3.3 Structure of Orlov Niva Public Company
these former enterprises became part of the agrofirm. The structure ofOrlovchshina agroindustrial public company is shown in figure 3.4.
Orlovchshina agroindustrial public company together with the unprof-itable system of regional consumer unions created “Soyuz Orlovchshiny”consumer society, to which Orlovchshina was to supply raw produce,and Soyuz Orlovchshiny was to process it and sell via its own tradingnetwork (Zlobin 2003, pp. 13–14).
On the whole the project was not a success. According to Goskomstatdata for 2001, Orlovchshina agroindustrial public company had 12.7 mil-lion rubles of losses and 44.5 million rubles of debts.
Agroholding Pshenitsa-2000 Orel
Another example is Pshenitsa-2000 Orel—a large international invest-ment project. A German company, Debis, became the investor and pro-vided a credit of 114.5 million Deutschemark within the framework ofan interstate credit with Germany. High-production German machineswere to be delivered, and new growing technologies adopted (Zemlya1999). The project also envisaged a combination of all production stages(production, postprocessing, storage, processing, and sale of wheat andwheat products) into one cycle.
To carry out these tasks Pshenitsa-2000 Orel public company wasfounded by 25 legal entities and 43 individuals. Five affiliated societieswere established on rayon level. They incorporated former agriculturalenterprises, machine and tractor stations, and processing and servicingfacilities. All these former independent organizations ceased to be legallyindependent and became departments of the affiliated societies. The
WP 42 Case Studies
62
Naryshkinpoultry farm
Kromskmixed-feed plant
Zolegochshinskoyegrain storage facility
Mokhovskayamachine and
tractor station
Pavlovskoye Rzhavetskoye
Agriculturaldepartments
Processingdepartments
Tradedepartment
Servicingdepartment
Orlovchshina agroholding Soyuz Orlovchshinyconsumer society
9 shops
FIGURE 3.4 Organizational Structure of Orlovchshina Agroindustrial Complex
structure is shown in figure 3.5. Pshenitsa-2000 Orel public companyhas 97,000 ha of arable land and 3,165 employees.
Agroholding Orel Agrocomplex
Orel Agrocomplex was created by the decree of the head of administra-tion of Orel region on May 7, 1999. Its founder was the committee onmanaging state property, which owned 100 percent of its shares. It wasmainly created as a structure duplicating Orel Niva public company, withthe same functions, to continue integration of production, processing,and sales in 13 districts of the region, and also to break the monopoly ofOrlov Niva and create a competitive market atmosphere.
Orel Agrocomplex initially included 18 agrofirms, 3 branches, and 3 sup-ply and processing daughter companies. In turn, agrofirms combined
Vertical Integration in an Agroindustrial Complex
63
Khomutov elevator
Mills –2
Trade-purchasingcomplex
Bavarskij Bazar shop
Orelagropromsnab (Pshenitsa-2000 Orel) public company
3 Agricultural departments, 1 machine and tractor station
4 Agricultural departments, 1 machine and tractor station, technical center
5 Agricultural departments, machine and tractor station, Selkhozkhimiya, Agroremtransservice
5 Agricultural departments, machine and tractor station
7 Agricultural departments, machine and tractor station, former dairy plant
Affiliated societies
Livensk
Orlov
Zmiev
Pokrov
Khomutov
Verkhov Agricultural department, machine and tractor station
Departments of the affiliated societies
FIGURE 3.5 Structure of Orelagropromsnab Public Company (Pshenitsa-2000 Orel)
several former agricultural enterprises (on average four to five per firm),and trading and processing organizations with loss of legal independence(Zlobin 2000, p. 136).
The controlling body of the company is the shareholders’ meeting.General management is performed by the board of directors. The generaldirector, elected for a term of five years, is the executive. The chair of theboard of directors of the agrocomplex is the deputy head of the admin-istration of the region. The only shareholder of the head company isthe committee on managing state property.
The new integrated formation also met the problems common to theagroindustrial complex of Orlov region. The list of participants in theagrocomplex was constantly changing. The structure of the holding isshown in figure 3.6.
As of today the main produce of agrofirms is grain, and, to a lesserextent, sugar beet, feed grains, dairy, and pig. Four large livestock com-plexes produce meat and pork. Agrocombine includes three dairies, twofood combines, and three grain elevators.
However, the structure is not stable. Several factors influence itscomposition: first, the changes in the structure of property of the agro-complex (in 2003 the head company was privatized, i.e., the combinewas transferred from state to private property); second, administrativechanges in the region; and third, curtailment of access to soft budgetfinancing.
In 2002 the agroholding employed almost 12,000 people, the proceedswere 1.5 billion rubles, and net profit was 67.3 million rubles. The lion’sshare of the proceeds goes to agrofirms—more than 70 percent (in 2002),including agrofirms controlled by the holding. The main share of profit in2001–2 was also brought in by agrofirms (including agrofirms controlledby the holding). However, it must be noted that the results of the activi-ties depend to a large extent on a very strong business, Yunost Ltd., whichwas included in the sphere of influence of the combine, but is not itsdaughter company. Without this business, the results of other agrofirmswould have been negative (−23.5 million rubles). Some processing andtrading companies of the agrocomplex in 2002 were also unprofitable.
Comparative Analysis of Efficiency
Table 3.4 shows indicators of efficiency, comparing averages of the fourmain agroholdings, of other integrated structures, and of other agricul-tural businesses of Orel region.
The data in table 3.4 indicate that integrated companies in the four agro-holdings have lower efficiency compared with both the group of agrofirms
WP 42 Case Studies
64
65
Orel
Agr
ocom
bine
pub
lic c
ompa
ny
Bran
ches
- 4
Leni
nsk
(sto
rage
, pro
cess
ing
of g
rain
)
Zmiy
evsk
(pro
duct
ion
of fo
odst
uffs
)
Agro
-torg
(w
hole
sale
and
reta
il tra
de)
Trad
e–in
dust
rial
com
plex
Othe
r dau
ghte
r com
pani
es,
exce
pt a
grofi
rms
Serv
icin
g en
terp
rises
Trad
e co
mpl
ex
Past
a fa
ctor
y Da
ught
er a
grofi
rms
Stru
ctur
al d
epar
tmen
ts o
f agr
ofirm
s
Sosk
ovo
Nar
yshk
ino
Sodr
uzhe
stvo
Orlo
vski
ye is
toki
Zush
a-M
tsen
sk
Dros
kovo
Russ
kij B
rod
Vosk
hod
Kras
naya
Zar
ya
Live
nsko
ye M
yaso
Lom
ovsk
oye
Tson
4 ag
ricul
tura
l dep
artm
ents
, 1 tr
adin
g, 2
pro
cess
ing
7 Fo
rmer
agr
icul
tura
l ent
erpr
ises
5 Fo
rmer
agr
icul
tura
l ent
erpr
ises
3 Fo
rmer
agr
icul
tura
l ent
erpr
ises
8 Fo
rmer
agr
icul
tura
l ent
erpr
ises
9 Fo
rmer
agr
icul
tura
l ent
erpr
ises
7 Fo
rmer
agr
icul
tura
l ent
erpr
ises
10 F
orm
er a
gric
ultu
ral e
nter
pris
es
6 Fo
rmer
agr
icul
tura
l ent
erpr
ises
8 Fo
rmer
agr
icul
tura
l ent
erpr
ises
6 Fo
rmer
agr
icul
tura
l ent
erpr
ises
FIG
URE
3.6
Ore
l Agr
ocom
bine
Pub
lic C
ompa
ny S
truc
ture
66
TABLE 3.4 Efficiency Indicators for Integrated and Nonintegrated Companies inOrel Region for 2002 (according to Goskomstat database) a
Agrofirms,Agricultural Not Making Nonintegrated
Enterprises of the Part of AgriculturalIndicators 4 Holdings 4 Holdings Enterprises
Funds, thousand rubles 435 287 553per 100 ha of arable land
Funds, thousand rubles per worker 140 83 143Earnings per 100 ha of arable 190 340 289
land, thousand rubles.Earnings per 1 worker, thousand rubles 61 98 75Total debts as % of profit 212.3 40.1 65.2Overdue debts as % of profit 48.0 14.7 32.1Pretax profit per 100 ha or arable land, −13 55.7 21.4
thousand rublesProfit on sales per 1 worker, −4.0 16.1 5.5
thousand rublesGrain yield, centner/ha 22 29 27Net cost of 1 centner of grain, rubles 130 123 102Price of 1 centner of grain, rubles 130 167 131Grain profitability, % 0 36 28Milk yield per 1 cow 2,238 2,351 2,819Milk profit on sales per cow, −407 1,914 104
thousand rublesNet cost of 1 center of sold milk, rubles 362 312 334Price of sold milk, rubles/centner 335 402 339Sold milk profitability, % −7 29 1Net cost of 1 centner of 3,924 4,230 3,141
sold pork, rublesPrice of 1 centner of sold pork, rubles 2,782 2,653 2,623Sold pork profitability, % −29 −37 −16
a. Rating of enterprises as integrated or nonintegrated performed by experts.
WP 42 Case Studies
that do not make part of the four holdings, or nonintegrated agriculturalenterprises. The group of agrofirms outside of the four holdings consistsnot only of large independent agrofirms but also of companies that usedto be part of one of the listed holding structures, but later left them forvarious reasons. One of the reasons for leaving a holding can be eitherthe desire of management of a strong agrofirm to “get rid of the super-vision” of a particular holding, or redistribution of the recourses by theregional authorities. On the other hand, there are examples of hold-ings that refused to deal with highly unprofitable firms; the latter alsojoined the group of “other integrated enterprises.”
Interaction of Agroholdings with Small Farms (LPKh) and CommercialFamily Farms (KFKh)
A complete analysis of the integration processes in the region mustinclude the interaction of the small-scale sector (subsidiary farms [LPKh]and commercial family farms [KFKh]) with the integrated organizations.Because of constant shortage of raw produce for their processing facilities,agroholdings and agrofirms are trying to cooperate with small farms andcommercial family farms, usually through contracts. For example, OrelNiva contracts with more than 100 commercial family farms; the holdingprovides them with resources on a tied credit basis, and they pay back withproduce. Orel Agrocomplex signed 74 similar contracts with commercialfarms in 2003. Many agrofirms also procure production from small-scaleproducers. At the same time, these large companies face strong competi-tion from private (individual) buyers. Self-employed buyers are moremobile and enterprising than specialists from agrofirms.
However, our own field studies in 2004 suggest that relations withsmall-scale producers are still limited and that there is much room fordevelopment, not only in procuring but also in contracting. Contractsbetween large companies and family-run farms are very rare in Orlovregion. Only in some individual cases do agrofirms contract (e.g., pigs onfeeding contracts) with small household farms.
CONTRACTING AND FINANCING WITHIN AN AGROHOLDING
Agrofirms and agrocomplexes allocate recourses according to a businessplan, which is compiled in the firms, and then revised and approved by thehead office. District Departments of Agriculture request a mandatory sub-mission of production-financial plans on a form, set forth by the Ministryof Agriculture of Russian Federation. They also try to insist on their own fig-ures and values, most often arable lands and gross charges, cattle popula-tion, volumes supplied to processing factories, and so forth. In their plansthere is little concern about the firms’ resources. Ignoring the demands ofthe heads of districts can lead to unpleasant effects; therefore most often thedecisions are passed on a consensus basis.
The agrocomplex supplies resources on a tied credit basis as follows:the complex receives soft (interest-free) loans from the government,attracts other loans, and uses its own funds to purchase the resources andprovides them with a certain marketing margin to its own agrofirms aswell as to commercial farms and to other businesses on a contractualbasis. The main items to be supplied are fuel and lubricants, fertilizers,means of plant protection, and sometimes crop seeds. The markup onfuel and lubricants is minimal and can be compared to the price of the
Vertical Integration in an Agroindustrial Complex
67
resources which they themselves would pay if buying directly in the mar-ket. On the other hand, tools and machines are “overcharged.” The “own”agrofirms receive resources at slightly lower prices—1 to 6 percent (in2003), depending on the type of resource.
The contracts signed with agricultural producers stipulate the principleof corrective price. That is, if the clearance price for agricultural producechanges at the time of delivery, the volume of the produce is changedaccordingly. So, if the market price on grain drops, the producers have tosupply a correspondingly bigger quantity of the product. In other words,the risks of price differences fall on the agricultural producers.
The agrocomplex supplies food to the regional food reserve fund inexchange for interest-free loans from the budget. For example, during the2000–2 period, 20 agrofirms, both from the agrocomplex and those receiv-ing credits per contracts, supplied 176,000 tonnes of grain to the regionalfood reserve fund. Guaranteed procurement prices for the regional foodreserve fund are set annually by the Concurrence Agreement with the firstdeputy of the governor of the region. Procurement prices have beeneither higher or lower than market prices. According to the specialists ofthe agrofirm, the regional administration also determines the minimumprocurement price for milk, and enterprises cannot purchase this prod-uct at a lower price. Also the marketing margin on pasteurized milk isofficially limited (maximum 10 percent). Charges of grain-gathering facil-ities and for milling of grain from the regional food reserve fund are alsoregulated.
Agrofirms have ambiguous feelings regarding the tied credits. They rec-ognize the necessity of the tied credits in periods when their finance isunstable; however, when their situation becomes more stable they wouldprefer to sell their produce fully on the market and receive the part ofprofit that now goes to the agrocomplex for the sales of their products.Even now agrofirms can purchase necessary resources on the market andsell surplus produce, left after paying back credits. The head organizationdoes not impede this process. However, to do so the firm needs to haveother financial resources, or a better credit line than the one offered bythe head company. Some agrofirms, such as Soskovo, have such options.However, most firms owe the agrocomplex large amounts of money forthe tools and machines supplied to them.
CONCLUSION
At the end of the 1990s and early 2000s, integrated companies appearedin Russian agriculture. The cause was the perceived need to restore thebroken ties between agriculture and processing, as well as to rehabilitate
WP 42 Case Studies
68
financially agricultural enterprises, whose lack of profitability by 1998was widespread. The default of 1998 increased the interest of processingand trading enterprises in dealing with domestic manufacturers of rawproduce and goods.
Weak financial positions of farms led to extensive forms of verticalintegration—holdings and agrofirms, most often as joint stock companies.Such forms allow the investor to monitor the investments and control theirspending via partially or fully consolidated planning, accounting system,and management.
The creation of agrofirms and agroholdings was strongly supported bythe Russian authorities. Integration is not only regarded by them as a wayto increase the effectiveness of the agroindustrial complex, but, mostimportantly, as a method to rehabilitate financially insolvent agriculturalenterprises and as a way to attract investments to agriculture.
Holdings can be private, state, or mixed property. In the Belgorodregion they are private, and in the Orel region the state has a large sharein the holdings. Regional and district authorities exercise a strong influ-ence in the agroindustrial complexes and the agrofirms and agroholdingsare not fully independent. These companies need to take into account theview of the authorities, and accept other functions apart from profit max-imization, such as the rehabilitation of insolvent businesses. In returnthey are granted certain privileges (finances, property, privileges in thenonagricultural production).
Orel region is a region with well-developed grain and milk production.Agriculture provides one fifth of the gross regional product and 20 percentof the population is employed in agriculture. Large and medium enter-prises specialize in grain and industrial crops (sugar beet), while house-hold subsidiary farms produce nearly all labor-intensive crops (vegetables,potatoes). Milk and meat are produced equally by large and medium enter-prises and small-scale commercial farms. The standard of living is low,especially in rural areas, where the wages are below the cost of living. At thesame time the unemployment rate is also low, and during 1995–2002there were no strikes in the region.
For a number of years there has been a policy of creating large integratedagricultural enterprises in Orel region. The state and the small-scale farmsector also participate in the integrated structures. During 1995–2001,4 large agroholdings and 37 agrofirms of district level were created. Majortasks of the holdings were to provide tied credits to agricultural organiza-tions (farms) and to replenish the state regional food fund. Significant bud-get resources were directed to the creation of these integrated formations,as well as to attract foreign credits with government securities for the deliv-ery of tools and machines. By 2003 about half of the resources and sales of
Vertical Integration in an Agroindustrial Complex
69
large and medium enterprises was under these integrated structures, usingtens of thousands of hectares. However, taking into account that the shareof the large and medium enterprises in the gross agricultural produce isonly 40 percent, the integrated structures only account for about 20 per-cent of the agricultural produce of the region, which is not that much, espe-cially in comparison to the attention paid to them by the authorities.
In agroholdings, agricultural producers (both daughter agrofirms andother agricultural producers, including commercial farms) receive tightcredits with a certain markup, which is used for maintaining the manag-ing company. On the market the prices are even higher. The main profitfor the holding is from the resale of products received from tied credits.The supply costs of agricultural products supplied to the regional fundon account of tied credits have been, in certain years, both higher andlower than the average per region. Thus a tied credit is not a bondage. Foran enterprise having no access to bank loans because of lack of currentassets, the tied credit is positive. At the same time, for a business with asound financial position, it may be less profitable to use a tied credit. Theeffects depend on the conditions for getting the loan from other sourceswhen they lack their own. In the case of tied credits, the price risks areborne by the agricultural producers. The purchasing prices for grain forthe regional fund, the lower price for milk, the marketing margin for pas-teurized milk, and so forth are regulated in the region.
Production increased after these changes. After 1999–2000, the croparea, including grains, increased. Also, yields of grain and sugar beetincreased. However, a comparative efficiency analysis shows that largeindependent agrofirms are more efficient than agrofirms which are partof the agroholdings, which have the lowest productivity indicators.
The state holdings of the Orel region can be regarded as a transitionalphenomenon, created to overcome the crises of the agroindustrial com-plex in the region. As a result, farms gained access to new tools andmachines as well as to other resources and credits. This led to increasesin production and sales and in crop yield and productivity. However,financial indicators such as profitability and profit, after a certain improve-ment, started declining again and debts increased. The integrated com-panies in the Belgorod region also face problems, although they are notas comprehensive.
The main cause for these phenomena is the conflict of interests of thepersons and structures involved in this process. In large integrated for-mations of Orel region, conditions have not yet been created to matchthe interests of an individual and the organization at all levels. The con-stant interference of the authorities does not help good business man-agement either.
WP 42 Case Studies
70
The workers of the agrofirms profited from the first stage of integra-tion. The disintegration and decline of the existing businesses and thesocial situation were curbed. Workers in individual agrofirms profited, toan extent, from the developments. For example, in Lomovskoye Ltd. andin former agricultural enterprises that now make up part of Soskovo pub-lic company, the workers started to regularly receive their wages, some-thing that did not use to happen before the changes. The firms pays fortheir training and, to a certain extent, supports their subsidiary farms.
The agrofirms and agroholdings pay close attention to the develop-ment of the small-scale farm sector, because it is there that a significantpart of milk and meat is produced. A strong competition with individualbuyers for their produce takes place in the region. These private buyersoperating on their own are often more mobile and successful than thepurchasing departments of the large companies, despite the fact that agri-cultural enterprises provide more assistance to the owners of subsidiaryfarms, who most often are employed by the enterprises.
REFERENCESChernyaev, A. A., V. M. Rossoshanskij, and A. F. Borodin. 2002. Razvitie integratsionnykh
protsessov v APK Povolzh’ya. Moscow: Russian Academy of Agricultural Sciences.Deryuga, A. S., K. S. Ternovih, N. V. Mitin, et al. 2003. Razvitie integratsionnykh otnoshenij
v APK Rekomendatsii. Voronezh: GNU NIIEOAPK TsChR RF, p. 16.Korol’kova, N. V. 2001. Organizatsionno-ekonomicheskie aspekty vzaimootnoshenij v
Zemlya, sobstvennost’, reforma. Orlovschina: puti i opyty agrarnykh preobrazovanij.Kollektivnaya monografiya i sbornik dokumentov po strukturnoj perestrojke agrarnogo sek-tora. V dvukh tomakh. Tom 2. 1999. Orel: Agromir Foundation, pp. 93–95.
Zlobin, E. F. 2000. Rynochnaya model’ agrarnogo sektor regiona. Moscow: AgriPress, pp. 112–113.
——. 2001. Upravlenie agropromyshlennym kholdingom. Moscow: AgriPress, p. 9.——. 2003. Agropromyshlennaya integratsiya v usloviyakh rynochnoj ekonomiki.
Regional’nyj aspekt. Moscow: AgriPress.
Vertical Integration in an Agroindustrial Complex
71
Vertical Coordination in theCotton Supply Chains in
Central AsiaM A R C S A D L E R
73
EXECUTIVE SUMMARY
The cotton-growing countries of Central Asia (Central Asian Republics,CARs), starting out from a common baseline, have chosen three distinctpaths to reform of the previous central command structure of their supplychains. First, in Kyrgyzstan and Kazakhstan, government control has beenremoved and both producers and processors have been left free to establishtheir own relations. Second, in Tajikistan, the government has continued itsinvolvement in the supply chain through the creation of official and unof-ficial monopsonies on a regional basis. Third, in Uzbekistan, up until the2005 season, the government maintained its dominant role in the supplychain following principles very similar to the traditional command econ-omy. Although there have been a series of potentially fundamental reformsin the sector in the past two years, their impact remains to be seen.
In all of the above cases, producers have fallen into a dependent posi-tion within the supply chain. This is largely due to the effects of the frag-mentation of the production base that has been inherent in the landreform process and privatization of the previous state farm system. Inother cotton-growing countries (e.g., Australia, United States, Brazil), theproducer is the dominant link in the chain and this enables him to matchhis production to the demands of the international market, to directly assessthe quality of his baled cotton, and to purchase his inputs in highly price-and quality-competitive markets. Of course, the existence of high subsidy
4
rates in countries such as the United States, Spain, and Greece distort thereal picture. However, in countries where there is no subsidy system, pro-ducers have become extremely efficient, such as in Australia.
The main detrimental effects of the dependent position of the pro-ducers in the CARs are a lack of bargaining power, weak farm gate pricesfor outputs, difficulty in obtaining crop finance and quality inputs, and ageneral reduction in the level of mechanization. As a result of this, therehas been a general trend of a drop in cotton yield in the initial period oftransition, but notably a recovery to 1991 levels in all countries, exceptfor Uzbekistan. However, reliance on production and yield data in coun-tries bordering Uzbekistan should be guarded, because there has been anotable cross-border smuggling of seed cotton into the neighboring coun-tries that may well be distorting the real picture.
What is clear is that, where real competition has developed in the out-put purchasing markets, this has been of real benefit to the producers.The best examples are Kyrgyzstan and Kazakhstan, where competitionamong ginners has led to increasing prices for outputs, the beginnings ofindependent input supply markets, and fair payments based on quality.The continuing development of such trends, however, will depend on thecreation of viable rural credit sources, as the tied finance packages of theginners will always enable them to maintain their dominant role.Medium- to long-term stability for the producers will always be tenuouswhile they are unable to secure third-party credits. In Kazakhstan, forexample, very strong competition between ginners in the 2003 and 2004seasons has led many to bankruptcy, with an inevitable decrease in com-petition in the sector, now evidenced by weak farm gate prices for out-puts and a fall in the amount of credit available in the sector.
INTRODUCTION
This report discusses the cotton supply chains in the countries ofUzbekistan, Kazakhstan, Kyrgyzstan, and Tajikistan. These four countriesproduce a total of approximately 1.3 million tonnes of baled cotton perannum, with a rough market value of US$2 billion. For some of theeconomies, cotton either is a major part of their gross domestic product(Uzbekistan) or potentially could be (Tajikistan/Kyrgyzstan). Therefore,the dominant position of cotton in the agricultural sector in these foureconomies cannot be understated. Kazakhstan currently only producesapproximately US$200 million per annum of revenue from cotton in aneconomy dominated by hydrocarbon revenues and investment. However,for southern Kazakh, cotton remains the dominant source of employmentand revenue generation.
WP 42 Case Studies
74
All of the countries in this study, prior to independence from the SovietUnion, exercised a system of centralized cropping control, input supply,processing, and export. Since independence, they have taken three dis-tinctive routes in reform: (a) a total removal of government control andinvolvement in the supply chain (Kazakhstan and Kyrgyzstan), (b) afluctuating degree of control and intervention in the supply chain(Tajikistan), and (c) a retention of government control throughout thesupply chain (Uzbekistan). These approaches have led to varying degreesof success and failure.
This report considers also those services that facilitate the farming ofcotton, finance, and input supply. Generally speaking, nearly all produc-ers receive their inputs from the party to whom they have contracted todeliver their seed cotton. There is a large degree of integration in the sup-ply chain.
This report first considers the general nature of the supply chain in cot-ton production in developed countries (such as Australia and the UnitedStates). Then each of the countries covered in this report is discussed. Theconclusions section compares the differing situations in the countriesand how these relate to a “developed” supply chain.
COTTON SUPPLY CHAINS
This section briefly considers the nature of cotton supply chains and thelinks that make up their structures (figure 4.1). The general model thatis found in developed cotton-producing countries is presented. The later
Vertical Coordination in the Cotton Supply Chains in Central Asia
75
FIGURE 4.1 Cotton Supply Chain in Developed Countries
Producer
Insurance
Finance
Gin
Contract Services
Input Suppliers
Trader
Textile Mill
Cotton salescontract
Services/inputscontract
sections of the report discuss the specific situations in the countries ispresented in question.
Developed Countries
In countries such as Australia and the United States, the producer isdominant in the supply chain, through to the point of sale of baled cot-ton. All growing, harvesting, financing, and ginning operations are self-contained within the producer’s “link” in the chain. Although the producerdoes buy-in outside services and utilizes external finance, he does so on acontracting basis and retains ownership of his crop throughout. The pro-ducer is purchasing services in highly competitive and transparent markets.
The producer’s profitability is directly connected to the quality of hisbaled cotton (cotton is only tradable on the international market after gin-ning and baling, as seed cotton is not a commodity in itself). Although itis possible to produce poor quality baled cotton from good quality seedcotton, the inverse is not true. Therefore, throughout all stages of produc-tion, the producer is geared to maximizing the quality of his cotton. Hewill vary his seed types and growing practices to ensure that he producescotton that is demanded, either domestically or for export.
This direct link to the market leaves the producer with certain risks,mainly price and crop risk. In developed countries, it is possible to miti-gate both of these risks. A producer is able to hedge his price risk throughhedging strategies on various futures markets. There is a cost involved inthis and the producer has to assess whether the cost is outweighed by thepotential benefits of having a price risk-hedging strategy. Crop risk (be itweather or pest) is also manageable through the purchase of insurancepolicies. These have a cost (or premium) and the producer has to factorthese into his costs of production. If the producer is operating with exter-nal credits, then normally one of the terms of his financing package is thathe has to carry these forms of insurance.
Cotton producers in these countries also take a very active interest in themarkets of “competing” crops (e.g., soybean, maize, wheat). This enablesthem to ensure that their farming operations are sustainable, even in theface of adverse trends in the cotton market. It should be noted, however,that the effects of direct and indirect agricultural subsidies can alter thesefactors. The most competitive, transparent, and subsidy-free cotton-producing country is Australia. They are probably the most efficient cottonproducers in the world today.
Producers sometimes work together as a “pool.” This normally occurswhere there are a number of producers with relatively small areas of landwho “pool” their resources and production in order to benefit from certaineconomies of scale. Often they will market their cotton together as a unit
WP 42 Case Studies
76
and then divide the revenues between themselves in accordance with theircontributions. In many countries there are also producers’ cooperatives(for example, Australia). These are generally ginning and marketing organ-izations. As well as using their gins to gin the cotton of their own members,they also offer toll ginning services to third parties. Each producer main-tains his direct connection with his baled cotton, but he leaves the actualmarketing to the cooperative. In this way, producers from certain regionshave sought to establish branding for their cotton in association withothers. An example is the Namoi Cooperative in NSW, Australia.
The cotton chain in developed countries consists of three main links—producer, trader, and final processor. The producer enters into contractualarrangements for the provision of finance, agricultural services, inputs,ginning, and (in some cases) marketing. These service markets are highlycompetitive and the producer is able to choose with whom he will con-tract. This competition ensures that the costs of these inputs are kept toa minimum. The producer’s key role in the chain also ensures that he willbe as efficient as possible. The only distortion with regards to efficiencyin developed markets occurs where there are subsidy systems.
Cotton Pricing
The most important traded cotton futures market in the world is the NewYork Cotton Exchange (NYCE). Only American cotton is traded under thisexchange. However, other cotton growths can be/are traded at prices relatedto the prevailing NYCE contract price. For example, many textile mills oftenpurchase non-American cotton, using the NYCE price as a price basis.
The other main international price index is created by an independentcompany based in Liverpool, United Kingdom called Cotton Outlook Ltd(Cotlook). They post prices for cotton not covered by the NYCE. They alsoprepare market and crop information globally and are information ser-vice providers. They receive price information from cotton trading com-panies and textile mills around the world. There are two main indicesthat Cotlook produces: “A” and “B.” They represent prices for differentqualities of cotton, with the “A” being for higher grades.
Generally speaking, the price against which traders contract for cottonfrom the CARs is the Cotlook “A” quote on the date of fixation. Because ofthe size of the Uzbek cotton crop, Uzbek cotton has its own constituent.Government pricing policy has linked sales of Uzbek cotton to the averagebetween the “A” index and the Uzbek constituent on the date of fixation.
When a producer delivers seed cotton, he is (in effect) selling threecommodities—baled cotton (32 percent), cotton seeds (62 percent) andshort fibers and waste (6 percent). In most developing countries he isbeing paid for only the first commodity and, although this is the most
Vertical Coordination in the Cotton Supply Chains in Central Asia
77
valuable of the three, he is not receiving value for the others. In manycountries (Australia, for example) the producer often pays for the ginningof his cotton by allowing the ginner to keep the by-products.
Quality Differentials
As mentioned above, the main price indices are based on a defined qual-ity of cotton. Obviously, not all cotton conforms to this quality and, there-fore, each growth has a generally accepted (by the international trade) setof discounts and premiums to allow for cotton that is of lower or higherquality, respectively.
The issue of quality is a matter of contract and acceptance of the phys-ical quality is something that has to be agreed by both buyer and seller.If the parties cannot agree on the quality of a party of cotton and it hasalready been delivered under the terms of the contract, then both partiesresort to the use of arbitration proceedings.
For the assessment and certification of quality there are two main sys-tems—either by the use of independent quality assessment companies(acceptable to both parties) or assessment by an independent organizationwhich automatically assesses all produced cotton without being appointedby the parties specifically. An example of the latter system is the USDAcotton classification system in the United States. This organization assessesthe quality of all bales produced in the United States and issues each balewith a certificate. Because both buyers and sellers have confidence in theaccuracy of USDA’s certification, they both accept the USDA quality cer-tificate for the purposes of contracting.
Nontechnical parameters of cotton quality (color, staple, and trash)can be assessed either by a trained quality assessor or by the use of highvolume instrumentation (HVI) equipment. The latter method is used inthe USDA system and also in Australia. Although this machinery is cali-brated regularly, it is dependent on the trained operator who is using it. Itshould be noted that it is possible, through manipulation, for the resultsof an HVI machine to be falsified. Therefore, the willingness of both buy-ers and sellers to rely upon this system is dependent on the confidencethat they have in the organization that operates the equipment. Technicalparameters such as fiber maturity and strength have to be assessed usingmechanical testing equipment.
In countries where no central certification organization exists, or theone that does exist does not have the confidence of one or either of theparties, then an independent assessor will be appointed or the buyer willinspect the cotton himself to ensure that the certificate issued conformswith the physical cotton.
WP 42 Case Studies
78
TAJIKISTAN
Supply Chain
Figure 4.2 is a schematic of the current supply chain in Tajikistan. The“investor” (a locally applied term) is the main link in the chain for han-dling of both seed cotton and baled cotton. An investor is a locally regis-tered company, which is privately owned, normally with 100 percentTajik ownership, although in some circumstances investors are joint ven-tures with a degree of foreign ownership. They are also normally eitherthe owner or majority shareholder in the gin. Generally the investor sellshis baled cotton within his credit arrangement with KreditInvest,although some cotton is now being sold to other parties. KreditInvest/Reinhart has a dominant position in the supply chain.
Producers are in a dependent position in the chain. Very few are ableto operate outside of the normal investor relationship. Generally they donot have direct access to finance, the ability to freely market their cotton,or access to inputs or services outside of the investor relationship. Theyalso have no direct relationship with the baled cotton that is producedfrom their seed cotton.
Vertical Coordination in the Cotton Supply Chains in Central Asia
79
FIGURE 4.2 Cotton Supply Chain in Tajikistan
Producer
Gin
Contract Services
Input Suppliers
Investor Company
International Merchant
Cotton salescontract
Seed cottoncontract
AgroInvestBank(AIB)
Reinhart
Textile Mill
Services/inputscontractFinance
contractCrop finance
package
Production and Yields
Table 4.1 provides the Food and Agriculture Organization (FAO) data forTajikistan. The harvested area in 2003 returned to 1992 levels, despite hav-ing declined heavily over the 1992–8 period (23 percent). This decline wasmainly due to the effects of the instability caused by internal conflict up to1997. Resolution of this conflict accounts for much of the improvementsince 1998.
Yields have increased by 4 percent over the period in question from 1.8to 1.9 tonnes of seed cotton per hectare. The initial decline in yields from1992 to 1997 (22 percent) was caused by a lack of inputs and instability.The marked decline in yields of 19 percent in 1999 was caused by a drought.Yields in 2003 showed a 2 percent decrease on 2002 levels (which was notdue to climatic conditions). Given current production conditions, furtheryield improvements are unlikely.
Despite a constant harvested area and 4 percent increase in yieldsover the period, there was a 33 percent decrease in baled cotton produc-tion between 1992 and 2003. Implied ginning outturn ratios based on thisinformation are only 22 percent and are much lower than expected levels.These figures can only be explained by inaccurate statistical reporting orfalse declaration on behalf of the ginners. In the author’s opinion, theanomaly is due to the latter, the reason for which is that they are avoidingthe payment of cotton sales taxes.
Quality
Tajik cotton used to be the most popular for final processing (textile mills),because of its color and slightly “silky” quality. Unfortunately, while theseed cotton itself has largely retained its characteristics, the quality of baledcotton has fallen. Buyers complain about large amounts of leaf and for-eign body contamination, which is leading to a low price for Tajik cot-ton. The main reason for this is a lack of maintenance of and investmentin the ginning plants.
The above problem is exacerbated by producers not delivering clean andsegregated seed cotton to the investors (in an attempt to raise their prof-itability). Because producers are paid according to the weight of deliver-ies, they have no interest in ensuring that they minimize foreign bodycontamination (stones, mud stalks, etc.). Because the quality of the deliv-eries is assessed by the investors, without any external inspection, pro-ducers do not feel that they are being fairly paid on a quality basis either.This gives them an incentive to mix both good and bad seed cotton (whichnegatively affects the baled cotton).
WP 42 Case Studies
80
81
TAB
LE 4
.1FA
O C
otto
n Pr
oduc
tion
Dat
a fo
r Taj
ikis
tan
Item
Title
Uni
t19
9219
9319
9419
9519
9619
9719
9819
9920
0020
0120
0220
03Pe
riod
Cha
nge
Seed
cot
ton
Area
Har
vha
(′00
0’s)
285
275
283
270
228
219
247
248
239
257
269
284
annu
al c
hang
e−4
%3%
−5%
−16%
−4%
13%
0%−4
%8%
5%6%
0%Se
ed c
otto
nYi
eld
tonn
es/h
a1.
791.
911.
881.
521.
391.
621.
551.
261.
41.
761.
911.
87an
nual
cha
nge
7%−2
%−1
9%−9
%17
%−4
%−1
9%11
%26
%9%
−2%
4%Se
ed c
otto
nPr
oduc
tion
tonn
es (′
000’
s)51
352
453
141
131
835
338
431
333
545
351
553
3an
nual
cha
nge
2%1%
−23%
−23%
11%
9%−1
8%7%
35%
14%
3%4%
Bale
d co
tton
Prod
uctio
nto
nnes
(′00
0’s)
174
180
167
130
119
110
115
9893
145
113
117
annu
al c
hang
e3%
−7%
−22%
−8%
−8%
5%−1
5%−5
%56
%−2
2%4%
−33%
Gin
out
turn
%34
%34
%31
%32
%37
%31
%30
%31
%28
%32
%22
%22
%
Land Reform and Privatization
Land reform is an ongoing and contentious issue in Tajikistan. In 1992the “Law on Land Reform” provided that land not being used by the statefarms (kolhoz, sovhoz) could be applied for by producers for the creationof dekhan (“private”) farms. In 1996 the land reform process was accel-erated as all lands were to be converted to dekhan holdings by 2005.Effectively, land remains the property of the state, and land registered asa dekhan holding cannot be bought or sold, but the producer is grantedinheritable rights to land tenure. There are also household plots (nor-mally attached to the family home, average 0.15 ha); Presidential plots(not attached to the home and granted to producers for the purposes ofproducing food for the family unit, average 0.12 ha); rented land (whereproducers rent land from the local dekhan or state farm, average 1.3 ha).
In principle, farmers are free to choose what they grow on their privatizedlands. However in a recent AAH survey, 50 percent of interviewees said thatthey had no choice of what to grow on rented lands and 100 percent saidthat they had no choice if they were farming on dekhan plots. Despite theofficial removal of regional cotton production targets, the continued exis-tence of a national target and unofficial allocation of this on a regional basismeans that the government still dictates what producers can grow.
Privatization of the gins was officially introduced in 1998, with 20 ofthe 23 gins sold to the private sector by 2002. Five of the gins are owned100 percent by investors, the other 15 still have a 25 percent interest heldby the Ministry of Agriculture.
Despite the apparent overcapacity of the ginning sector, there is no effec-tive competition. The main reason for this is that farmers are not able totransport their seed cotton to gins in other districts and they are unofficiallytold which investor/gin they will contract with by local government.
There has been very little investment in the sector. Two gins were con-structed by a foreign investor, but they closed their operations due tooperational problems with their local partners and the government.
Financing
From 1991 the government gave credits direct to state farms for their cot-ton operations. After the Rouble collapse of 1993, the government intro-duced a system of National Bank credits to fund the state farms. Due tosevere budgetary problems and a lack of credit repayments, the govern-ment stopped this system in 1996 in agreement with the advice of theInternational Monetary Fund (IMF). In 1997 the government concludeda US$60 million syndicated financing package with the Credit Suisse FirstBoston and Reinhart (an international cotton merchant). Execution ofthis financing was passed to AIB (a local bank) in 1998 in conjunction
WP 42 Case Studies
82
with Reinhart and the total amount of funding increased to US$80 mil-lion. AIB’s debt portfolio was restructured in 2004 with the creation ofKreditInvest and the transfer of the majority of the cotton financingoperations to it from AIB. AIB/KreditInvest accounts for 77 percent of all credit in the agricultural economy (ADB 2002b), 90 percent ofwhich is for cotton. Between 1998 and 2001 the amount of AIB creditquadrupled, with Reinhart allegedly increasing their involvement toUS$200 million (ADB 2002b). According to the ADB, only 8 percentof agricultural finance comes from producers’ own resources.
The main AIB/KreditInvest facility is lent to the 16 investors who oper-ate in the Republic, who then on-lend the money to the producers.Repayment is made through the delivery of seed cotton to the investors,with the price of cotton at harvest time being used for calculation of thephysical volumes concerned. The implied annual cost of this finance hasbeen estimated by the ADB at 20 percent per annum.
Contracting and Pricing
The vast majority of cotton is produced under investor finance packageschemes (WB 2000). In advance of the season, producers sign sales con-tracts with the investors for a certain area of cotton and based on a pre-dicted yield. This is then expressed in terms of tonnes of seed or baledcotton. In previous years this prediction has been largely inaccurate andis one of the reasons for the mounting debts. Some investors are now bas-ing this calculation on the preceding three years actual yields. The investorcontracts to supply the producer with the necessary inputs (physicaldeliveries of fuel, seed, fertilizer, etc.). Producers should also receive cashat harvest time to pay for picking labor. The price of the inputs are oftenonly declared at the end of the season.
The price for the cotton is decided at the time of the cotton harvest (forseed cotton) or shipment (for baled cotton). Actual figures for prices paidfor cotton are not available, although a recent study found in 2002 thatproducers were receiving US$250–350/ha in inputs, for which theinvestors were demanding 2 tonnes of seed cotton (equating to a seed cot-ton price of approximately US$150/tonne. Although the producer shouldreceive back his by-products (in tolling contracts), he often does not.
Cotton exports are dominated by Reinhart, due to their off-take agree-ments with the AIB. However, in the past few years, more cotton has beenoffered at origin to the general international trade. In 2002, Reinhartexported 47 percent of the crop, seven other companies exported a further36 percent, the balance (17 percent) being exported by a number of Russiantraders. In reality, the seven other main exporters were working withReinhart and, therefore, Reinhart controlled over 80 percent of exports in2002.
Vertical Coordination in the Cotton Supply Chains in Central Asia
83
In recent years, a number of “middlemen” have entered the market,offering small parcels of cotton for sale. Unfortunately, they often do notown the cotton or are trying to smuggle it out of the country. These partieshave often defaulted on their commitments and this has had a detrimen-tal effect on trader and textile mill confidence, which has had a nega-tive effect on sales prices for Tajik cotton.
All exports have to be registered with the Tajik commodities exchange(TUGE), which regulates the price of export contracts according to a setprice formula. Because of the method of calculating the price and discountsapplied, the author estimates that the average underpayment for cottonis approximately US$80/tonne in comparison with similar quality cot-ton sold by neighboring countries. The amount of the underpaymentvaries according to the value of the international price. With an averageexport of 150,000 tonnes per year, this formula causes a loss to the Tajikcotton sector of approximately US$12 million per year.
Inputs/Services
Inputs are supplied by the investors in their financing package with pro-ducers. There are many complaints about this: overpricing (AAH report of2003 showed double/triple market prices), low quality (with no means ofindependent assessment), and late/short deliveries. Apart from water andelectricity, input prices are equivalent to international prices (ADB 2002b).Resolution 580 of 2003 declared that producers should receive financing incash only, allowing them to purchase their inputs on the open market. Thishas, however, not materialized and investors continue to supply. Anothermajor problem is the availability of quality planting seed, the domesticresearch and seed breeding program having now largely collapsed.
The payment of salaries (which is provided for under the investorfinancing packages) is very often not executed or severely delayed. This pay-ment is the producers’ only access to actual cash during the growing sea-son. The only time that salaries or cash payments actually appear to bemade is for the picking of the cotton (at a rate of 3 c/kg).
A producer’s ability to obtain agricultural services depends on theinvestor with whom he is working and the investor’s willingness/ability toprovide such services. Due to the strict control of cash by the investors,producers have little or no opportunity to bring in outside service providers.According to the Swedish Institute for Public Administration (SIPU) reportof 2003, the provision of agricultural services (agronomic and technical)is very weak, but is starting to receive attention. However, this tends tobe directed only at the larger collective dekhan farms. Some producershave purchased new equipment from their investors, although there aregrave concerns that they were overcharged for this capital equipment.
WP 42 Case Studies
84
UZBEKISTAN
Supply Chain
Figures 4.3 and 4.4 provide a scheme of the supply chains in Uzbekistan.There are two different supply chains: one for state quota for cotton pro-duction, and one for cotton that is free from the quota, although the dif-ference is mainly cosmetic. It should be noted that there have been somepotentially dramatic reforms in 2004/5. At present, the actual impact ofthese reforms is not clear. The following discussions therefore highlightthe pre-2005 system, but note the recent reforms where relevant.
The government is the main link in the supply chain through the gins(owned by UzPakhtaSanoatish [UPS]) and the foreign business companies(FBCs). The government still controls the ginning plants in Uzbekistan(although they have offered 49 percent of the shares in them for privatiza-tion) and controls the provision of finance in the cotton sector.
Producers do not have access to finance outside of the government sys-tem, due to a lack of available credit, an inability to pledge sufficient assets,
Vertical Coordination in the Cotton Supply Chains in Central Asia
85
FIGURE 4.3 Cotton Supply Chain in Uzbekistan, 50 Percent State Quota
Producer
Input Suppliers
Contract Services
Ministry of Finance
Gin
Domestic Textile Mills
Foreign BusinessCompanies
Cotton salescontractInternational Trader
Foreign Textile Mill
Seed cottoncontract
Services/inputscontract
Domesticcurrency
payments
Domestic Bank
and lack of knowledge. Although a producer is able to buy inputs and ser-vices from external sources, the terms of his financing package prevent himfrom doing so. However, under the new financing scheme, this situation ispotentially changing.
There are textile joint ventures operating in Uzbekistan. However, manyof these companies are now suffering from increasing bad debts and manyof them have ceased to operate. The previous success of the sector wasbased on a subsidized internal cotton price and the ability to profit fromthe different exchange rates (central, over the counter, and black market).The exchange rates have now harmonized and the internal price of cottonis no longer subsidized or discounted. Many operators also suffered becausethey were unable to secure allocations of cotton in the internal market.Although they are now able to purchase freely from the commoditiesexchange, many of them do not have the financial capacity to be ableto do so.
The schematic shows the theoretical shape of the chain should legisla-tion passed in December 2002 actually be implemented. This would enable
producers to sell their 50 percent allocation through the FBCs or the com-modities exchange (previously UzAuctionSavdo, now internalized in thecommodities exchange). Under legislation passed in 2005, any party is nowable to purchase cotton through the commodities exchange (domestic cur-rency for internal and hard currency for export). The main problem is theability of producers to be able to access this marketing channel and there-fore it mainly remains another marketing route for central government.
Production and Yields
Table 4.2 has data from FAO for Uzbekistan. There has been a relativelylarge (16 percent) decrease in harvested area in the period 1992–2003,largely due to a switch in the cropping of wheat, in line with govern-ment’s policy of developing self-sufficiency in this product.
Yields have fallen 17 percent, although the 2003 decrease of 10 per-cent was due to weather conditions, distorting the overall picture. Theyield data fall into two distinct categories: the 1992–95 period and the1996–2003 period. In the former period there was an average yield of2.54 tonnes/ha and in the latter period a yield of 2.22 tonnes/ha—a dif-ference of around 12 percent. Average current yields are in the region of2.25–2.30 tonnes/ha. The decrease in the amount of seed cotton resultsfrom decreasing harvested area and falling yields and is clearly seen in thedata provided in the table.
The “seepage” of seed cotton into the Republics of Kazakhstan andKyrgyzstan is depressing production figures and is due to the higherprices paid in the neighboring countries compared with the state price inUzbekistan. No analytical work has been undertaken to quantify thiseffect, but Uzbek government estimates put this at around 300,000tonnes of seed cotton. Logistically speaking, this is impossible and wouldnecessitate the use of thousands of lorries and tens of thousands of peo-ple carrying 20-kg bags. Even allowing for that the seepage of 80,000tonnes of seed cotton, this would only have a 3 percent effect on impliedyield data. In 2003, this would imply an actual yield of 2.11 tonnes/ha, asopposed to the reported figure of 2.05 tonnes/ha. In the past two years,border controls have been stricter and prices have dropped relatively inneighboring countries, so seepage has been much less.
The decrease in baled cotton production corresponds to the decreasein seed cotton production (largely due to a flat ginning outturn over theperiod). The statistics are also likely to be inaccurate, as they are moredriven to meet with government targets than a true reflection of produc-tion. They are also inflated by the inclusion of cotton that is not of mer-chantable quality (see the following section).
Vertical Coordination in the Cotton Supply Chains in Central Asia
87
88
TAB
LE 4
.2FA
O C
otto
n Pr
oduc
tion
Dat
a fo
r Uzb
ekis
tan
Item
Title
Uni
t19
9219
9319
9419
9519
9619
9719
9819
9920
0020
0120
0220
03Pe
riod
Cha
nge
Seed
cot
ton
Area
Har
vha
(′00
0’s)
1,66
71,
695
1,53
91,
493
1,48
71,
513
1,53
21,
517
1,44
41,
452
1,39
71,
393
annu
al c
hang
e2%
−9%
−3%
0%2%
1%−1
%−5
%1%
−4%
0%−1
6%Se
ed c
otto
nYi
eld
tonn
es/h
a2.
482.
502.
562.
632.
252.
402.
092.
372.
082.
252.
292.
05an
nual
cha
nge
1%2%
3%−1
4%7%
−13%
13%
−12%
8%2%
−10%
−17%
Seed
cot
ton
Prod
uctio
nto
nnes
(′00
0’s)
4,12
94,
235
3,93
63,
934
3,35
03,
639
3,20
63,
600
3,00
23,
275
3,20
02,
856
annu
al c
hang
e3%
−7%
0%−1
5%9%
−12%
12%
−17%
9%−2
%−1
1%−3
1%Ba
led
cotto
nPr
oduc
tion
tonn
es (′
000’
s)1,
274
1,32
11,
258
1,26
51,
081
1,08
01,
147
1,02
11,
000
1,01
51,
008
914
annu
al c
hang
e4%
−5%
1%−1
5%0%
6%−1
1%−2
%1%
−1%
−9%
−28%
Gin
ning
out
turn
%31
%31
%32
%32
%32
%30
%36
%28
%33
%31
%32
%32
%
Quality
By the mid to late 1990s Uzbek cotton had started to become regarded bythe international processing market as a premium growth, as opposed toa blend cotton. Demand therefore grew, causing the price to rise in com-parison with competing growths. This was mirrored by the fact that Uzbekcotton began to be consumed in the high-quality markets of Europe (Italy,Germany, Belgium, etc.) and Asia (Thailand and South Korea).
However, in the past few years, there have been several very concerningdevelopments. First, the quality of baled cotton has begun to deteriorate,with mixed qualities, foreign body contamination, and badly preparedbales. Second, the previous trend of timely and predictable shipments hasreversed, with buyers suffering from lengthy delays and contract frustration.
There are several factors behind these problems and they include prob-lems with seed cotton quality deliveries (mentioned below), overselling bythe government trading organizations (FBCs) and a collapse of the logisticand management matrix at the ginning level. The main reasons for thisare the attempts by the various links in the chain to meet unrealistic tar-gets and quotas and a total lack of supervision by the government of thelinks involved.
In consequence, the demand for Uzbek cotton in the premium marketshas declined. The impact of this is currently being masked by changes inother competing growths and a dramatically increasing demand for cot-ton by the Russian textile industry. This latter effect is very marked becausetextile off-take contracts there are very profitable and buyers are pre-pared to pay high prices for low-quality product.
Uzbekistan attempted to address its quality problems by using HVI test-ing equipment, the purchase of which was financed by a World Bank proj-ect. The executing agency is called SIFAT (Uzbek word for quality) andanswers to the Cabinet of Ministers. Unfortunately, there are several prob-lems with this system, the major one being that SIFAT does not involveitself with the analysis of seed cotton deliveries—its function is only toclass baled cotton. Producers therefore do not have any independentorganizations available to enable them to have their seed cotton assessed.
The impact of the project on the quality of baled cotton and sales hasbeen severely hampered by the dichotomy of the relationship betweenSIFAT and UPS. Until the government introduces a real requirement forthe classing of 100 percent bales and separation of these bales in storage,there is going to be no real benefit from the use of the HVI technology. Anew decree was introduced in June 2003 that provided for the further useof centralized cotton storage points and their use for the creation of evenrunning shipment parcels. Unfortunately the infrastructure required forthe implementation of such a system does not exist and therefore the
89
Vertical Coordination in the Cotton Supply Chains in Central Asia
effect of this decree has been disastrous, with delayed shipments and anactual lowering of quality predictability.
Land Reform and Privatization
The government of Uzbekistan has introduced a package of legislationwith regard to land reform, with the previous state and collective farms hav-ing been converted to shirkats (cooperatives) of 1,500–2,000 ha in size.The previous labor brigades have been replaced by “pudrats,” which arecontracted family units. Most pudrats were set up in 1998 and 1999. Theyare granted five- to eight-year leases, with land allocation decided eachyear. This is a major disincentive for producers to carry out maintenanceor improvements on their land, as they are not sure that they will be crop-ping the same area in the next year.
Shirkats are based on collective ownership, with pudrats having a theo-retical share in the shirkats’ profitability. However, in a World Bank study(2000), it appeared that very few pudrats knew they owned a legal shareof the shirkat and only 8 percent had received a dividend from the shirkat.The shirkats are still subject to local authority decision making as to crop-ping patterns. The management of shirkats is nominated by the local gov-ernment and rubber stamped by the members at a general meeting.
There has been an acceleration of the creation of private farms, whichaverage approximately 20 ha (size varies form 5 to 200 ha), whichaccounted for 20 percent of cropland in 2000. Private farmers can obtainleases of up to 50 years and are legally free to grow whatever they wish.In reality they are dependent on local authorities and shirkats for theirsupplies of inputs, credits, and so forth, and therefore are bound to growwhat the local authorities decide.
Reform has been very slow in Uzbekistan and many of the apparentlyreforming decrees appear to have little effect in terms of true privatiza-tion. Immediately after independence, the government introduced anallocation of cotton production that producers could sell outside of thegovernment procurement system (in 1991 this was 5 percent, rising to 331⁄3 percent in 1995). However, after a poor harvest in 1995, the gov-ernment created a monopoly in the purchase of cotton and prices werefixed at a percentage of the prevailing international prices (70 percent in1996, 85 percent in 1997, and 100 percent in 2000). However, priceswere actually calculated on the basis of the costs of production adjustedfor inflation. A lot of the price increase was actually absorbed by infla-tion. Currently, producers are subject to a state allocation of 50 percentof their actual, as opposed to planned production, with the balance pro-duction being theoretically free for sale.
With regards to ginning, except for gins operating under a World Bankproject, there is basically 100 percent government control. Until 2002
WP 42 Case Studies
90
only three gins (out of a total of around 120) had passed into privateownership. However, these gins are only operating on a contracting basisfor UPS and are therefore subject to government control. In 2003 the gov-ernment offered to partially privatize the gins, with shareholdings to be 51 percent government, 24 percent employees, and the balance 25 percent for investors to purchase. Not surprisingly, there has beenlittle or no acceptance of this offer and nearly all the gins in the countryremain in government ownership.
Financing
Initially, the government operated a system of direct financing of produc-ers, routed through the central office of UPS (then known as UzKhlop-koprom). Fifty percent of total finance was provided at the beginning ofthe season to cover inputs, 30 percent paid in cash before harvest (to coverpicking) and the final 20 percent payment after ginning (based on thequality of actual quantities and qualities delivered). A cosmetic changewas made in the late 1990s, with these funds being routed through thelocal banks. The amount of finance was calculated by the Ministry ofFinance based on production norms. The producer was not able to accessthe funds and they were managed by the banks according to set instruc-tions with state suppliers of inputs. The loans were repaid directly by UPSthrough credits made for the delivery of seed cotton by producers.
It is, theoretically, possible for producers to raise private finance out-side of the government system, although there are various reasons whyproducers do not do this. For example, bank transaction costs are veryhigh and producers have very little control over their own bank accounts,with various government departments making deductions from the pro-ducer accounts without prior permission. This makes credit control verydifficult for both producers and the banks themselves. In the 2000 WBstudy, 85 percent of both private and dekhan farmers made no long-terminvestments in 2000.
The above system was amended in 2005, with the finance being pro-vided from government funds and made available through the commer-cial banking system. The main changes are that producers are no longerlegally obliged to accept this finance. While the amounts available foreach head of expense are predetermined, the producer is free to spend themoney with whichever service or input supplier he wishes and does nothave to use all of the available funds (if he spends less than the govern-ment plan dictates). Equally, as the finance is no longer routed throughUPS, they no longer have any claim of ownership over the cotton, butnow enter into service agreements with the producers to store and gintheir seed cotton. This is potentially an extremely important reform anda first important step to the liberalization of the sector.
Vertical Coordination in the Cotton Supply Chains in Central Asia
91
The government currently uses baled cotton to access internationalfinancing through the sale of cotton with contracts that provide forprefinancing (which is discussed below).
Contracting and Pricing
Prior to 2005, producers entered into a seed cotton sales contract beforethe beginning of the season with their local branch of UPS. With this theywere able to obtain financing (discussed above). The government set aprice for both state and private allocation seed cotton at the beginning ofthe growing season based on a predicted international price. If the priceat the time of delivery fell or increased in comparison with the initial price,then the actual price paid to producers should have been altered. In real-ity, the price was set so low that it was not necessary to reduce it, but anynet gains flowed to the government, as the price was not increased. The“advantage” of this system for producers was that they are not subject tomarket risk and are effectively guaranteed a minimum price.
Despite legislation inferring that producers would be able to sell theirprivate allocation cotton using available marketing channels, this has notbecome reality, with all seed cotton being bought by the government. Themain argument for not allowing this is that, if a producer has used gov-ernment finance to grow his crop, then he is bound to sell it all to them.Of course, up until this year, a producer had little other choice but to usegovernment financing. According to current legislation, if a producer hasnot used government finance, then he is not subject to the state order atall; however, this does not apply in practice, nor could a producer find aparty other than the government to sell to.
With the introduction of the new financing packages and removal ofthe seed cotton sales contract with UPS, developments in the sector willneed to be closely followed. Potentially we might be on the verge offundamental reform of the sector, although previous experience with non-implemented reforms has left most commentators cynical about govern-ment commitment to real reform in any area of the Uzbek economy.
Export contracting started after independence with a governmentdepartment—UzContractorg—issuing export licenses and registering con-tracts for domestic companies. The local companies purchased cottonfrom producers (private allocation) and from the government and thensold it overseas for hard currency or under barter contracts with Russiaand international companies.
In 1995, the government introduced a state monopoly over the pur-chasing and marketing of cotton. This is executed by the FBCs under theAgency for Foreign Economic Relations (AFER)—recently reorganizedagain as a ministry. Initially execution of sales also provided for the con-
WP 42 Case Studies
92
clusion of barter contracts, although this was prohibited in 1996. TheFBCs enter into contract with foreign companies for the sale of baled cot-ton. This contract provides for the payment of a percentage of the contractvalue in advance of shipment (prepayment). This prepayment is madeagainst a guarantee that is issued by the National Bank of Uzbekistan. Themonies received under these prepayments are compulsorily convertedinto domestic currency through the Central Bank. The FBC then uses thisdomestic currency for purchases of baled cotton from UPS.
In principle, with the opening up of the commodities exchange as apractical marketing channel, producers should actually be able to selltheir cotton either to the domestic or export markets. Initial results fromthe commodities exchange on the transactional success of the new sys-tem are encouraging. The future success of this reform depends entirelyon the commitment of the government to this reform.
Inputs/Services
Uzbekistan, until recently, maintained a system of centralized provisionof inputs, reinforced through the old government financing program. Asmall number of state-controlled enterprises controlled the inputs sectorand, because of their traditional links with the old state farms, they givepriority to the large shirkats. Fertilizer and pesticides are expensive andoften in short supply and are therefore often underutilized. Fertilizerusage is estimated at 50 percent of recommended rates. The prices forthese inputs are determined by the government (despite the fact thatUzchimprom was privatized in 1995). Pesticides are now rarely used inthe Republic, largely because of the requirement for hard currency toimport them and the large debts that are still owed to the major interna-tional manufacturers. The introduction of the new financing scheme andintroduction of privatization of input supply is leading to the develop-ment of private sector service and input suppliers (who are often cheaperthan their state-owned competitors).
The seed sector is managed by the state seed monopoly Uzsabsavot-naveourouglare, which is responsible for the production and distributionof seeds under the Ministry of Agriculture. It was privatized in 1990 and hasbeen without state budget since that time. In the cotton sector, their oper-ations are helped by the involvement of UPS, who handles the redistri-bution of planting seeds to producers each season. While there is noproblem with the availability of seed for cotton production, there are con-cerns about the preparation of the seed and the lack of development of newseed types. It should be noted, however, that this sector is doing better thanin other Republics. In fact, some of their new breeds (e.g., Bukhara 6) appearto be producing excellent results in terms of staple length and uniformity.
Vertical Coordination in the Cotton Supply Chains in Central Asia
93
In general terms, input supply was considered to be inadequate witha reported below 80 percent sufficiency for all inputs except for seed andfuel (WB RESP data 2000). Prices for inputs are now very close to worldmarket prices, although fuel remains relatively cheap.
Provision of services such as farming equipment and agronomic advicehave largely continued according to the old state system, although thisappears to be changing over the past two years. Shirkats, however, stillmaintain their MTPs (pool of farming equipment) and employ agrono-mists. The agronomy system has changed little, with not so much advicebeing offered, but instructions as to how to plant and when. Private farm-ers still have little access to these services and generally rely on unofficialarrangements with equipment operators of the shirkats (32 percent ofprivate farmers noted that the main problem was access to agriculturalequipment) (WB survey 2000).
The government has spent an enormous amount of money (circaUS$600 million) on new tractors and picking equipment in a leasingdeal with the company CASE. However, the equipment is difficult andexpensive to maintain and therefore charges to producers are very high.
There have been various government incentives for the creation of pri-vate agricultural service companies. In 1998 a law was introduced to pro-vide for a three-year tax exemption for the creation of rural businessadvisory services. In 1999 the government launched a program for thecreation of regional consulting centers, but this initiative lacked fundingand qualified personnel to staff these centers. Also in 1999 a law wasintroduced that promoted the creation of private machinery service pro-vision centers.
KYRGYZSTAN
Supply Chain
As we can see from figure 4.5, the supply chain in Kyrgyzstan is relativelysimple. The sector is free from government control and the gins are pri-vatized. The ginners supply finance in the form of inputs to the producersand in return the producers sell their seed cotton to their contracting gin.
There are a number of local traders in the market, who consolidatebaled cotton shipments and then supply these to various internationalmerchants, because a number of the gins in Kyrgyzstan are small and donot supply sufficiently large shipment for international traders to con-tract with them. Some of the gins are supplying cotton direct to textilemills in Turkey and Russia. The gins are owned and operated by Russianand Turkish shareholders, who have the necessary contacts in their homecountries.
WP 42 Case Studies
94
Production and Yields
Table 4.3 shows that there has been a dramatic increase in the harvestedarea: 71 percent. The number of gins has increased dramatically (from 3to 22), creating a large demand for seed cotton. The main area of expan-sion has been in the Jalal Abad region, which has increased its harvestedarea from 13,900 ha in 1992 to approximately 28,000 ha in 2002.
There has also been an increase in yield of 21 percent. However, thisstatistical increase is dubious. It is more likely that this increase iscaused by the mixing of smuggled Uzbek seed cotton with local pro-duction by producers. It is believed that actual yields are in the regionof 2.2 tonnes/ha (Lupton 2002). The decrease in 2003 was due to thepoor weather conditions.
The increase in baled cotton over the period is 264 percent, which isfar in excess of the increase in seed cotton available for ginning (108 per-cent). The reason is twofold. First, in the early years there was an under-declaration of baled cotton production (denoted by the very low impliedginning outturns). Second, the gins are purchasing smuggled seed cottondirect for processing (as denoted by the extraordinarily high impliedginning rates).
Vertical Coordination in the Cotton Supply Chains in Central Asia
95
FIGURE 4.5 Cotton Supply Chains in Kyrgyzstan
Producer
Bank Gin
Cotton salescontract
Textile Mill
International TraderLocal Trader
Seed cottoncontract
Services/inputscontract
Crop financepackage
Contract Services
Input Suppliers
96
TAB
LE 4
.3FA
O C
otto
n Pr
oduc
tion
Dat
a fo
r Kyr
gyzs
tan
Item
Title
Uni
t19
9219
9319
9419
9519
9619
9719
9819
9920
0020
0120
0220
03Pe
riod
Cha
nge
Seed
cot
ton
Area
Har
vha
(′00
0’s)
2220
2733
3225
3235
3438
3638
annu
al c
hang
e−9
%35
%22
%−3
%−2
2%28
%9%
−3%
12%
−5%
6%73
%Se
ed c
otto
nYi
eld
tonn
es/h
a2.
382.
422.
022.
242.
322.
492.
462.
512.
62.
593.
012.
87an
nual
cha
nge
2%−1
7%11
%4%
7%−1
%2%
4%0%
16%
−5%
21%
Seed
cot
ton
Prod
uctio
nto
nnes
(′00
0’s)
5249
5475
7362
7887
8898
109
108
annu
al c
hang
e−6
%10
%39
%−3
%−1
5%26
%12
%1%
11%
11%
−1%
108%
Bale
d co
tton
Prod
uctio
nto
nnes
(′00
0’s)
1413
1718
2125
2325
2934
4651
annu
al c
hang
e−7
%31
%6%
17%
19%
−8%
9%16
%17
%35
%11
%26
4%G
inni
ng o
uttu
rn%
27%
27%
31%
24%
29%
40%
29%
29%
33%
35%
42%
47%
Quality
The past five years have seen a slight drop in baled cotton quality, whichis probably due to a lack of maintenance of the gins (partly due to theentry into the market of inexperienced gin operators). International mer-chants note that there is a specific problem with the staple (fiber) lengthof the cotton being produced. This is mainly being caused by the lack ofgenetic potential of the current seed stocks and the lack of separation ofdifferent seed types at the production level. Equally staple length unifor-mity is low in baled cotton, because of poor seed cotton separation ondelivery and poor ginning.
A very concerning quality problem is the regularity with which Kyrgyzcotton is suffering from “honeydew” contamination (caused by insectinfestations). The use of pesticides has been low and, mixed with the recentmild winters, the insect population is growing and causing this problem.This sort of contamination is disastrous for any cotton growth and can leadto price reductions of up to 50 percent. More importantly, mills in devel-oped countries will rarely buy such cottons and this means that Kyrgyz cot-ton will only be purchased by the lower technology markets which pay lessfor cotton, because they produce cheaper textiles. This would explain theincrease in shipments to Russia, a low-quality textiles producer.
From an international trading perspective, the lack of agreed and regis-tered standard boxes (physical representations of different qualities)means that the sale of Kyrgyz cotton happens purely based on outtake sam-ples, because there is no standard against which Kyrgyz sellers are able torefer. These standards are normally adopted and designed by central gov-ernment or trade associations and then they are registered with the maincotton trading exchanges in the world (Liverpool, Bremen, and Milan).
Land Reform and Privatization
Initially the constitution of Kyrgyzstan (article 4) did not provide for pri-vate land holdings, but a decree of 1995 allowed for 99-year land leases(which could be sold, bequeathed, gifted, or mortgaged). In 1998, privateownership rights were allowed. As of January 2000, 47 percent of the arableland was controlled by 69,000 small and medium sized farms. The remain-ing 53 percent was managed by 600 corporate-collective farm enterprises(Childress and Mogilevsky 2000).
A decree of 1994 set maximum holdings for private ownership of 20 hafor intensively farmed land, but this was abolished by a land decree in1995. The latter decree did, however, set minimum land holdings at 5 haper family and, given that most families’ actual holdings are less than thisamount, it means that a number of families have to work together on
Vertical Coordination in the Cotton Supply Chains in Central Asia
97
98
WP 42 Case Studies
communally held land. The effect of this decree was to ensure that manyof the old state and collective farms were effectively privatized, but on thebasis of communal land holdings, or land share.
Small-scale privatization began in Kyrgyzstan in 1991 and, as of January1998, 96 percent of small businesses were privately owned. The mass pri-vatization program started in 1994 but suffered major setbacks in 1997,after evidence of collusive bidding and underpricing of assets. The programresumed in 1998 and provided for the privatization of such assets as thenational airline, electricity generation/distribution network, and telecom-munications. There were three state-owned ginning plants in the Soviettimes and, as far as the author has been able to ascertain, these plants wereprivatized under the initial phase of reforms in 1993 and 1994.
There are now a total of 23 ginning plants in Kyrgyzstan (including thethree above plants, which are still operating), with the majority of thenew plants having been constructed since 1995 (with at least nine plantshaving been constructed since 1999). It should be noted that these newplants are either old Soviet plants that have been re-sited from otherRepublics or are secondhand roller gins that have been imported fromTurkey. The newer gins are operating with relatively low throughputs andit should be noted that the original three plants processed approximately50 percent of total production in 2002. There are two main reasons for thedramatic increase in ginning plants in Kyrgyzstan. First, the gins ownedand operated by Turkish and Russian companies are accessing the localmarket so that they can export direct to their home countries’ textilemills. Second, due to the availability of smuggled Uzbek seed cotton,there are large amounts of cotton available for purchase in Kyrgyzstanwhich can be bought without the provision of crop finance and are spotcash purchases. In this situation, the ginner does not need to worry aboutproducer defaults and is able to manage his operating risk very efficiently.
Financing
Most cotton crop financing is provided to producers by the ginners, butthis is not sourced domestically. Many ginners, in the period 1994–2000,began to develop good relations with international merchants and wereable to attract prefinancing from this source (at rates in the region of12–14 percent). Unfortunately, many of the ginners are now not operat-ing and the amount of merchant prefinancing has dropped. The reasonsfor the ginners’ withdrawal from the market mainly revolved around oper-ational and political difficulties, as opposed to problems with the financialviability of their operations.
In many cases, the ginners now finance out of their own cash reserves andthis is seriously hampering their ability to finance sufficiently large amounts
of seed cotton. This has led to a much larger number of ginners and seedcotton buyers being active in the marketplace (as has been discussedabove). Many ginners either find it impossible to attract finance from thedomestic banking sector or find the costs of it to be prohibitive. The mainproblem is that domestic banks only finance against pledged assets, thevalue of which they heavily discount (partly because of a weak legal sys-tem and lack of law of pledge).
Crop financing is provided under seed cotton “forward” contracts, withthe producer contracting to deliver a predefined quantity of seed cottonto the gin and the ginner agreeing to supply the producer with local cur-rency and inputs at certain times of the season to cover the cost of inputsand labor. It should be noted that all inputs can be purchased domesti-cally and that there are no hard currency inputs. From the ginners’ pointof view, this places the currency devaluation to their advantage (as they buyin local currency and sell in hard currency), while it does not adverselyaffect the producer.
Contracting and Pricing
In return for the provision of finance, the producers contract to deliver theirseed cotton to the gin. The price that the ginners pay to the producers isbased on seed cotton weight, as opposed to a value linked to the baledcotton.
Producers used to be offered a domestic currency price for their seedcotton in advance of the season, that is, a fixed price. In this situation, theprice risk passes from the producer to the ginner. It should be noted, how-ever, that these fixed prices have been reneged on before by the ginnerswhen they have faced a drop in the international during the season. Morerecently, ginners have introduced floating price contracts, with the pricefor seed cotton pegged to the “A” index.
There appears to be little collusion between ginners as to the price paidfor seed cotton, because of the competition caused by the large number ofginners now operating in the market. There is a concern that many of thesmaller gins are not viable in the long term, which would enable the largerginners to collude, leaving producers with little or no access to a competi-tive market. One of the advantages for producers in Kyrgyzstan is that thecotton-producing regions are relatively compact and that they are thereforeable to transport their seed cotton the short distances to competing gins.
It should be noted that the price for seed cotton in Kyrgyzstan is gener-ally higher than that in Tajikistan and Uzbekistan. In 2003, average priceswere US$450/tonne for seed cotton, in comparison with US$200/tonne inUzbekistan and roughly US$550/tonne in Kazakhstan. There was anapproximate US$75 price premium being paid in the Jalal Abad Oblast,
Vertical Coordination in the Cotton Supply Chains in Central Asia
99
as opposed to the Osh Oblast. One reason for this is that there are a lot ofnew gins in the Jalal Abad area and they are competing to secure cottonsupplies. Another explanation is that there is more smuggled cotton avail-able in the Osh Oblast and this supply means that prices are lower than inJalal Abad. The price paid for seed cotton in Kyrgyzstan includes the seedand other by-products that ginners receive while processing the seed cotton.
The main problem with contracting for the export of Kyrgyz baled cot-ton is the lack of dependability of shipment (which is linked with the gin-ner’s or domestic trader’s ability to secure cotton). There have been a lotof cases of contract violations from origin and this is partly caused by thelack of transparency as to who are actual owners of the baled cotton.International traders are generally only prepared to purchase Kyrgyz cot-ton once it has been delivered to a reputable port warehouse. These prob-lems have a direct impact on the price that international traders areprepared to pay for Kyrgyz cotton. International traders normally avoidsuch problems by having local procurement offices in the country of ori-gin. The problem with Kyrgyzstan is that the crop is so small that it is hardto justify such overheads and therefore only Reinhart has an office inKyrgyzstan.
Inputs and Services
Producers receive inputs and cash payments from the ginners during theseason roughly in accordance with the main stages of crop production(planting, tending, and cropping). Producers complain that input sup-ply can often be unpredictable and late. This is due to the problems thatginners suffer raising finance and the difficulty of procurement of inputsin the Osh and Jalal Abad regions. There are major problems with thesupply of fertilizers and fuel, much of which is smuggled across theUzbek border from the Fergana Valley region of that republic. Many ofthe inputs are also supplied by monopolistic organizations and thereforethere is little ability to obtain competitive inputs from other sources.
Under the Soviet Union, Kyrgyzstan produced and developed its owncotton seeds (e.g., Kyrgyz-3 seed type). Since independence, this systemhas totally collapsed and now producers rely on smuggled Uzbek seedtypes. In fact, the new Kyrgyz-6 is actually an Uzbek seed that has merelybeen renamed (Lupton 2002). According to IFDC agronomists, mostKyrgyz producers have now switched to the Uzbek variety Fergana-6. Asmentioned above, there are some serious problems with quality seedavailability in Kyrgyzstan.
There appears to be a severe underusage of pesticides at present. This isexacerbating the pest problem and is evidenced by the development of astickiness problem linked with insect infestation. This lack is partly because
WP 42 Case Studies
100
pesticides have to be imported and there is no private sector importation/trading in this commodity and also because of the high cost of the importedpesticides (which explains the lack of private sector involvement).
Some ginners offer contract services to their producers, because they haveinvested in plant and equipment for their own farming operations (some ofthe ginners have leased land for cotton production). The costs for these ser-vices are deducted from the final payments made to producers for their seedcotton. No real independent agricultural service providers have developedin Kyrgyzstan and producers tend to manage with their own resources. Someof the old collectives are still operating their outdated Soviet equipment(now organized under land share arrangements) and the operators of theequipment do contracting for private farmers on an unofficial basis.
There are no private agronomic service providers and most agronomicadvice appears to be coming from internationally funded projects suchthe World Bank RAS (Rural Advisory Services), Helvetas, and IFDC. Forthe long-term future of the sector, it will be important for these servicesto become self-supporting by convincing producers of the value of pay-ing for their services.
KAZAKHSTAN
Supply Chain
Figure 4.6 presents a scheme of the Kazakh cotton supply chain. The ginand not the producer is the dominant link in the chain. There are twomain reasons for this:
a) Land privatization and dissolution of the previous farming systemshave led to the creation of a very large number of independent pro-ducers, who have small land holdings. This is exacerbated by the highdensity of population in southern Kazakhstan.
b) The nature of farm financing operations. The producers are not ableto attract commercial credits, whereas the gins are. This places the bar-gaining power in the chain into the hands of the ginners.
In the past five years the number of gins operating in southern Kazakhstanhas escalated dramatically, with up to 15 gins operating in the area. Mostginners have taken the step of purchasing or hiring seed cotton deliverypoints in places outside of their immediate area. This means that a producernow has the option of delivering his seed cotton locally, to a ginner who isnot from that area. The cost of the transportation of the seed cotton now fallson the ginner. Given the small geographic area involved, this has meant thatthere is fierce competition among ginners to attract seed cotton deliveries
Vertical Coordination in the Cotton Supply Chains in Central Asia
101
from producers. However, the strong competition among ginners in the2003 and 2004 seasons has led many gins to close in bankruptcy. This hashad the effect of reduced ginner competition in the 2005 season.
The gin provides the crop finance, inputs supply, and some of the agri-cultural services. As opposed to the Kyrgyz supply chain, there are nolocal traders because the ginners are of a sufficient size to trade directlysufficiently large parties of baled cotton. There is a growing tendency forthe Kazakh ginners to conclude direct export contracts with textile mills,specifically in Russia and Eastern Europe.
Production and Yields
Table 4.4 presents FAO statistics for cotton production in Kazakhstan forthe period 1992–2003. One striking development is the 64 percentincrease in harvested area due to the large demand for seed cotton causedby the construction of a large number of ginning plants. However, expan-sion of this area is unlikely in the future, as Kazakhstan is climatically ina marginal cotton growing area (too far north). Development of cottonlands is currently in the Kyzl-Orda region where land is being switchedfrom rice production because of profitability of cotton.
There has been a 95 percent increase in seed cotton production duringthe period, implying an increase in yields of 19 percent over the period.However, part of this is actually due to the smuggling of Uzbek seed cotton
WP 42 Case Studies
102
FIGURE 4.6 Cotton Supply Chain in Kazakhstan
Producer
Bank Gin
Cotton salescontract
Textile Mill
International Trader
Seed cottoncontract
Services/inputscontract
Crop financepackage
Contract Services
Input Suppliers
103
TAB
LE 4
.4FA
O C
otto
n Pr
oduc
tion
Dat
a fo
r Kaz
akhs
tan
Item
Title
Uni
t19
9219
9319
9419
9519
9619
9719
9819
9920
0020
0120
0220
03Pe
riod
Cha
nge
Seed
cot
ton
Area
Har
vha
(′00
0’s)
111
110
110
107
103
102
115
141
153
184
168
182
annu
al c
hang
e−1
%0%
−3%
−4%
−1%
13%
23%
9%20
%−9
%8%
64%
Seed
cot
ton
Yiel
dto
nnes
/ha
2.21
1.81
1.9
2.08
1.77
1.93
1.41
1.76
1.87
2.27
2.15
2.64
annu
al c
hang
e−1
8%5%
9%−1
5%9%
−27%
25%
6%21
%−5
%23
%19
%Se
ed c
otto
nPr
oduc
tion
tonn
es (′
000’
s)24
619
820
822
318
319
816
224
928
741
836
148
0an
nual
cha
nge
−20%
5%7%
−18%
8%−1
8%54
%15
%46
%−1
4%33
%95
%Ba
led
cotto
nPr
oduc
tion
tonn
es (′
000’
s)76
6072
6979
6762
6795
113
9012
0an
nual
cha
nge
−21%
20%
−4%
14%
−15%
−7%
8%42
%19
%−2
0%33
%58
%G
inni
ng o
uttu
rn%
31%
30%
35%
31%
43%
34%
38%
27%
33%
27%
25%
25%
into the southern Kazakh regions. The smuggled cotton is estimated to bebetween 25 percent and 50 percent of total Kazak production, although ithas been reducing in the past two years as a result of more stringent bor-der controls by the Uzbek authorities.
Quality
From information received in a recent survey, the annual quality splits ofboth seed cotton and baled cotton appear to be relatively static (75 per-cent of seed cotton classed as first grade and 85 percent of baled cottonbeing classed as first grade). The differential is probably caused by theunderclassification of seed cotton by the ginners on delivery. One hundredpercent of seed cotton is classed by the ginners’ own laboratories and only8 percent of producers interviewed responded that they always trusted theresults of the ginners’ laboratories; 59 percent did not always believe theresults and 33 percent never believed the results.
In general terms, the baled cotton produced in Kazakhstan is the mosteven running of the CARs (that is, consecutive bales are of the same qual-ity). This is mainly due to the care that ginners take in seed cotton storage,preparation, and ginning. It is also because producers are being paid attrac-tive prices for their seed cotton and, while they do not receive a premiumfor the delivery of particularly well prepared seed cotton (only 1 percent ofrespondents said that they did), they are penalized for delivery of bad orcontaminated seed cotton (as noted by 100 percent of respondents).
The main problem that has been noted by the international cotton tradeis that the staple (fiber) length of the cotton is slightly shorter than the cot-ton from other CARs. This hinders the access of Kazakh cotton to the maintextile markets in developed countries and therefore is having a negativeimpact on the international price for Kazakh cotton. There are several rea-sons for this shortening of fiber length.
Land Reform and Privatization
Several land laws have been passed, the most recent on June 20, 2003,which legalized the private ownership of agricultural land. In the southof the republic (the cotton growing areas), nearly all producers are smallpeasant farmers, who are already farming their allotted areas.
The government initially took a slow approach to privatization of themarketing and agroindustrial processing sectors. Since that time, stateprocurement arrangements were abolished for nongrain crops and in1995 a state procurement system was introduced based on a competitivetender system (Spoor 1999).
Reform was increased in the 1994–95 period, with the transformation ofmany state enterprises into joint stock companies or privatization. The gov-
WP 42 Case Studies
104
ernment also introduced extensive legislation to break up the monopsonypowers of many of these companies, in order to improve competition forfarm gate purchase prices and reduction of marketing costs (Spoor 1999).
In the cotton sector, it appears that the previously existing gins hadbecome fully privatized by 1998. The majority of the gins in the Makhtaralregion only began operating after the 1998 period and many of them wereonly constructed in the past three years (at least three of the gins).
There are now a total of 15 ginning plants in Kazakhstan (10 ofwhich are in the Makhtaral/Chimkent region). There are two main rea-sons for the increase in ginning plants in Kazakhstan. First, the ginsowned in conjunction with Russian companies are accessing the localmarket so that they can export directly to Russian textile mills. Second,because of the availability of smuggled Uzbek seed cotton (as seenabove), there are large amounts of cotton available for purchase inKazakhstan which can be bought without the provision of crop financeand are spot cash purchases.
The current ginning charge for producer cotton and toll ginning is inthe region of US$150/tonne (according to contracts that have been seen).This is high (comparable rates in Australia are US$120/tonne, even allow-ing for the higher outturn rates), especially when one considers that themain costs of ginning are depreciation of assets (gins are much cheaper inCARs), electricity (which is very cheap in Kazakhstan), and labor (whichis much less than in countries such as Australia). Therefore, simply oper-ating as a toll ginner in Kazakhstan is a profitable business.
Financing
Most cotton crop financing is provided by the ginners, as producers havelittle collateral and are therefore unable to obtain commercial bank credit(89 percent of respondents noted they received finance from their gin).With higher prices paid for seed cotton, many producers should bepartially self-financing, but they rarely retain earnings for future farmingoperations. Any extra disposable income is normally spent on consum-ables and family celebrations. Fifty-two percent of respondents saw a needfor the creation of a specific bank for farmers.
The ginner finance is provided in installments throughout the grow-ing season (30 percent at the beginning, 40 percent at the time of har-vest, and 30 percent upon delivery of the contracted seed cotton). A largepart of this finance is provided in the form of physical inputs and the bal-ance is in cash (for example, to pay for the hand picking of the cotton).The standard charge for this finance from the ginners is 18 percent perannum, although it does appear that this cost is higher when one con-siders the costs of inputs supplied under the financing packages (see
Vertical Coordination in the Cotton Supply Chains in Central Asia
105
below). Ginners finance the producers in the absence of any collateralguarantees and rely on a signed contract for repayment of the loans.
The ginners obtain finance from three sources: trader finance, domesticbanks, and their own cash reserves. Trader financing takes the form of for-ward sales of cotton, against which the ginners receive a percentage of thevalue of the cotton that is due to be delivered under the contract. Theamount of prefinance ranges from 15 percent to 50 percent of the total con-tract value. Generally, these advances from the purchasers are not backedby a collateral bank guarantee. The cost of this finance can range fromLIBOR plus 4–5 percent (for long established trading partners) to LIBORplus 8–10 percent (for new trading partnerships). This system has workedwell, with ginners and traders having established good trading relationsover the past 10 years. However, many of the international buyers havebecome less willing to advance such forms of finance, because of concernsabout the ginner’s ability to purchase sufficient seed cotton to cover the cashadvances.
The ginners in Kazakhstan have now begun to develop financing rela-tions with domestic commercial banks. Previously, the amount of financeavailable from this source was hampered by the ginner’s ability to providecash and collateral cover to the domestic bank. Another problem here wasthe cost at which these banks were prepared to offer finance (generallyaround LIBOR plus 15–20 percent). However, the costs of this financeare now decreasing and the credit volume is increasing. In fact, it isbelieved that some of the new ginning operations are totally financed, ifnot owned, by some of the major domestic banks. In 2003 some ginnershave managed to secure financing packages with their domestic banks inthe region of LIBOR plus 6 percent for hard currency loans. This is becausethey have quite large cash reserves themselves and large amounts of cap-ital equipment (which they can pledge) and have worked hard on theirrelationships with their banks.
A government-sponsored financing package is being planned for the2004 cotton season. This envisions the provision of US$50 million cropfinancing through Halyk Bank. The total interest rate will be 18 percent,with the producer being expected to pay 3 percent and the balance of 15 percent being paid by the government. Halyk Bank was offering com-mercial credits in 2003, but required the provision of collateral and thatthe minimum land holding of producers be 50 ha (which meant that veryfew producers were eligible).
Contracting and Pricing
Producers contract to sell seed cotton based on an agreed harvesting areaat a predicted yield of 1.5 tonnes/ha. Eighty-three percent of respondents
WP 42 Case Studies
106
replied that the reason for entering into producer contracts was access toprefinance. The formula price in the contracts has changed over the years,with the formula in 2004 being based on the “A” index at the time fixa-tion (delivery or later) minus 10 percent, minus the cost of ginning (atUS$150/tonne) and a ginning outturn of 32 percent.
The prices that producers are receiving have improved over the pastseasons. However, it should be noted that there is a two-tier cotton mar-ket operating in Kazakhstan—the price that is paid for seed cotton cov-ered under the above agreements and the price that is paid forproduction which is in excess of the original agreement (“free seed cot-ton”). In 2003, when the “A” index was at the 74 c/lb level, ginners werepaying an average of US$500/tonne for “free seed cotton” (prices actu-ally reached up to US$600/tonne). This was 21 percent more than theprice paid for contracted cotton. The premium was due to the competi-tion between the ginners to secure volumes of seed cotton.
Obviously, there was a temptation for producers to break their producercontracts with ginners and for them to deliver to other ginners at the higher“free seed cotton” price. Because of the short distances between gins andthe fact that many ginners rent collection points outside of their ownimmediate area, this is also achievable for producers. However, under theproducer contract terms, there are penalties for breach–repayment ofmonies outstanding, a penalty of 15 percent of the value of seed cotton not delivered under the contract and an increase in the cost of finance from18 percent to 35 percent. Obviously the quantum of these penalties ishigher than the price differential that producers can gain.
Because ginners are providing seed cotton storage points outside of theirimmediate areas and the gins are located so close to each other, producersdo have a choice as to whom they will contract with at the beginning of theseason (97 percent of respondents said they were able to change their gin-ners if they so wished and 92 percent noted that they had done so [althoughthis was only 80 percent in another similar question in the survey]).
It is worth mentioning here that the contract ginning rates provide for a32 percent outturn and that the purchase contracts also provide for anyincrease in outturn to be shared between the ginner and the producer (nor-mally 50:50). However, given that the producer’s seed cotton is stored inpiles with that of other producers (according to 100 percent of producerrespondents and 75 percent of ginners), it is not possible to imagine howthis can be ascertained. In this regard it is interesting to note that 95 per-cent of producer respondents did not know what the basis ginning outturnwas and 96 percent had not received any extra payments for higher ginningoutturn (although 62.5 percent of ginner respondents claimed that therewas a process for extra payments.)
Vertical Coordination in the Cotton Supply Chains in Central Asia
107
Although there is no provision for increased payment under the pro-ducer contract for higher quality baled cotton than seed cotton deliveries,50 percent of ginner respondents claimed that there was a price adjustmentfor this and 25 percent responded that baled quality was higher than seedcotton deliveries. It should be noted that 97 percent of producer respon-dents have not been able to inspect the baled cotton resulting from theirseed cotton deliveries and only 31 percent were aware of the discountsand premiums applicable for quality.
Inputs and Services
As shown above, finance and inputs are generally supplied to producersby the ginners. In terms of inputs, 81 percent of producer respondentsfelt that they were being overcharged for these from the ginners. The pricedifference for inputs supplied under producer contracts and the openmarket was in the region of 20–30 percent (seeds 29 percent, fertilizer 23 percent, and fuel 22 percent). It is clear from the results from pro-ducers and ginners that the majority of inputs are provided by the gins.Eighty-nine percent of producers said that they were receiving finance (89 percent of ginners said they were providing this), 65 percent of pro-ducers said they were receiving seeds (93 percent of ginners said theywere providing them), 40 percent of producers said they were receivingfertilizer (45 percent of ginners were providing them), and 73 percent ofproducers were receiving their water through the gins (70 percent of ginsresponded that they were providing water). The main anomaly was that20 percent of producers claimed to be receiving fuel from the gins,whereas 60 percent of the gins responded that they were supplying fuel.
Twenty-eight percent of producers complained that deliveries wereusually late and 25 percent claimed that they were of a low quality. Only15 percent of producer respondents felt that they had no problems withtheir input supply from ginners. Forty-three percent of respondents felt thatthe creation of independent input suppliers would be beneficial to theiroperations.
An interesting area is the current mechanization of producer operations.No ginners are currently supplying equipment or contracting services toproducers. Ninety-seven percent of producer respondents felt that theywould achieve better results if they used equipment in their operations(although only 23 percent claimed to have used equipment previously).Despite this, only 37 percent of producers would consider purchasingequipment in cooperation with other producers in order to increase theirproductivity. Equally, only 33 percent of producers had considered work-ing in cooperation with other producers in order to increase their efficiencyin input and marketing. Thirty-two percent of respondents felt that the
WP 42 Case Studies
108
creation of agricultural equipment service organizations (MTPs) would beimportant for the future development of their business.
Finally, it should be noted that the provision of agrotechnical advisoryservices appears to have completely stopped at present (with only 4 percentof respondents claiming to receive any kind of advice in this area). It is inter-esting to note that the producers also did not consider this to be a high pri-ority for development of the sector (8 percent). The problems here are thatthe producers have been used to receiving these services for free under theSoviet Union and during the immediate transition period and they areloathe to pay for them now and that many producers do not feel that theyneed external advice (or are adverse to it given previous central control).
CONCLUSIONS AND RECOMMENDATIONS
Supply Chains
In the CARs, the gin is the dominant link in the domestic supply chain. Thisstructure has led to many problems. These problems are worse in republicswhere there is no real competition between ginners (Uzbekistan andTajikistan) and the price offered to producers leaves them little option butto try and maximize their revenues in manners detrimental to the finalbaled cotton.
In terms of future development of the cotton sectors in the CARs, it isrecommended that privatization and total removal of government inter-vention in seed cotton procurement and ginning is a vital first step. Anyprivatized ginning sector also needs to be monitored by the governmentsto ensure that no private monopoly is created and that the private ginnersare not acting in a cartel manner.
Cotton farms, where they are based on small fragmented units, shouldbe encouraged and aided in the creation of organizations that will increasetheir collective bargaining power. In many of the CARs, there is a reticenceto work in producer cooperatives, as this is seen as a move back toward theproduction systems prevalent in Soviet times. However, there are indica-tions that such structures as marketing associations may be acceptable toproducers. Given an increase in producers’ bargaining power, their abilityto increase the price for their seed cotton or even to be able to enter intotoll ginning agreements with the gins would be possible.
Production and Yields
With the exception of Uzbekistan, the production levels in the CARs haveincreased since the beginning of independence, although Tajikistan pro-duction levels have remained relatively flat. The majority of the increase inproduction in Kyrgyzstan and Kazakhstan is due to the increase in planted
Vertical Coordination in the Cotton Supply Chains in Central Asia
109
area. The yield levels have also increased dramatically in these tworepublics, although much of this increase is due to smuggled Uzbek cot-ton. In Kyrgyzstan much of the smuggled cotton is being purchased directlyby the ginners. The apparent decrease in yields in Uzbekistan is alsoaffected by smuggling, with a disproportionate decrease in recorded yieldsin areas that border Kyrgyzstan and Kazakhstan.
The prices paid to producers in Kyrgyzstan and Kazakhstan are muchhigher than in the other CARs and this is the main reason that producershave increased their planted area. Uzbek smuggled cotton has interestedmore investors to build gins in these countries and competition has ledto higher prices for seed cotton.
Quality
Apart from Uzbekistan, the quality grading systems in the CARs haveeither collapsed or not been developed. Generally speaking, the applica-tion of the grading systems is carried out by a small number of underpaidbureaucrats, who are easily convinced to lower or raise grading results forfinancial incentives. However, these systems—including Uzbekistan’s—are focused on the quality of baled cotton for export. Given the discon-nection of the producer with their equivalent baled cotton, the currentsystems provide little protection for producers.
It would be in the producers’ interests to organize a system of inde-pendent assessment of their seed cotton at the time of delivery. It is alsoimportant to ensure a realistic link between the grading system for seedcotton and baled cotton. Ginners can minimize their prices to producersand maximize their returns through regrading of bale cotton.
Privatization, Ginning, and Investment
Apart from Uzbekistan, there has been privatization of the means of pro-duction and processing in the cotton sector. However, in Tajikistan, pri-vatization of the government monopoly of the gins has led to the creationof effective private monopolies or cartels. It is therefore important that thegovernments of the CARs are encouraged to develop effective and trans-parent monopoly monitoring. It is clear that, in Kazakhstan and Kyrgyzstan(where there has been true privatization), producers are benefitingfrom the effects of real competition.
For competitive markets to develop, it is vital that the governments areable to offer stable investment climates for domestic and foreign investorsequally. Such climates are based not only on the provision of clear invest-ment law, but also on the availability of an independent judiciary (wheredecisions of courts are subject to legal review) and the minimization of thepowers of central and local government. The governments in the CARs
WP 42 Case Studies
110
should be further encouraged to provide such investment climates and todeepen or initiate reforms insofar as the current domestic markets are notdeveloped.
Financing
Financing has become a major role for ginners and this is enabling themto maintain their dominant position in the supply chain. This control offinance also means that producers have to receive their inputs from a lim-ited number of suppliers and have little or no ability to negotiate theprices of these inputs. Finance, therefore, is a fundamental issue that needsto be addressed if we are to improve the producers’ current position. With-out access to finance, producers will not be able to attain any position ofpower in the chain.
In developing policy and international financial institution (IFI) pro-grams, it is important that an assessment of the domestic financing situ-ation takes into account producers’ actual abilities to access financedirectly and not through ginners. The structure of financing very muchdepends upon the nature of the producers. Where there are a large num-ber of small holders, the most effective system of financing is the creationof rural microcredit institutions. Another financing system that promotescommunity development is the creation of credit clubs. It is important,however, that these clubs are created in a structured manner, with provi-sion of suitable by-laws that ensure equal access to the assets of the creditclub by all members. Because of the transaction costs involved, centralbank provisioning regulations, and potential lack of competition leadingto high interest rates, support in the area of rural financing with the com-mercial banking sector should be directed at their role as finance whole-salers to the microcredit sector.
It should be noted that assistance is also needed by the commercial banksto develop their ability to offer structured trade and commodity finance.These forms of finance are based on an assessment of contractual and com-modity risk, as opposed to pure borrower risk. They involve the use of ware-house/inventory finance and risk management tools such as insurance andprice hedging. Of course, the introduction of such types of financing toolswill also require review of central bank provisioning requirements. Throughthe use of these financing tools, it will be possible to increase the gearing ofthe banks’ capital base and therefore increase the amounts of credit avail-able in the domestic banking sector.
Contracting and Pricing
Producers in the CARs contract for the sale of their seed cotton and there-fore have very little understanding of the baled cotton markets and no
Vertical Coordination in the Cotton Supply Chains in Central Asia
111
appreciation of where they and their product fit into the overall supplychain. Because of their lack of bargaining power in this contractual rela-tionship, they are price takers in the domestic market and often this inter-nal price is dislocated from the international price (with the majority of theprofit being taken by the ginners). Given the size of producers in the CARs,the amount of baled cotton that they are able to contract for sale is belowthe practical level at which traders (either international or domestic) wouldbe interested. However, it is clear that the development of this sector isdependent, in the long term, on the producers’ ability to receive a value fortheir cotton that is commensurate with the prevailing international price.
Therefore, the development of any policies in this sector, where produc-ers continue to sell seed cotton, should concentrate on the producers’ abil-ity to receive a price that is linked directly to the international baled cottonprice (with provisions for quality adjustment, actual ginning outturn, rea-sonable costs of ginning, and independent assessment of seed cotton qual-ity). This can be achieved by the education of producers to the factors of thecotton market, development of private independent quality assessmentservices, and training in contracting with ginners. Linked with this policyshould be a program of informing producers of the clear advantages to col-lective bargaining and the methods that could be employed to achievethis, while providing for the current concerns of producers about collectiveresponsibility and maintenance of their newfound independence.
Alternatively, producers should be encouraged to retain ownership oftheir cotton through to the stage of baled cotton. However, given the diffi-culties of marketing small parcels of baled cotton, it is important to providea viable market place for sale of this cotton. This can be achieved by the cre-ation of marketing associations or groups and the introduction of baled cot-ton auctions or commodity exchanges. If such a step is to be promoted, itis important to note that this system needs to be supported by the provisionof sufficient warehousing infrastructure. Warehousing enables producers tocollate their baled cotton, make it available for inspection, and offer a securefacility for the transfer of ownership of the baled cotton to the buyer.
Another advantage of the introduction of a cotton auction is that it willlead to the development of a real traded market in the domestic cottonand allow clear differentiation for each growth from the current pricingstructure (Cotlook A), which is not a traded market and is subject todirect influence by the buyers themselves.
Inputs and Services
Most input producers/suppliers are still monopolies and deliveries andprices of these inputs are being controlled by the ginners/financiers. Thefirst problem means that there is little or no competition and therefore
WP 42 Case Studies
112
pricing may be very arbitrary. A further complication here is that the priceof the inputs may be benefiting from subsidies, either direct or indirect.
With the second problem, the producers have no ability to negotiatebetter terms or prices for their inputs—they are dependent on the termsthey receive from their ginners/financiers. It is clear that, in some coun-tries (especially Tajikistan), producers are being charged vastly inflatedprices for inputs and are also suffering from late and short deliveries. Dueto the nature of their contracts with the suppliers, they have no optionbut to accept the terms that are forced upon them. In an attempt to miti-gate some of these losses, producers often use the delivered inputs oncrops from which they can derive financial or personal benefit (e.g., pri-vate plots). This is leading to a crop in cotton yields and poses a seriousthreat to the sustainability of cotton production in many of the CARs.
The development of competitive input sectors is closely linked with theproducers’ ability to receive direct financing and the impact this will haveon the producers’ choice of what inputs they wish to buy and in whatquantities. Also, with the increase of producer sophistication, there willbe a greater demand for quality inputs and modern agronomic additives.When producers are closely linked to the profitability of their cotton,yield and quality issues will become more important and this will alsoencourage the development of a private, competitive, and quality-basedinput supply system.
Since the breakup of the Soviet system, there has been a general declinein the agricultural services sector, which has been mainly due to a lack ofinvestment and institutional funding. In some countries this apparentvacuum has been filled by the ginners themselves, who have created sep-arate companies to provide farm services such as spraying and harvesting.They are able to do this because they can raise finance for the purchase ofexpensive capital equipment and also because they are able to recoup theircosts from producers through deductions in payments for the seed cottondelivered. This situation typically lacks any competition in the provisionof the services and therefore can be quite expensive for producers.
Farming equipment was old, outdated, and very inefficient. The lack ofaccessible finance in the CARs has meant that very little new equipmenthas been purchased. To encourage developments in this sector, it is nec-essary for viable financial products to be introduced. Although there are anumber of leasing packages available throughout the CARs, these pack-ages are based on financial leasing and not on operational leasing (mainlybecause there is a lack of a traded market in secondhand equipment).Often the costs of financial leasing is prohibitive for private operators andalso the period term offered for the leasing packages is insufficient for theoperator to be able to repay the value of the equipment. It should also be
Vertical Coordination in the Cotton Supply Chains in Central Asia
113
noted that many of these packages do not provide for the leased asset tobe considered as collateral and therefore many potential operators areunable to provide sufficient capital to be able to take out leasing.
The general collapse of institutional funding for activities as seedbreeding and agronomy is of great concern. Only Uzbekistan has man-aged to maintain a viable seed breeding program. Unfortunately, thereappears to have been little development or new technology usage in theagronomy field and most producers and agronomists continue to use theoutdated and even harmful farming practices that were developed dur-ing the Soviet period.
REFERENCESADB (Asian Development Bank). 2002a. Report and Recommendation of the President
on a Proposed Loan for the Tajikistan Agriculture Rehabilitation Project.——. 2002b. Cotton in Central Asia, A Review of Policy and Technology.Childress, M., and R. Mogilevsky. 2000. Understanding Farm Returns in the Kyrgyz
Republic During Agricultural Sector Transition. Kyrgyzstan: CASE.Lupton, J. 2002. Cotton Survey Report on Visit to Kyrgyzstan. Bishkek: BMZ.Spoor, M. 1999. Agrarian Transition in Former Soviet Central Asia. Netherlands: ISS,
September.World Bank. 2003. Farmer and Ginner Survey in Kazakhstan. Washington, DC: World
Bank.
BIBLIOGRAPHYGillham, F., et al. 1995. Cotton Production Prospects for the Next Decade. Washington,
DC: World Bank.Greenhow, T., and P. Forberg. 2003. Land Reform in Tajikistan: Assessment and
Recommendations on the Way Forward. Sweden: SIPU.IMF (International Monetary Fund). 2004. Uzbekistan Country Report.Lerman, Z., C. Csaki, and G. Feder. 2002. Land Policies and Evolving Farm Structures in
Transition Countries. Washington, DC: World Bank.Lucock, D. 2003. Tajik Debt Resolution and Policy Reform. Asian Development Bank.Pomfret, R. 2000. The Mechanisation of Cotton Harvesting in Soviet Central Asia. University
of Adelaide.——. 2003. Central Asia Since 1991—The Experience of the New Independent States.
University of Adelaide.Porteous, O. 2003. Land Reform in Tajikistan—From the Capital to the Fields. Action
Against Hunger.Prosterman, R., and T. Hanstad. 1999. Legal Impediments to Effective Rural Land
Relations in Eastern Europe and Central Asia. Washington, DC: World Bank.Thurman, M., and M. Lundell. 2001. Agriculture in Uzbekistan—Private, Dehqan and
Shirkat Farms in the Pilot Districts of the Rural Enterprise Support Project. Washington,DC: World Bank.
WP 42 Case Studies
114
Foreign Investment andVertical Coordination in
Supply Chains in Europe and Central Asia
Lessons from Dutch Agrifood Companies
S I E M E N VA N B E R K U M * A N D J O S B I J M A N †
115
EXECUTIVE SUMMARY
Findings are based on interviews with Dutch companies investing inEurope and Central Asia (ECA), held in spring 2004. The sample consistsof seven companies: two dairies, two fruit and vegetable processors, twopotato processors, and one feed-producing company. The main findingsof the interviews are summarized below.
� Dutch agrifood-related foreign direct investment (FDI) in ECA haslargely focused on Poland: this country accounts for one third of allDutch investments in the region. Russia (21 percent), Hungary (17 per-cent), and Czech Republic (15 percent) follow in importance. Allexcept one of the companies interviewed have invested in Poland.
� Major motives for investing in Poland and other countries in theregion were to increase market share in the country and/or region, orto enhance market potentials in the ECA. The companies have investedin the region in order to obtain a strong position in the local or regionalmarket. Access to raw material has been of higher importance in thisdecision than cheap labor or tax advantages.
5
*Agricultural Economics Research Institute, LEI-Wageningen UR, The Netherlands.E-mail: [email protected].
†Department of Business Administration, Wageningen University, The Netherlands.E-mail: [email protected].
� All companies interviewed have contracts with individual farms. Potatoprocessors show a preference for the larger farms supplying them.Processors of fruit and vegetable products rely largely on contracts withintermediate traders and producer associations. The feed producer pur-chases its raw material almost exclusively from intermediate traders.
� Companies demand their suppliers to comply with both public- andcompany-specific quality standards. Public quality standards arereferred to as national as well as European Union (EU) standards.Company-specific standards refer to specific types and specifications ofthe raw material. All companies interviewed indicate that their qualitycriteria are strongly linked to quality requirements set by their clients.
� Quality control points are at the factory gate. The companies controlthe quality, with only limited public inspection involvement. Only inthe case of milk processing do public inspection services play a sub-stantial role in controlling and inspecting both dairies and farmers.
� Contracts are written documents in which agreements are made aboutprices and quantities to be delivered. The latter is, however, not in thecontracts about milk deliverances.
� Terms of contracts differ much among companies. Dairies make con-tracts for three months or one year, yet with frequent price negotia-tions. Fruit and vegetable processors and the feed producer make dealson the spot market or draft short-term contracts (one year). Potatoprocessors normally draft one- to two-year contracts.
� Dutch companies apply farm assistance programs to farmers that sup-ply them, while the feed producer offers assistance to its clients.Assistance is mainly applied through training and extension. The majormotive for this support is to increase the quality of the agriculturalproducts supplied, or in the case of the feed producer, to improve per-formance of the clients and encourage expansion of their businesses.
� Occasionally Dutch processors provide financial support to farmers.This support is mainly through prefinancing of inputs. Two (out of thethree) companies providing this assistance link this service to require-ments set to suppliers on input use: certain varieties of seed potatoesand seedlings. This service of prefinancing inputs is only provided tothe larger farms.
The survey raises four issues that hamper efficiency improvements inthe sector. Government action is proposed to overcome the obstacles forfurther development:
1. Credit is scarcely available for farmers. Governments could improvecredit facilities to farmers in order to facilitate modernization by pro-viding loan guarantees to banks.
WP 42 Case Studies
116
2. There is a lack of public service for technical and managerial assistanceto farmers. Public research and extension services may provide theknowledge and information needed for the modernization of the agri-cultural sector in ECA countries.
3. Governments should increase their role in developing, implement-ing, and controlling quality standards, whether for raw materials orprocessed products. Currently, many companies design and imple-ment their own standards, which may be inefficient because parallelquality systems appear and may increase transaction costs as farm-ers or manufacturers face switching costs when they change tradingpartners.
4. Encouraging contract compliance may reduce transaction costs andthus improve overall efficiency in the agrifood industry.
INTRODUCTION
This chapter provides an analysis and documentation of the vertical coor-dination between Central and Eastern European companies’ (CEECs’)farmers and Dutch food processors. Investigating the link between verti-cal coordination and foreign direct investment (FDI) is important becauseinvestments by foreign firms may promote efficient vertical transactions,particularly in developing and transition countries where public institu-tions necessary to support market-based transactions are weak or evenlacking. In comparison with domestic firms, foreign firms are often largefirms, well financed and highly skilled. While these firms acknowledge thedifficulties in doing business in transition economies, many take a long-term view by seeking a position that will generate future growth.
When the institutional environment does not sufficiently support mar-ket transactions, foreign companies may introduce private arrangementsthat may substitute for public institutions. Economies in transition oftenexperience major contract breaches, because public enforcement institu-tions are themselves being reformed. The result of contract breach wasfinancial distress for the firms and a shift toward lower investments andless sophisticated products (Swinnen 2003). According to Gow andSwinnen (1998, 2001), foreign firms may introduce institutional innova-tion in contracting with farms. Innovative vertical contracting betweenprocessors and their suppliers has induced contract enforcement andreduced financial constraints for the suppliers through private contractenforcement mechanisms. Contracts between private agents act as a sub-stitute for missing or imperfect public enforcement institutions. In thisway, private institutions help to expand market opportunities andincrease market efficiency (see also World Bank 2001).
Foreign Investment and Vertical Coordination in Supply Chains in Europe and Central Asia
117
In CEECs, foreign firms have developed vertical contracts in order toimprove the quality and stability of supplies, by providing supplyingfarms with a broad farm assistance program. Often these assistance pro-grams include elements for access to inputs, investment assistance, tradecredit, bank loan guarantees, and extension and management advisoryservices (Swinnen 2003).
The combination of a supply contract with a farm assistance programlowers transactions costs, because it provides farmers with technical andmanagement information and the processor with information on theintentions of the farmer, and because it functions as a safeguard forinvestments in relationship-specific investments by both parties.
The chapter continues with a brief overview of investments by theDutch agribusiness in Central and Eastern Europe. Next, we present thecompanies in our sample. These companies have been interviewed inspring 2004 and the following analysis of vertical relations is based onfindings from these interviews. Emerging vertical relations are describedwith a focus on types of and conditions for vertical coordination betweenfarms and processors. Further, this chapter reports on the farm assistanceprograms offered by processing companies and provides an analysis ofthe impacts of vertical coordination on quality, yields, and access tomarkets. This chapter concludes with a number of recommendationsfor key policy actions and investment priorities for promoting the ben-eficial effects of increased vertical coordination and avoiding or miti-gating possible negative effects, from the perspective of both equity andefficiency.
DUTCH FDI IN CEECs
Dutch agribusiness investments abroad are substantial: in 2003 totalassets of Dutch agribusiness abroad were valued at 26.9 billion euros (DeNederlandsche Bank 2005). The most important regions of investmentare the United States (6.0 billion euros) and the European Union (EU)(5.0 billion euros). The trends in the figures—in general as well as in thefood industry—indicate a continuous increase of the Dutch foreigninvestments since the second half of the 1980s. Initially, nearby countriesreceived most attention: investments in the EU countries have increasedparticularly in the early 1990s. Subsequently, investments in the UnitedStates gained in importance, surged at the end of the 1990s, and stag-nated and even declined again in recent years. Meanwhile, the Dutch foodindustries showed increasing interest in Central and Eastern Europeancountries: the region’s share in total FDI by Dutch food industriesincreased from 0.5 percent in 1991 to 5 percent in the years 1996–98, to
WP 42 Case Studies
118
reach around 12 percent in 2003. Total assets owned by Dutch compa-nies in CEECs were valued up to almost 3.1 billion euros in 2003 (seetable 5.1). The prospect of becoming a member of the EU has been amajor driving force for Dutch companies to look for investment oppor-tunities in CEECs long before the enlargement was a fact. Indeed, com-panies expected that joining the EU would foster economic growth inCEECs, which then would encourage demand for food products, makingCEECs a promising market. Companies have also invested in CEECsbecause they wanted to explore possibilities for lowering productioncosts and subsequently export products from the East to the West.
Foreign Investment and Vertical Coordination in Supply Chains in Europe and Central Asia
119
Dutch agrifood-related FDI in CEECs has largely been focused onPoland: that country accounts for one third of all Dutch investments inthe region. Russia (21 percent), Hungary (17 percent), and Czech Republic(15 percent) follow in importance. Dutch agribusiness invested in Poland,Hungary, and the Czech Republic starting in the early 1990s. Investmentsin Russia did not expand until the country had recovered from the eco-nomic crisis of 1997/98 and political stability was reached. Romania hasattracted Dutch investments only in recent years, which is also due to (acertain minimum level of) economic and political stability.
Motives
In the literature, four reasons for internationalization are mentioned:access to raw material, access to markets, access to strategic assets, andeconomies of scale (Dunning 1993). The survey indicates that majormotives for Dutch agribusiness companies investing in Poland and othernew member states have been to increase market share in the country
TABLE 5.1 Direct Investment by Dutch Food Industries in CEECs (December 31)
Note: Other CEECs include Albania, Bosnia-Herzegovina, Bulgaria, Belarus, Estonia, Croatia, Lithuania, Latvia,Moldavia, FYROM, Serbia and Montenegro, Slovenia, and Ukraine. The 2003 investments in “Other CEECs” arelargely investments in Serbia and Montenegro.Source: De Nederlandsche Bank, Statistical Bulletin June 2005.
and/or region and to enhance market potentials in the CEECs (table 5.2).Starting with exporting to these countries from the Netherlands, the com-panies have invested in the region in order to obtain a strong position inthe local or regional market. Access to raw material has been of higherimportance in this decision than cheap labor or tax advantages.
WP 42 Case Studies
120
Country Choice
All except one of the companies interviewed have invested in Poland.Some of the companies have invested in one or more countries in theregion, next to Poland. Clearly, Poland is preferred by the Dutch agri-business for its location. The choice for a foreign investment in specificcountries and/or regions is based on a combination of company strat-egy and country- and region-specific characteristics. Studies that concen-trate on country characteristics refer to many factors that may enhance FDI
inflows. Ning and Reed (1995), for instance, claim that foreign invest-ments by U.S. agribusiness are mainly driven by cultural ties, trade blockmembership, a strong dollar, and a large and growing market, low taxes,and cheap labor in the hosting countries. Political stability and a certainminimum level of economic stability are other issues mentioned in theliterature (for an overview, see Van Berkum 2002). Probably the mostimportant reason for choosing the location of an investment is the pres-ence of purchasing power. This factor together with the market potentiallinked to the size of its economy has also been important to the Dutchagribusiness investing in Poland.
PROFILES OF DUTCH COMPANIES INTERVIEWED
Many Dutch companies are active in CEECs either by trade or by invest-ing locally. In the framework of this study, we interviewed a (limited)number of the larger companies that have had processing units in theCEECs already for some time. This survey largely builds on the insightsfrom interviews. The companies were asked to fill in a questionnaire, sup-plemented by personal communication. The profiles of the companiesinterviewed are presented below.
� Campina is a cooperative dairy company with a turnover of 3.65 billioneuros in 2003. The company has production locations in countries likeBelgium, Germany, Poland (since 1997), and Russia (since 1998). In2004 it bought the Parmalat dairy in Thailand, indicating that, next toEurope, Campina wants to expand in (South East) Asia. Campina sellsa broad assortment of dairy products, including consumer productsand products for industrial use. Its clients are all over the world.
� Friesland Foods is a cooperative dairy company with several subsidiariesin Europe, Asia, Africa, and South America. With a sales figure ofUS$4.7 billion in the year 2003, Friesland Foods is among the 10biggest dairy companies in the world. Friesland Foods produces andsells dairy products and fruit-based drinks in several European coun-tries: the Netherlands, Belgium, Great Britain, Germany, the CzechRepublic, Slovakia, Hungary, and Romania.
� Oerlemans Foods is a privately owned company. The company wasestablished in the second half of the 1970s and now has 425 employ-ees. The company specializes in the production of “freshly frozen” veg-etables, fruit, and potato products. The company offers a broad rangeof products for the international food service, retail, and industry. Inaddition, Oerlemans Foods is the market leader in Europe in the areaof organically and biodynamically grown vegetables, fruit, and potato
Foreign Investment and Vertical Coordination in Supply Chains in Europe and Central Asia
121
products. Production locations are in the Netherlands, UnitedKingdom, Spain, Poland, and Hungary. The company claims to havesales in over 50 countries. The largest customer base is in Europe,with areas further including Middle East, Far East, and North andSouth America.
� SVZ is an internationally operating company engaged in the develop-ment, production, sale, and distribution of fruit and vegetable rawmaterials and ingredients to the global food industry. SVZ is part ofthe Royal Cosun group (with, among others, business units SuikerUnie [sugar] and Unifine Döhler [bakery ingredients]), a farmers’cooperative with around 14,000 members. SVZ is based in Europe,United States, Africa, and Asia. In CEECs, SVZ has operations inRomania and Poland.
� Farm Frites is a privately owned business, established in the 1970s.Presently, the company is the third largest potato processor in Europe.The company exports to more than 45 countries from eight productionlocations in, among others, France, Egypt, and Argentina. Farm Fritesstarted operations in the north part of Poland in 1992, built a new fac-tory for processing potatoes locally, and over time has invested around40 million euros in the processing unit. The company has sales officesin the CEEC region in Russia, Poland, the Czech Republic, and Hungary.
� McCain is the worldwide market leader of frozen potato products.McCain has more than 55 processing units on six continents and asales organisation covering over 100 countries. The company countsmore than 20,000 employees. The European head office of the com-pany is located in the Netherlands. This office is responsible for theoperations in Central Europe. McCain started operations in Poland in1999, by building a new processing unit in the South of Poland (Silesia).This factory does not only produce for Poland but also for Central andSouth Europe and the Baltics.
� Cehave-Landbouwbelang is a farmer-owned cooperative, with 11,000members. It is a multipurpose cooperative, with a turnover of 750 mil-lion euros in 2003. More than half of the turnover is earned by pro-ducing and selling compound feed. Cehave is the largest feed producerin the Netherlands, producing more than 2.5 million tons of feed peryear. Cehave produces feed for pigs, poultry, and ruminants, as well asspecial premixes and feed ingredients. In 2002, Cehave had produc-tion units in the Netherlands, Belgium, Germany, and Poland. In addi-tion, it had sales offices in many more countries. The internationalfocus of Cehave is particularly on Central and East European coun-tries. Approximately one third of Cehave turnover is earned outside ofthe Netherlands.
WP 42 Case Studies
122
VERTICAL RELATIONS BETWEEN DUTCH COMPANIES AND LOCALPRIMARY PRODUCERS
Contract Partners
All companies contract individual farms (see table 5.3). Both dairies con-tract small and large(r) farms. Because the Romanian dairy farm structureis extremely fragmented and dominated by “farms” with one to twocows, Friesland does not have much choice than to take supply from smallfarms. In its operations in Poland, Campina indicates that the company’ssupply base is more and more shifting from the group of small dairyfarms to the larger ones: in 2004 the average farm delivering Campinahad 20 cows. The two potato processors in the sample contract on aver-age the larger farms. Dutch processors of fruit and vegetable products alsocontract farmers directly but mainly purchase the raw material fromintermediate traders and producer associations. The latter indicates thatthe marketing of fruit and vegetables in Poland has developed, with someconcentration of business in the stages between growers and processors.Cehave buys its feed ingredients almost exclusively from intermediatetraders, because they can deliver large quantities and guarantee quality.
Foreign Investment and Vertical Coordination in Supply Chains in Europe and Central Asia
123
Contract Terms and Agreements
Contracts with traders, producer associations, and the larger farmers arewritten documents. Usually, agreements are set about prices and quanti-ties to be delivered. The latter is, however, not in the contracts about milkdeliverances. Agreements with the smaller farms on quantities of andprices for deliveries are largely by verbal agreement.
In general, the written bilateral agreements between the farmer (sup-plier) and processor (buyer) are not laid down in a notary’s deed. Dutchcompanies indicate that Polish farmers are increasingly aware of the neg-ative consequences of breaching contracts. Farmers know that this will
a. Refers to contracts with suppliers of feed ingredients.
give them a bad image; it will point out that they are unreliable and thismay limit their chances on a contract with another processor. Therefore,the farmers have an interest in investing in a long-term, durable rela-tionship with the processor. Following this argument, a notary’s deedmay not be necessary to enforce contract agreements. However, Dutchcompanies in the survey indicate that they would favor a stronger legalsystem for enforcing contracts.
The terms of contracts differ much among companies (table 5.4).Dairies usually make contracts for three months or one year. However,they indicate that they frequently renegotiate with farmers about prices;the frequency depends on the market situation and inflation rates. Fruitand vegetable processors purchase their raw material through deals onthe spot markets (as does feed producer Cehave), but also rely on short-term and medium-term (up to three years) contracts. Potato processorsnormally draft one- to two-year contracts. Farm Frites also reports to havecontracts up to three years, to provide growers with secured sales whenthey have invested in storage and/or other quality-improving invest-ments (see below).
Quality Issues
The quality issue is important to all processors and may affect the choiceof contract partners of the companies. In some cases, this also has impli-cations for the size of the contract partners. Campina’s strategy mayillustrate this point. In its communications with farmers supplying thecompany’s factories, Campina continuously stresses the need for milkquality improvement. Since the start of operations, the company hasincreased milk quality norms step by step. The company reports that anumber of small farmers could not comply with the norms, with the con-sequence that their milk has been refused by Campina. Some of thedropouts were able to supply milk to other dairies, but others were notand had to look for alternative marketing channels (e.g., street markets)or stop business.
Both potato-processing companies in our sample have indicated thatthey prefer contracting large rather than small suppliers, referring to qual-ity levels and control issues. McCain requests specific potato varieties, suit-able for the production of its high-quality potato products. These varietieshave to comply with the company’s specific quality criteria. Therefore, thecompany is committed to having direct contact with Polish farmers toassist them in making the appropriate choices on varieties and providingfarmers with technical assistance. To minimize the costs of guiding andassisting farmers as well as of the quality control system, the company hasa preference for the larger potato farmers. Farm Frites also emphasizes the
WP 42 Case Studies
124
125
TAB
LE 5
.4Te
rms
of C
ontr
acts
Frie
slan
dCa
mpi
naO
erle
man
sSV
ZFa
rm F
rite
sM
cCai
nCe
have
Term
of c
ontra
ct1
year
3 m
onth
s1–
3 ye
ars
Daily
, sea
sona
lly1
seas
on,
1–2
year
sPe
r del
iver
y,
(occ
asio
nally
m
onth
ly3
year
s)Ta
citly
rene
wed
Fr
eque
nt p
rice
Freq
uent
pric
e N
o, n
ew
Shor
t-ter
m c
ontra
cts
No,
neg
otia
tions
Annu
alCo
ntra
ct
cont
ract
s(re
)neg
otia
tions
(re)n
egot
iatio
nsne
gotia
tions
are
taci
tly re
new
ed,
nego
tiatio
nsne
gotia
tions
seas
onal
con
tract
s fo
r eac
h ar
e ne
gotia
ted
deliv
ery
importance of having close contacts with the potato grower. Cultivationand postharvest knowledge and techniques applied as well as the choice ofthe potato variety highly affect the yields and quality of the harvested pota-toes. In the early years of its presence in Poland, Farm Frites found that veryfew Polish farmers had the knowledge and means to supply Farm Friteswith good-quality potatoes. Therefore, the company leased land and culti-vated potatoes by itself to supply the factory with good-quality potatoes.Next, Farm Frites contracted mainly foreign potato growers already settledin Poland, which were used to West European quality standards. Step bystep Farm Frites has been able to increase local supply by Polish farmers byassisting them in improving their performances both in yield and the qual-ity of their produce. In 2004, the company had reduced most of its ownpotato-growing activities, while Polish farmers supply almost 50 percentof the company’s total purchase of potatoes.
Companies demand that their suppliers comply with both public- andcompany-specific quality standards (see table 5.5). Public quality standardsare referred to as national as well as EU standards and are considered min-imum levels with which raw material deliveries have to comply. Company-specific standards refer to specific types and specifications of the rawmaterial and in most cases depend on the requirements set by the client ofthe processing company. In order to reach the specific quality requirementlevels, Dutch companies have developed programs to assist farmers toimprove their production methods (see below on assistance programs).
Quality control points are at the factory gate, indicating that the proces-sor always supervises what comes into his processing unit. The companiescontrol the quality on the basis of appearance, content, and other criteriaby using their own company facilities (laboratories). These quality inspec-tions determine whether farmers have complied with requirements set bythe company and form the basis for the payments to farmers. Presently,involvement of an independent third party to evaluate companies’ qual-ity control systems and their production methods is limited. Only in thecase of milk delivery, do public inspection services play a substantial role,controlling and inspecting both dairies and farmers on a regular basis.
SUPPORT TO FARMERS
Except for SVZ, all Dutch companies in the sample apply farm assistanceprograms to farmers who supply them (table 5.6). Assistance is appliedlargely through training and advice/extension. The major motive for thissupport is to increase the quality of the agricultural products supplied.Several companies have inspectors out on the field. Campina, for instance,has two inspectors who constantly are in contact with the 200 farmers
WP 42 Case Studies
126
127
TAB
LE 5
.5Q
ualit
y Is
sues
in C
ontr
actu
al A
gree
men
ts
Frie
slan
dCa
mpi
naO
erle
man
sSV
ZFa
rm F
rite
sM
cCai
nCe
have
Expl
icit
cont
ract
ual
agre
emen
t on
qual
ityPu
blic
- ver
sus
com
pany
-sp
ecifi
c qu
ality
st
anda
rds
Who
con
trols
qu
ality
?
Qual
ity c
ontro
l po
int
Qual
ity
dete
rmin
ed b
y pr
oces
sor/c
lient
Qual
ity
dete
rmin
ed b
y pr
oduc
t or b
y pr
oduc
tion
proc
ess
Invo
lvem
ent o
f pu
blic
in
spec
tion
Yes
Com
pany
-spe
cific
Com
pany
and
th
ird p
arty
At fa
rm le
vel,
at c
ol-
lect
ion
poin
t and
at
fact
ory
gate
Both
Prod
uct
Cont
rol a
t dai
ry le
vel,
not a
t far
m le
vel
Yes
Com
pany
-spe
cific
Com
pany
(eve
ryde
liver
y) a
nd
third
par
ty (e
ach
3 m
onth
s)At
farm
leve
l and
at
fact
ory
gate
Both
Prod
uct a
nd p
rodu
c-tio
n pr
oces
s
Cont
rol a
t dai
ry a
ndfa
rm le
vel
Yes
Both
Com
pany
At fa
ctor
y ga
te
Clie
nt
Both
Very
lim
ited
role
Yes
Both
Com
pany
At fa
ctor
y ga
te
Both
Both
Only
with
dis
pute
s
Yes
Com
pany
Com
pany
At fa
ctor
y ga
te
Both
Both
Only
in
food
saf
ety
issu
es
Yes
Com
pany
Com
pany
At fa
ctor
yga
te
Clie
nts
Prod
uct
Only
in
food
saf
ety
issu
es
Yes
Both
Com
pany
At fa
ctor
y ga
te
Clie
nts
Both
Sets
stan
dard
s
who currently supply the company. These inspectors give personal adviceon technical and economic issues for free. Friesland has 36 trainers out onthe field in Romania. Farm Frites has a number of staff who provide assis-tance in cultivation and storage techniques and advice on investmentssuch as in mechanization. Cehave does not have an assistance programfor its suppliers of ingredients for the compound feed (which are mainlytraders), but offers several services to its clients (mainly poultry farms).The service is mainly advice for better technical performances (forinstance, when farmers want to purchase animals, how to improve milkand meat quality and increase quantities of production), advice on man-agement, and advice on investment decisions. SVZ does not offer supportto its suppliers, which are, next to traders, producer associations and somefarmers too. This company largely purchases at spot markets and throughshort-term contracts. This purchase strategy implies that the companydoes not (want to) invest in enduring business relations.
WP 42 Case Studies
128
Investment Financing and Other Input Arrangements
Three companies—Friesland, McCain, and Cehave—provide credit totheir farmers (Cehave to their clients of compound feed) (table 5.7).Friesland occasionally provides financial support to farmers for invest-
a. Cehave has a program for clients purchasing compound feeds.
129
TAB
LE 5
.7In
vest
men
t Sup
port
by
Com
pani
es
Frie
slan
dCa
mpi
naO
erle
man
sSV
ZFa
rm F
rite
sM
cCai
nCe
have
Cont
ribut
e to
farm
er’s
inve
stm
ent
finan
ceSu
ppor
tive
tofa
rmer
in
rece
ivin
g a
bank
loan
Elig
ibili
ty fo
r co
mpa
ny’s
inve
stm
ent
supp
ort
Occa
sion
ally
(mai
nly
in c
oolin
g fa
cilit
ies)
Yes
Loya
l, relia
ble,
and
larg
erfa
rmer
s
Indi
rect
ly (s
ee b
elow
)
Prov
idin
g go
od
refe
renc
es to
ban
ks;
payi
ng fa
rmer
s in
tim
e
Inci
dent
ally
pr
efina
ncin
gpr
opag
atio
nm
ater
ial
Relia
bilit
y, c
olla
tera
lre
ques
ted
Only
in p
refin
anci
ngse
ed p
otat
oes
Yes,
if re
ques
ted
byfa
rmer
In p
rinci
ple,
eve
ryfa
rmer
Shor
t-ter
mcr
edit
to c
us-
tom
ers
ments in cooling facilities and improving cow sheds. However, the com-pany is very reluctant to offer farmers short- to medium-term loans,because few farmers have enough collateral. On the other hand, Frieslandis prepared to pay farmers in advance for milk deliveries so that farmerscan purchase necessary inputs in time. Furthermore, farmers may usedelayed payment for feed purchases (from Friesland) or the companydeducts part of the milk money for a number of months.
Credit offered by McCain is linked to the purchase of certain seed potatovarieties, which are highly recommended by the company. McCain doesnot call this a loan, but calls it input prefinance: in the supply contractbetween the farmer and the company the counter value of seed potato pur-chases from the company is mentioned and that value will be deductedfrom the eventual payment to the farmer for potato delivery.
Cehave provides credit to its customers (mainly poultry farmers andsome pig farmers) who invest in production facilities by permitting themto pay for feed deliveries after a certain 30 to 35 days. As money is scarcein Poland, this payment delay is an important source of credit for farm-ers. About two thirds of Cehave turnover falls under this credit arrange-ment. Farmers paying in cash receive a discount.
Farm Frites does not supply their farmers with any credits, loans, orprefinance arrangement. However, the company provides an importantservice to their farmers in the purchase of inputs (seed potatoes, fertiliz-ers, plant protection products) by acting as an intermediate, buying inputsfor its farmers in large quantities and distributing these inputs to farm-ers. Farmers benefit from discounts and get their inputs at low cost ontheir farmyard.
An issue affecting a farmer’s financial position is timely payment forits deliveries to the food processor. Campina explicitly mentions timelypayments to its farmers as an important instrument of assistance, becausecash flow is very important to farmers. Friesland indicates that timelypayment is indeed very important to farmers in Romania, because accessto credits is extremely difficult. Friesland shows that through timely pay-ment the company has been able to compete with other dairies in attract-ing milk from farmers.
IMPACTS OF VERTICAL COORDINATION
Quality Improvements
Vertical coordination through contract arrangements between Dutchprocessors and CEECs’ farmers has several implications. All companiesclaim that the supply of good-quality raw material is a major issue thatneeds to be addressed by contract arrangements. Contracts consist of
WP 42 Case Studies
130
quality requirements with which farmers have to comply. Farmers whoare unable to comply with those requirements are refused as supplier.However, Dutch companies have developed programs through whichfarmers are assisted in improving their production methods in order toproduce higher quality products over time. Examples from Campina,Friesland, and Farm Frites illustrate that farmers willing to learn andinvest in quality-improving measures can achieve higher quality perfor-mances step by step.
Yields and Production Levels
The survey does not indicate to what extent vertical coordination hasaffected yields and/or production of individual farms. This brief researchdid not include interviews with farmers. However, especially withrespect to dairy farmers and potato growers, processors in the sampleclaim that their suppliers have benefited from their assistance programsand point at examples of supplying farmers that gradually increasedtheir yields and their scale of production. The two sectors mentioned aresectors where companies have relatively long-lasting business relationswith farmers.
Access to Inputs and Output Markets
Vertical coordination improves access to inputs. All companies of thissurvey provide farmers with extension services and advice on various hus-bandry issues, cultivation techniques, hygienic standards, and farm eco-nomics. This is extremely important in a country like Poland wherehardly any public service is available for technical and managerial assis-tance. Furthermore, farmers have improved access to (small) loans for(small) investments, if financial support for investments is included inthe assistance program. However, most Dutch companies seem very cau-tious in providing farmers with loans: they select farmers eligible forloans very carefully. Companies do not consider it their responsibility tosolve the problem of credit scarcity and surely do not want to act like abank. Instead of providing loans, Dutch companies prefer prefinancingof inputs or improving the farmers’ liquidity position through timelypayments. Both are important ways to reduce financial constraints forsuppliers, which may have positive effects on investments and modern-ization of the sector.
With respect to access to output markets, it is important to notice that allseven companies surveyed have contracts with supermarkets, food indus-tries, and/or fast food chains. In most cases the clients of the Dutch com-panies are internationally operating industries and chains. This enlargesthe market for agricultural products from Polish farmers importantly.
Foreign Investment and Vertical Coordination in Supply Chains in Europe and Central Asia
131
Moreover, through vertical coordination with foreign multinationals,like the Dutch companies in this sample, Polish agriculture is includedin an international network of food suppliers. Such a position willbecome an important factor for the sector’s future competitiveness.
Vertical Coordination and FDI
For the development of the agricultural sector, foreign investment in thefood processing industry is of significant importance. Compared withother CEECs, Poland has received much foreign investment in the agri-cultural sector since the early 1990s. These investments show that foreigncompanies see good prospects in the Polish market in the longer term.Important impacts arise from these foreign investments. One observationis that the competition in the market has increased. More firms with bet-ter products are entering the market and competing with the existingestablished businesses. Increased competition from internationally oper-ating companies has fueled a growing tendency of specialization in thesector. Furthermore, foreign investment has resulted in an increasingnumber of products being available to the consumer. Moreover, as thesecompanies want to accept only agricultural commodities of good qual-ity, they initiate further efforts to implement strict quality standards rightalong the agricultural supply chain.
CONCLUSIONS AND ISSUES FOR POLICY ACTION
This chapter has analyzed vertical relations between farmers in CEECs(mainly Poland) and Dutch agrifood companies. The latter are in searchfor good-quality raw material for further processing. This survey indicatesthat private arrangements between processors and farms largely focus onquality issues. An important instrument to help the farm sector complywith quality requirements is the farm assistance program. Dutch compa-nies apply such programs, although in different degree. The impacts onquality improvement, yield, and production growth are claimed to be pos-itive, yet the evidence is indirect and could be the subject of furtherresearch. Important implications of the vertical coordination with for-eign companies are the improved access to inputs and to output markets,in particular with internationally operating food industries and retailchains. Lining up with industries active at international markets mayprove an important factor in shaping the competitive position of thefarm sector in CEECs.
The Dutch companies interviewed point at a number of issues thatwould require further government actions. These issues mainly refer tothe provision of public goods, which, if sufficiently supplied, would
WP 42 Case Studies
132
improve the efficiency of the agrifood sector. Note that although refer-ence is made to the Polish situation—as six out of the seven companiesinterviewed have invested in Poland—it is assumed that these policyrecommendations are valid in other CEECs too. The issues followedfrom the survey plus the government actions proposed are briefly sum-marized below.
First, credit is scarcely available for farmers. Poland is lacking agri-cultural banks such as the Rabobank in the Netherlands. Polish bankshave little knowledge of farming and agribusiness. Therefore, the gov-ernment should improve credit facilities to farmers in order to facilitatemodernization of Polish agriculture. Providing loan guarantees to bankscould do this.
Second, for Polish farmers there is hardly any public service availablefor technical and managerial assistance. A public research and extensionservice system may provide the knowledge needed for the modernizationof Polish agriculture. The private initiatives by the companies in this fieldare targeted on a limited number of farms (only their suppliers) and oncompany-specific objectives. Such private initiatives can supplementpublic services but not fully replace them.
Third, developing, implementing, and controlling quality standards,whether for raw materials or processed agricultural products, are anotherfield where the public sector could play a major role. Currently, manycompanies design and implement their own standards, which may beinefficient because parallel quality systems appear and may increasetransaction costs as farmers or manufacturers face switching costs whenthey change trading partners.
Fourth, encouraging contract compliance may reduce transaction costsand thus improve overall efficiency in the agrifood industry. There is anincreasing awareness of Polish farmers that breaching contracts has neg-ative consequences for them. Yet, the judicial system could be strength-ened so that contractors could rely more on legally backed agreements.
REFERENCESDe Nederlandsche Bank (Dutch Central Bank). 2005. Statistical Bulletin June.
Amsterdam: DNB.Dunning, J. H. 1993. Multinational Enterprises and the Global Economy. Wokingham:
MacMillan.Gow, H. R., and J. F. M. Swinnen. 1998. “Up- and Downstream Restructuring,
Foreign Direct Investment, and Hold-up Problems in Agricultural Transition.”European Review of Agricultural Economics 25: 331–50.
——. 2001. “Private Enforcement Capital and Contract Enforcement in TransitionEconomies.” American Journal of Agricultural Economics 83(3): 686–90.
Foreign Investment and Vertical Coordination in Supply Chains in Europe and Central Asia
133
Ning, Y., and M. R. Reed. 1995. “Locational determinants of the US Foreign DirectInvestment in Food and Kindred Products.” Agribusiness 11: 77–85.
Swinnen, J. F. M. 2003. “Vertical Integration, Interlinking Markets, and Growth in theCentral and East European Agri-food Sectors.” In Importance of Policies and Institutionsfor Agriculture, ed. G. Van Huylenbroeck et al., 101–18. Gent: Academia Press.
Van Berkum, S. 2002. Trade and Foreign Direct Investment Patterns: the Case of DutchAgribusiness. Wageningen: Ponsen en Looyen.
World Bank. 2001. World Development Report 2002: Building Institutions for Markets.Washington, DC: World Bank; New York: Oxford University Press.
WP 42 Case Studies
134
A Comparative Study ofVertical Coordination in the
Dairy Chains in Bulgaria,Poland, and Slovakia
L I E S B E T H D R I E S * A N D N I V E L I N N O E V †
135
EXECUTIVE SUMMARY
The goal of the present study is to combine insights from interviews atdifferent levels in the dairy supply chain with analysis of survey data (inthe countries where such data are available) and information from exist-ing studies to provide an analysis and documentation of the changes thathave occurred in the vertical coordination of the dairy supply chain, andits effects on the various agents in the chain.
The study will focus on three countries: Poland, Slovakia, and Bulgaria.These countries represent an interesting mix with respect to several rele-vant issues. Poland is the main dairy-producing country in Central andEastern Europe, while Bulgaria and Slovakia are only small players on thedairy market. Both Poland and Slovakia joined the European Union (EU)in 2004 and are therefore more advanced in the EU integration process than
6
*Assistant Professor, University of Leuven (KUL), Belgium. E-mail: [email protected].
† Research Associate, University of Leuven (KUL), Belgium. E-mail: [email protected].
The authors thank Hamish Gow for discussions on the issues addressed here andfor collaboration in part of the data collection in Poland. Furthermore we are grate-ful to Ewa Maciag, Mr. Klekotka, Dr. Uminski, and students from the University ofGdansk for their help with the Polish survey. The authors also gratefully acknowledgehelp from Artan Qineti and Elke Van Kerckhove during the field work in Slovakia, andProfessor Jan Pokrivcak and the University of Nitra for logistical support.
Bulgaria. In terms of farm structure, the Polish and Bulgarian dairy sectorconsists mainly of small-scale household production. In contrast, theSlovakian dairy sector is dominated by large-scale farming enterprises.Similarly, the processing sector is much more fragmented in Poland andBulgaria than it is in Slovakia.
Interviews were conducted with dairy processing companies in eachof the three countries. The dairy companies were selected to provide vari-ety in size (processing capacity), ownership structure (private, coopera-tive), and degree of foreign ownership. In line with the different dairyfarm structures we find that dairy companies in Poland mainly sourcefrom small-scale individual farms, that dairies in Slovakia source almostexclusively from large-scale farming enterprises, and that dairy companiesin Bulgaria source both from small-scale and large-scale milk producers.
Improving milk quality has been a crucial aspect of the dairy companies’policies. In all three countries, dairy companies are paying price premiumsto farmers who are able to deliver high-quality milk. Due to the small-scaledairy operations in Poland even under Communism, the initial situationwas more problematic in Poland with respect to milk quality than in theother countries where the large-scale cooperative farms had the necessaryinstitutions in place to ensure at least a minimum degree of milk quality.
Foreign investors in the dairy sector have played an important role by setting an example strategy for improving quality: making investments,introducing new quality tests, and so forth. However, besides new policiesintroduced by foreign investors, export strategies of local and foreign firmsmay have an important impact on the average quality of milk supplies aswell. Dairy companies in all three countries have indicated that the acqui-sition of an EU export license had a significant impact on their milk qualitypolicy. Finally, government regulations have also played an important role.
In all three countries dairy companies are offering assistance programsto their suppliers. Assistance is provided most often under the form of facil-itating access to inputs and investment credit (mainly for dairy-specificinvestments) as well as the provision of extension services. Often thesetypes of assistance are complemented with the provision of a bank loanguarantee for farmers who are applying for a bank loan.
Access to these assistance programs is in some cases limited to large-scale producers, delivering best-quality milk and in the best financialposition (in other words, the most “valuable” suppliers for the dairy).
While the share of dairy companies that are offering assistance to theirsuppliers has increased in all three countries, the content of the programsmay have changed over time. For example, support is shifted from sup-pliers who want to buy a cooling tank to buying new cows (because mostof suppliers have bought a cooling tank with aid from the dairy in previ-
WP 42 Case Studies
136
ous years). Similarly, while extension services in earlier years may havebeen focused mainly on improving hygiene conditions during the milk-ing process, these days, farmers are, for example, being informed aboutupgrading the genetic material of their herd.
The farm survey shows that assistance programs have a significant pos-itive impact on on-farm investments. The reason why loans come fromdairies or from banks is determined by the type of investment rather thanfarm characteristics. Dairy loans are used almost uniquely for invest-ments in enlarging and upgrading the livestock herd and cooling tanks.
Evidence suggests that foreign investment has played a more importantrole early on in transition as an initiator of change and institutional inno-vation. A key issue is how opening of the dairy sector to foreign competi-tion and increased quality requirements has affected the survival andgrowth of dairy farms. We do not find support for the hypothesis that theseforces drive local companies, in particular the smallest, out of business.From the Polish farm survey we find that 87 percent of households in thesample continued delivering to dairies despite radical restructuring of thedairies and tightened quality demands. Moreover, some of those whostopped delivering might have stopped anyhow: the average age of thosewho stopped producing is 56 years, compared to 45 years for the entire sam-ple. As a consequence, the size distribution changed, but only gradually. Theshare of farms in the 4–12 cow category has reduced significantly withabout the same amount upgrading to a larger size as falling back to smaller,presumably subsistence farms producing solely for home consumption.
However, the Bulgarian survey evidence shows that the direct impactof assistance programs on on-farm investments may be limited if accessto these assistance programs is restricted to large-scale farms. This maylead to an important conclusion. In countries where the initial size distri-bution is more equal (either only small farms like in Poland, or only largefarms like in Slovakia), farmers are more likely to have access to assis-tance programs of the dairy to which they deliver. However, in a countrylike Bulgaria, where the initial size distribution includes a large numberof very small dairy farms (less than five cows per household) but a rea-sonable number of large-scale farms (former state or collective farms),dairy companies are more likely to invest their resources in maintainingthe large-scale supply base than in upgrading the small-scale sector.
INTRODUCTION
Studies find that foreign firms facilitate the adoption of new technologiesand can solve contract enforcement problems (Gow and Swinnen 1998;Key and Runsten 1999). Yet most studies conclude that the impact on localsuppliers is mostly negative, in particular for small suppliers in developing
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
137
countries (Dolan and Humphrey 2000; Weatherspoon and Reardon2003). The latter often cannot comply with the higher standards and grad-ing requirements for the supplied products (Farina and Reardon 2000;Henson, Loader, and Brouder 2000; Reardon et al. 1999). Moreover,foreign investors prefer to deal with a few large suppliers to minimizetransaction costs, forcing consolidation of the supplier base and hence sep-arating many small suppliers from their traditional outlets (Hollowayet al. 2000; Runsten and Key 1996; Winters 2000). Reardon and Berdegué(2002) show, in the case of retail investors in Latin America, how thisprocess can lead to the rapid exclusion of thousands of small suppliers.
A major problem in transition countries is the breakdown of exchangesystems and contract enforcement mechanisms (Blanchard 1999; Koningsand Walsh 1999). Private institutional innovations have solved these prob-lems in some countries (Johnson, McMillan, and Woodruff 1999; McMillanand Woodruff 1999). Case studies suggest that foreign investors haveplayed an important role in this process through vertical coordinationthroughout the supply chain (Foster 1999; Gow et al. 2000). At least insome cases such foreign direct investment (FDI)-induced vertical coor-dination has contributed to improved access to finance and inputs andproductivity growth of suppliers (Gow and Swinnen 2001).
This chapter presents evidence of vertical coordination and the roleplayed by foreign investors in three Central and Eastern European (CEE)countries: Bulgaria, Poland, and Slovakia. These countries represent aninteresting mix. With its 12 million tonnes of milk in 2003, Poland is byfar the most important dairy-producing CEE country. Slovakia andBulgaria both produced about one tenth of this amount: 1.1 and 1.2 mil-lion tonnes, respectively (FAO 2004). Both Poland and Slovakia joinedthe European Union (EU) in May 2004, meaning that the process of EUintegration has already proceeded further in these countries than it has inBulgaria (expected to join the EU in 2007).
Furthermore, the three countries present an interesting mix with respectto the structure of their dairy farms. Both in Poland and in Bulgaria, thedairy sector consists of mainly small-scale household production as morethan 85 percent of all milk producers have a herd size of less than fivecows (see table 6.1). A high share of their production is used for self-consumption and the remainder is often sold to dairies through villagecollection points. The situation is completely different in Slovakia. A 1999representative survey (ACE) shows that only 10 percent of family farmshave dairy cows and more than half of the milk produced in these farmsis used for self-consumption. On the other hand, 81 percent of farmingenterprises have dairy cows and 100 percent of this milk production issold (of which, 87 percent is sold directly to a dairy processing company).
WP 42 Case Studies
138
The processing sector is much more fragmented in Poland and Bulgariathan it is in Slovakia. For example, in Bulgaria, 95 percent of all dairyprocessing units are classified as so-called mandras (mini-dairies) with acapacity of less than 10 tons/day (FAO, 2000a). This in contrast toSlovakia where the 10 largest dairy companies hold about 60 percent ofthe market (table 6.2).
It seems that there has been a larger inflow of foreign direct investmentsin countries (sectors) where the processing capacity and supply base havebeen more concentrated. By 2003, 77 percent of the milk purchased inSlovakia was processed by foreign-owned dairy companies (Agra Europe,April 2003). Table 6.2 shows that the 22 main dairy processing compa-nies in Slovakia together held about 97 percent market share in the begin-ning of 2003. In contrast, while foreign dairy companies have investedboth in Bulgaria and in Poland, the combined market share held by for-eign investors in these two markets is only limited (less than 10 percent).
The political and macroeconomic situation in a country is a crucialaspect of the attractiveness of that country for foreign investors. Table 6.2shows that most of the foreign investments in the dairy sector in Slovakia,with the exception of the entry of Meggle in 1993, have taken place since2000. This seems to be relatively late when we compare to Poland where amajor inflow of foreign investors in the sector occurred already in the mid-1990s. The sudden attractiveness of Slovakia can be attributed at leastpartly to a shift in the political environment in the previous years. In themid-1990s Slovakia appeared to be moving toward authoritarian politics.The country was even singled out from the 10 CEE applicants for EU mem-bership as the only country that had failed to meet the political criteriafor EU entry. The 1998 elections ended the totalitarian regime of Meciarand the new government moved quickly to implement the EU’s demands,hence creating a more stable investment climate.
The data used in this chapter are the result of interviews that were con-ducted in the three countries between July 2001 and March 2003. The next
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
139
TABLE 6.1 Dairy Farm Structures in Poland and Bulgaria
section presents evidence of changes that have occurred and policies thatare implemented at the level of the dairy processing companies. The last sec-tion summarizes the impact of these changes and policies at the farm level.
DAIRY PROCESSING COMPANIES
Poland
Table 6.3 summarizes information on the selected dairy companies.The six Polish companies were selected in the northeastern region ofWarminsko-Mazurskie and provide an interesting mix. Four are medium-size companies (50–70 million liters of milk) with one large (420 mil-lion liters) and one small (2.5 million liters). Three are cooperatives, twoprivate, and one a joint venture of a cooperative and a private company.In terms of foreign investment, two are majority foreign owned, and twohave important links to foreign companies.
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
141
TABLE 6.3 Dairy Companies in the Sample
Company Name Legal Structure Milk/Yr (ltr.) FDI Home Country Since
PolandMlekpol Cooperative 420 million No — —Mleczarnia Private 2.5 million No — —Kurpie Cooperative 65 million No — —Mazowsze Cooperative 55 million No — —ICC Paslek JV private–coop 53 million Yes U.S.A. 1994Warmia Dairy Private 70 million Yes Netherlands 1995
BulgariaMerone Private 4 million No — —Fama Joint Stock C. 19 million No — —Mlekimex Private 20 million No — —Danone Private 36 million Yes France 1993Iotovi Private 11 million No — —Milky World Private 1 million No — —Markelli Joint Stock C. 10 million No — —Mandra Obnova Private 2 million No — —Meggle Private 6 million Yes Germany 2000PRL Private 3 million No — —Serdika 90 Joint Stock C. 24 million No — —
SlovakiaLiptovska Private 75 million Yes France 2000Mliekospol Private 102 million Yes Italy 2002Rajo Private 155 million Yes Germany 1993Levicka Private 42 million No — —Tatranska Private 25 million No — —Nutricia Dairy Private 42 million No Netherlands 2000
� Mlekpol is one of the largest dairy cooperatives in Poland and currentlyreceives milk from 14,000 dairy farmers. It produces a wide variety ofproducts.
� Mleczarnia, in contrast, is a small domestically owned private com-pany. Its main production consists of yogurts. Mleczarnia sells its prod-ucts to local shops in the region.
� Kurpie is a middle-size domestic cooperative. In 2000, Hochland(German, French) opened a dairy production plant next to the dairycooperative. Kurpie is the sole supplier of cheese to Hochland, whoproduces secondary-level processed cheeses.
� Mazowsze is also a middle-size Polish dairy cooperative. Since 1993they started supplying pasteurized milk to Kraft, who had bought thecooperative’s debts from the bank and thus acquired part of the coop-erative’s buildings. In 1998, Kraft was bought by Bel (French). Bel stillbuys milk from Mazowsze.
� ICC Paslek was founded in 1994 when Land O’ Lakes (United States)entered into a 50–50 joint venture with the local dairy cooperative inPaslek. Through consecutive capital injections, Land O’ Lakes currentlyhas a 70 percent ownership share in ICC Paslek.
� Warmia Dairy started also as a joint venture between a foreign investor(Hoogwegt, Netherlands) and a local dairy cooperative in 1995. Since1997 Hoogwegt has acquired 100 percent ownership.
Slovakia
The six Slovakian dairy companies are located in West and Central Slovakia.Three are medium-size companies (25–42 million liters per year) and threeare large companies (75–155 million liters per year). Four dairies aremajority foreign owned; two are domestically owned companies.
� Liptovska Mliekaren is a large dairy company and since 2000 has beenowned by Bongrain (France). Liptovska buys milk from around 40 milksuppliers; all milk suppliers are large scale and, with one exception, allare enterprises. Its main product is cheese (80 percent).
� Mliekospol is a large dairy that was taken over by Sole (Italy) in 2002.The dairy buys milk from 90 suppliers of which 30 are individualfarmers. The main products are milk, butter, and milk powder.
� Rajo is the largest dairy company in Slovakia and was bought byMeggle (Germany) as early as 1993. Milk is bought from 78 suppliersand the main products are milk and yogurts.
� Levicka Mliekaren is a medium-size domestically owned dairy com-pany. Milk is bought from 52 suppliers. The main products are cheeseand milk powder.
WP 42 Case Studies
142
� Tatranska Mliekaren is a medium-size dairy company and is 100 percentdomestically owned. The dairy has 29 milk suppliers. The main prod-ucts are cheese and milk.
� Nutricia Dairy is medium-size. The company was bought by FrieslandCoberco (Netherlands) in 2000. Milk is bought from 12 suppliers aswell as from Rajo. Nutricia mainly produces yogurts.
Bulgaria
The 11 Bulgarian companies are spread over the whole country. All aresmall- to medium-size companies. Two dairies are majority foreign owned.
� Merone is a small-scale dairy company. About 75 percent of the milksupply is supplied through the company-owned collection stations.Another 17 percent is bought from intermediaries and about 8 percentof milk is delivered by individual farmers and companies that havetheir own cooling tank. The company’s main product is yellow cheese.
� Fama is a medium-size dairy company. Cooperatives (10 percent) andprivate companies/individual farmers deliver 80 percent of the com-pany’s milk supply. The remaining 20 percent is delivered to collec-tion stations. The company’s main products are yellow cheese andyogurt.
� Mlekimex is a medium-size dairy company. Forty percent of milk deliv-eries come from collection stations, another 40 percent is boughtdirectly from individual farmers and private companies, and 20 percentis supplied by cooperatives. The company mainly produces yogurt.
� Danone is the largest (36 million liters per year) dairy processor in thesample. It has existed since 1993 when the formerly state-owned sub-sidiary Serdika Sofia was bought by the French-owned Holding GroupDanone. About 20 percent of their milk supply is delivered throughcollection stations. Individual farmers and private companies andcooperatives deliver 50 percent and 30 percent, respectively. Danoneexclusively produces yogurt.
� Iotovi is a small- to medium-size dairy company. Around 75 percent ofthe milk deliveries come from collection stations; the remainder issupplied directly by individual farms or companies (less than 3 percentfrom cooperatives). The company’s main product is yellow cheese.
� Milky World is a small-scale dairy company. Individual farms and privatecompanies and cooperatives deliver 30 percent and 10 percent of totalmilk supplies, respectively, while 60 percent of milk is bought throughcollection stations. The company’s main product is yellow cheese.
� Markelli is a small- to medium-size dairy company. Its main productsare yellow cheese and yogurt.
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
143
� Mandra Obnova is a small-scale dairy company. Approximately 50 per-cent of its milk supply comes from the company’s own collection sta-tions, and another 30 percent of milk is supplied by intermediates.Cooperatives deliver the remaining 20 percent of milk supplies. Thecompany mainly produces yogurt.
� Meggle is a small-scale dairy company that was established in 2000through foreign investments by the German Holding Group Meggle.Meggle buys all its milk from large-scale milk producers that have theirown on-farm cooling tank: 56 percent from cooperatives; 44 percentfrom individual farmers and private companies. The company’s mainproduct is UHT milk.
� PRL is a small-scale dairy company. Milk deliveries originate fromindividual farmers/private companies (30 percent) and collection sta-tions (70 percent). The company only produces yogurt.
� Serdika 90 is a medium-size dairy company. About 45 percent of milkis delivered through collection stations, 20 percent is bought fromindividual farmers and companies with their own cooling tank, and35 percent is supplied by cooperatives. The company’s main productis white cheese.
General
All six Polish dairy companies purchase milk mainly from individualfarmers, either through village collection points or directly at the farm incase the farmer has invested in on-farm cooling equipment. Figure 6.1shows the share of milk that these companies buy through village col-lection points. Although collection point supplies are decreasing in
WP 42 Case Studies
144
0
20
40
60
80
100
120
1996 1998 2001
Shar
e of
col
lect
ion
poin
t sup
plie
rs (%
) Mlekpol
Mleczarnia
KurpieMazowsze
ICC Paslek
Warmia Dairy
FIGURE 6.1 Share of Milk Purchases from Collection Points (Poland)
importance, they nevertheless still make up an important share of totalmilk deliveries.
In contrast to the situation in Poland, we see that Slovakian dairy com-panies are buying milk exclusively from large-scale milk producers. Thisis in line with the observation that only a small share of family farmshave dairy cows and those households that have cows mainly use themilk for self-consumption.
Like in Poland, an important part of milk is delivered through collec-tion stations (only Meggle is following a policy that excludes the small-est producers from their supply base). In contrast, however, cooperativeshave a higher share in milk deliveries in Bulgaria than in Poland. This dif-ference is mainly because collectivization of the agricultural sector wasmuch less successful in Poland than in most other Central and EasternEuropean countries so that collective farms were practically nonexistenteven before the start of the reforms. It should be noted, however, that theimportance of cooperatives in the dairy sector in Bulgaria is also declin-ing. FAO (2000a) state that the ownership structure of cooperatives hin-ders sound management and decision-making mechanisms. As aconsequence, most cooperatives are posting chronic losses and are alsodecapitalizing.
QUALITY POLICY DAIRY COMPANIES
Poland
In the case of Poland, foreign investors in the dairy sector have played animportant role by setting an example strategy for improving quality.When Land O’ Lakes invested in ICC Paslek in 1994, milk quality of itssupplying farms—as everywhere in the region—was poor. From the start,ICC Paslek set out a clear strategy to increase the quality of deliveredmilk. One of their requirements was that the cooperative—from whichthey lease collection stations—should install cooling tanks in these col-lection points. Furthermore, they invested in agricultural extension toraise farmers’ awareness of the importance of milk quality and to improvequality through basic hygienic rules for farmers handling the milk. Fromthe beginning, ICC Paslek also required germ count and cell count tests(in accordance with EU standard tests for milk quality classification).Farmers were also allowed to have their milk tested for antibiotic residuesfree of charge in the dairy’s laboratory. This was especially helpful forfarmers who had had a cow disease in their farm and who needed tomake sure that no antibiotic residue was left in the milk. Soon after LandO’ Lakes set up its quality improvement programs, local dairies started tocopy these practices and by doing so have created an important spillover
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
145
effect as shown by the dramatic milk quality improvement throughoutthe region since 1995 (see figure 6.2).
Milk quality improvements were primarily driven by export strategiesof the dairy companies, rather than by domestic/foreign ownership. Notall foreign investors have required high-quality standards from the start.Warmia Dairy was initially primarily interested in exporting skimmedmilk powder to Asia and Northern Africa. Only in more recent years hasit become Warmia’s goal to become EU certificated. Therefore it is onlynow shifting its company strategy from increasing quantity to increasingquality of delivered milk.
In contrast both ICC Paslek and Kraft/Bel’s clear focus on increasingmilk quality followed directly from their objective to prepare productionfor export to the EU. As with ICC Paslek, Kraft required Mazowsze toconduct cell count and germ count tests since they started their opera-tions in 1995. Furthermore, Mazowsze had to refocus their farmers’ pro-grams toward increasing milk quality in order to meet Kraft’s higherquality standards. At this moment, Mazowsze produces pasteurized milkfor Bel, and because Bel exports to the EU, it can only accept extra-classmilk. Therefore, Mazowsze delivers only its highest class milk to the for-eign investor.
Other domestic dairies have also increased quality requirements earlyon as a consequence of their export orientation. For example, Mlekpol,which is now EU certificated for export to the EU, started implementingstrict quality measures early on, including EU standard tests for milkquality classification. Kurpie indicated that they started to emphasize
WP 42 Case Studies
146
0
20
40
60
10
30
50
70
80
90
100
1996 1998 2001
Shar
e of
ext
ra-c
lass
milk
in to
tal (
%)
Mlekpol
Mleczarnia
Kurpie
MazowszeICC Paslek
Warmia Dairy
FIGURE 6.2 Share of Extra-Class Milk in Total Deliveries (Poland)
milk quality in their programs in 1996, because they want to preparetheir farmers for implementation of EU standards.
Government regulations have also had an impact. Since 1999, Polandhas implemented the EU classification system of milk quality gradingand, as a consequence, has obliged dairies to do specific tests (e.g., germcount, cell count, etc.) to classify their supplied milk in Extra (highest),First, Second, and Third (lowest) class milk. It was at this time thatWarmia Dairy, Kurpie, and Mleczarnia started implementing this grad-ing system. In January 2000, a Polish law was passed which specified thatsecond-class milk is the minimum milk quality that may be used bydairies for further processing. All dairies still accepted third-class milk atthe time the law was passed which excluded third-class milk from theprocessing sector. In 2003, dairy companies in Poland were no longerallowed to accept second-class milk either.
Slovakia
Table 6.4 shows the evolution of the quality of milk deliveries to theselected Slovakian dairy companies. Ninety percent of the milk deliveredto the six dairy companies is up to EU standards, and for most of the com-panies, this was already the case in 1997. The six companies are notexceptional in this respect in Slovakia. Table 6.5 shows that in the wholeof Slovakia, 95 percent of all milk deliveries to dairy processors is of EU-standardized quality. The high share of EU quality milk in Slovakia rela-tively early on in the transition period is somewhat different from thePolish case, where in 2001, still only 50 percent of milk purchases wereup to EU standards. The reason for this may be that the large dairy farmsin Slovakia that dominate the milk market already had basic investments,such as on-farm cooling equipment and a milk line (that ensured thatmilk would flow directly from the cow to the cooling tank, minimizingthe contact with possibly contaminated sources), while the Polish milkproducers were in general too small to make these investments thatrequired scale economies. Furthermore, cooperative farms also had atrained veterinarian staff readily available that would allow a quickresponse in case of an infection or other veterinary problem.
However, the dairy company interviews show that important qualityimprovements may have occurred earlier on in the transition process. Forexample, Rajo reports that milk quality has increased about 15 timessince 1993 (the year that Meggle invested in the company). Furthermore,of the four dairies that have an export license for the EU, three agree thatit required substantial investments at the company level to obtain thislicense. One company also admits that it forced them to stop accepting low-quality milk deliveries. Rajo claimed that it did not require any additional
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
147
TABLE 6.5 Milk Deliveries in SlovakiaAccording to Quality Class, 2003
Class Million ton Percent
Total 506 100Class Q + I 480 95Class Q 271 53Class I 209 41Unstandardized 27 5
Source: VUEPP (Research Institute of Agricultural and FoodEconomics in Bratislava) (2003).
TABLE 6.4 Quality of Milk Deliveries to the Six Slovakian Dairy Companies(Percent)
Company/Date Q-Class 1st Class 2nd Class 3rd Class Unstd.
Note: Tatranska used the 2nd / 3rd quality classification system until 2002; other dairies stopped reporting thesequality classes since they obtained an EU export license. Milk of lower quality than Q or 1st class is classifiedas unstandardized milk. Q and 1st quality milk is of acceptable quality according to EU standards.
WP 42 Case Studies
148
investments to obtain an EU export license because the foreign investorhad been the main reason for upgrading quality. Finally, milk qualityremains an important issue for all dairies since all of them offer a qual-ity premium for high-quality milk. Hence, while the numbers do notclearly show this, it seems that important quality improvements haveoccurred after the start of the reforms. In this sense, the situation is sim-ilar to that in Poland, although the starting point for quality improve-ments may have been less problematic in Slovakia because of the initialfarm structure.
Bulgaria
Table 6.6 presents the share of milk deliveries in different quality classesfor the Bulgarian dairy companies in our sample. One should be carefulwhen interpreting these results because there is no standard quality clas-sification system for milk in Bulgaria.1 The definition of the differentquality classes may therefore be based on different indicators and limitsdepending on the company that was interviewed. As a result, cross-countryand even intercompany comparisons may be misleading.
However, like in Poland and Slovakia, improving the quality of milkdeliveries is one of the main objectives of dairy companies in Bulgaria.To achieve this goal, all dairy companies pay price premiums for high-quality milk. Because of the absence of a standard classification system,these premiums are paid on the basis of different indicators (fat content,protein content, dry defatted residual, germ and cell counts) for suppli-ers to different companies.
Government regulation is playing a role as well. Recently, the gov-ernment has regularly circulated new regulations with respect to milkquality to all dairy companies (according to some of the respondentsthese policy changes occur much too frequently). For example, at theend of 2002 a communication was circulated indicating that from nowon dry defatted residual should be used as a proxy for quality ratherthan fat content. Furthermore, farmers who are applying for milk pricesupport have to present the results of germ and cell count tests, andapparently the extent of support is based on these results (i.e., better testresults give right to higher subsidy levels). Finally, the government isalso involved in quality tests itself as all dairy companies send samplesof milk deliveries to the State Veterinary Service at least twice a month.The State Veterinary Service laboratories are equipped with devices toperform germ and cell count tests (these tests are only rarely performedin the dairy company labs or at delivery, but samples are normallytaken and tested for other indicators by the dairy company on a dailybasis).
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
149
WP 42 Case Studies
150
TABLE 6.6 Quality of Milk Deliveries to the Bulgarian Dairy Companies
The two foreign-owned companies, Danone and Meggle, both have aquality policy that seems to go further than that of domestic companies.Danone uses its own quality classification system, based on germ counts,where the top category (lowest germ count) is labeled “Danone class.”Farmers delivering Danone-class milk are rewarded with a price bonus.Furthermore, the company has introduced a system of “traceability” fortheir suppliers, the Danone Quality Control System (imposed by theInternational Danone Group). Once per year all suppliers are visited andevaluated on the basis of 26 criteria related to quality and safety of milkproduction. Suppliers that are evaluated positively on all 26 criteria arelabeled “Traced and Controlled Danone” and are preferred suppliers forDanone. Suppliers that do not fulfill all 26 criteria are labeled “Tracedand Controlled,” “Traced and Not Controlled,” and “Not Traced and NotControlled.” Collection stations are mainly located as “Traced and NotControlled” (the manager of the collection station is required to have adetailed list of all cows that supply milk to this station). Meggle has asomewhat similar traceability requirement for its suppliers. All Megglesuppliers have to keep a diary reporting for each of the animals: identifi-cation, inseminations, veterinary services, feeding details, quality andquantity of milk, and so forth.
General
In conclusion, the improvement of milk quality has been a crucial aspectof the dairy companies’ policies in all three countries. For example, as anincentive to upgrade the quality of milk deliveries, dairy companies inPoland, Bulgaria, and Slovakia are paying price premiums to farmers whoare able to deliver high-quality milk.
Because of the small-scale dairy operations in Poland even underCommunism, the initial situation was more problematic in Poland withrespect to milk quality than in the other countries where the large-scalecooperative farms had the necessary institutions in place to ensure at leasta minimum degree of milk quality. Qualitative evidence from Bulgariaindicates that average milk quality even decreased in the first years ofthe reforms as the former large-scale production structures were beingdecapitalized and milk production was shifted to small-scale householdproduction units.
Foreign investors in the dairy sector have played an important role by set-ting an example strategy for improving quality: making investments, intro-ducing new quality tests, and so forth. This was the case in Poland, but alsoin Bulgaria, Danone and Meggle are implementing quality and traceabil-ity systems that are more advanced than what most domestic companiesare doing.
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
151
However, besides new policies introduced by foreign investors, exportstrategies of local and foreign firms may have an important impact on theaverage quality of milk supplies as well. Dairy companies in all threecountries have indicated that the acquisition of an EU export license hada significant impact on their milk quality policy.
Finally, government regulations have also played an important role.Both in Poland and Slovakia, the introduction of more stringent milkquality standards in 2000 resulted in reduced milk deliveries to dairies(FAO, 2000b). Also regulations concerning the classification system ofmilk quality have forced at least some dairies in these countries to shiftaway from the traditional classification system that they were using. InBulgaria, as in other countries, a state-owned institution is involved in test-ing milk quality. Finally, milk subsidies for dairy farmers are sometimeslinked to the quality of the milk deliveries (as is the case in Bulgaria).
INVESTMENT ASSISTANCE TO SUPPLIERS
Poland
All the interviewed Polish dairies have programs that assist their supply-ing farms (table 6.7).
� All have an input (esp. feed) supply program. The companies provideaccess to inputs, such as feed or seeds and fertilizers for on-farm feedproduction. Farmers purchase the inputs through company shops andthe inputs are paid from the milk checks.
� Five out of six companies assist farms in investing through credit pro-grams. Investment assistance takes the form of leasing of equipmentand cows, also with payments deducted from future payments for milkdeliveries, as well as loans for buying new or secondhand cooling andmilking equipment. The only dairy that did not provide credit assis-tance programs or agricultural extension services to its suppliers was thesmall dairy, probably because it did not have sufficient means (size).
� Most of the companies also provide extension services to their suppliers.� Five of the dairies provide bank loan guarantees for bank loans to farm-
ers. Almost all bank loans for farm investments are with preferentialinterest rates (subsidized interest rates around 5 percent compared withcommercial loans with interest rates often above 20 percent). In orderto obtain such a loan, the farmer needs collateral. However, in manycases land or buildings are not accepted as a bank guarantee. Therefore,most interviewed dairies provide an additional service to their suppli-ers by co-signing the bank loan. In this way the dairy provides the bankloan guarantee and facilitates its farmers’ access to bank credits.
WP 42 Case Studies
152
Slovakia
Similarly, in Slovakia all the interviewed dairies provide assistance pro-grams to their supplying farms.
� All companies assist farms through investment credit programs. Suchinvestment credit can only be used for dairy-specific investments, suchas buying dairy cows or a cooling tank.
� Three out of six of the interviewed companies assist their suppliers inaccessing inputs, such as feed or seeds and fertilizers for on-farm feedproduction.
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
153
TABLE 6.7 Assistance Programs Offered by the Interviewed Dairy Companies toTheir Suppliers
Credit— Credit— Input Extension Veterinary Bank Loan Company Name Specific General Supplya Service Service Guarantee
Poland b
Mlekpol Y Y Y N YMleczarnia N Y N N YKurpie Y Y Y N YMazowsze Y Y Y N NICC Paslek Y Y Y N YWarmia Dairy Y Y Y Y Y
BulgariaMerone Y(2000) N Y(n.a.) Y(1992) N NFama Y(1994) N Y(1994) N N Y(once)Mlekimex Y(1997) Y(1998) Y(1997) Y(1999) Y(1997) Y(1998)Danone Y(1997) N Y(1998) Y(2000) Y(1995) Y(1999)Iotovi N N Y(1995) N N Y(1995)Milky World Y(1999) Y(2000) Y(1999) Y(1999) N Y(1999)Markelli Y(1999) N Y(1998) N N NMandra Obnova Y(1998) N Y(2000) Y(2000) N NMeggle Y(2001) N Y(2001) Y(2001) N NPRL N N N Y(2002) N NSerdika 90 Y(1997) N Y(1997) Y(1997) N N
SlovakiaLiptovska Y(2000) N N Y(1994) N NMliekospol Y(1999) N N Y(1992) Y(1992) Y(1992)Rajo Y(2001) N Y/N Y(1992) N NLevicka Y(1998) N Y(1998) Y(0000) N Y(1998)Tatranska Y(2001) N Y(2000) Y(0000) N NNutricia Dairy Y(2000) N N N N Y(2000)
a. Either the company provides inputs and the farmer pays back later, or the company offers forward credit,which the farmer uses to buy inputs.b. In Poland we did not make the distinction between credit for dairy-specific investments and general invest-ments. Farm-level evidence shows that the dairy companies mainly support dairy-specific investments (seethe last section).
� Most of the companies also provide extension services.� Three of the dairies provide bank loan guarantees for bank loans to
farmers. In this way the dairy puts in the bank loan guarantee and facil-itates its farmers’ access to bank credit.
From the interviews it seems that not all suppliers have equal access tothe dairies’ assistance programs. Three out of six dairy companies saidthat farms need to have a minimum size to have access to the offered pro-grams. A fourth company indicated that only the bigger and better qual-ity suppliers were allowed to use the (forward) credit program. A fifthcompany only offers programs to financially healthy farms. Rajo was theonly dairy that claimed to offer programs to all of its suppliers, withoutany conditions.
According to the respondents, there are two main reasons for offer-ing these programs. First, programs are offered to upgrade milk quality.Second, programs are necessary to secure the supply base (i.e., your com-petitor offers these programs so you better offer them as well if you don’twant to lose your farmers). Tatranska Mliekaren and Nutricia Dairy bothindicate that the dairy could not offer these programs in earlier yearsbecause of the bad financial situation of the company.
Bulgaria
Finally, most Bulgarian dairies are also offering assistance to their sup-pliers.
� All but two companies assist farms through credit programs for dairy-specific investments. Two of the companies indicate that they alsooffer general investment credit.
� All but one of the selected dairies assist their suppliers in accessinginputs, such as feed or seeds and fertilizers for on-farm feed production.
� The majority of companies also provide extension services.� Bank loan guarantees for bank loans to farmers are offered by five out
of the 11 companies in the sample.
Danone explicitly limits these assistance programs to contracted sup-pliers only; this means that farmers supplying to a collection station can-not apply for financial or other kinds of support from the dairy. Twodomestic dairies indicate that there is a minimum size limit for farms toqualify for these programs; a third claims that it does not apply an explicitsize-based rule for which farmers may use the assistance programs butthat small producers supplying through a collection station are not inter-ested to make investments and hence do not apply for support. Meggle’s
WP 42 Case Studies
154
programs are limited to large suppliers by default since only farmers withlarge milk quantities can deliver to Meggle.
Quality improvement is often cited as an important reason for offeringthese programs. However, securing the supply base (i.e., offering assis-tance as a tool for competing for suppliers with other dairies) is indicatedas the main reason in almost all cases.
In this respect, some companies have indicated that also the paymentperiod can be a good tool for competition. All the dairy companies in thewest and central parts of Bulgaria pay for milk deliveries on average twicea month, while in the eastern part milk payments are made only once amonth (not taking into account occasional prepayment for inputs, feed,fuel, or other occasions). This could indicate that competition is less fiercein the eastern parts. However, according to one respondent, Danone isbuying milk from some eastern villages as well and in these villages, theeastern dairies also pay more regularly.
General
In conclusion, all three countries’ dairy companies are offering assistanceprograms to their suppliers. Assistance is provided most often under theform of facilitating access to inputs and investment credit (mainly fordairy-specific investments) as well as the provision of extension services.Often these types of assistance are complemented with the provision ofa bank loan guarantee for farmers who are applying for a bank loan.
Access to these assistance programs is in some cases limited. Forexample, in Slovakia, several dairies indicated that they offer programsonly to large-scale producers, who deliver the best-quality milk and arein the best financial position (in other words, the most “valuable” sup-pliers for the dairy). In Bulgaria, a similar restrictive policy is appliedby the foreign investors. Only in Poland do all suppliers seem to havea reasonably equal chance of getting access to the assistance programsoffered by the dairy companies.
Finally, the reason for offering these programs was in most casestwofold. First, assistance programs are meant to help farmers to upgradethe quality of their milk production. Second, assistance is offered becauseit is felt to be necessary to keep suppliers from delivering to the com-petitor (who is offering these programs as well). Price premiums and thelength of payment period are other tools that are used to compete withother dairies in the area for milk supplies.
Table 6.8 shows how the share of dairies that offer assistance programsin these countries has changed over time. Dairy companies in Polandseem to have been faster in implementing assistance programs for theirsuppliers. In Bulgaria, gradually more dairy companies have started to
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
155
offer assistance. In Slovakia, however, the increase in assistance to localfarmers was stronger in the period 1998–2002 than in the previous fouryears. The inflow of foreign investments in the dairy sector in Slovakia alsosurged in the period 1998–2002. On the one hand, foreign investors mayhave played an example role by implementing these assistance programsand local diary companies copied these policies. On the other hand, for-eign investors may also have increased competition in the market andassistance programs could be used as a tool to compete with other dairies.
While the share of dairy companies that are offering assistance to theirsuppliers has increased in all three countries, the content of the programsmay have changed over time. For example, one of the Polish dairy com-panies explained that currently they were no longer supporting suppliersthat want to buy a cooling tank (because most of their suppliers hadbought a cooling tank with aid from the dairy in previous years); how-ever, the investment credit program was now mainly used for buying newcows. Similarly, while extension services in earlier years may have beenfocused mainly on improving hygiene conditions during the milkingprocess, these days, farmers are being informed, for example, about upgrad-ing the genetic material of their herd.
IMPACT AT THE FARM LEVEL
Evidence on the impact at the farm level is limited and is often based oncase-study evidence only. This section presents results of a representativesurvey of Polish dairy farmers, preliminary evidence of a survey of
WP 42 Case Studies
156
TABLE 6.8 Share of Interviewed Dairy Companies Having Assistance Programs (Percent)
Country Credit Inputs Extension Veterinary Bank Total
Bulgarian dairy farmers, and qualitative evidence from interviews withSlovakian dairy farms.
Poland
Evidence from a 2001 survey of 290 Polish rural households shows thatthe assistance programs have a significant positive impact on on-farminvestments. More than three quarters (76 percent) of all households inthe survey made investments in the past 10 years (see table 6.9). Of thosewho invested, 58 percent used loans. Further, the reason why loans comefrom dairies or from banks is determined by the type of investment ratherthan farm characteristics. Dairy loans are used almost uniquely for invest-ments in enlarging and upgrading the livestock herd (30 percent) andcooling tanks (56 percent). Together these account for 86 percent of alldairy loans. In contrast, only 29 percent of all bank loans are used forthese types of investments. Note that the loans from dairies are only a par-tial indicator of the financial assistance offered by dairies. As explainedabove, part of their assistance is under the form of loan guarantees withthe banks. Hence, part of the loans given by the banks is indirectly dueto these loan guarantee programs of dairies, which are very important.Almost half (45 percent) of the households who could not obtain pref-erential bank loans identified lack of sufficient collateral as the mainreason.
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
157
Furthermore, the programs which assist farms in accessing inputs(mainly feed) enhance investment indirectly by lowering input costs, orreducing transaction costs in accessing inputs and, consequently, throughimproved profitability.
Evidence suggests that foreign investment has played a more importantrole early on in transition as an initiator of change and institutional innova-tion. We found no significant difference in 2001 of assistance programsprovided by foreign-owned companies and domestic dairies, except for
TABLE 6.9 Investments and Loans of Farm Households (Poland)
Uses Loan Uses Uses Uses Uses Size Invests to Invest Dairy Loan Bank Loan Dairy Loan Bank Loan(# of Cows) (% of Total) (% of A) (% of B) (% of B) (% of A) (% of A)
the loan guarantee programs, which were more extensively provided bythe foreign dairies. The survey also shows that the share of farms deliver-ing extra-class milk (the highest quality by EU standards) was significantlylarger among farmers delivering to foreign-owned dairies (58 percent ver-sus 38 percent among farmers delivering to domestic dairies) in 1995.However, by 2000 this gap had almost disappeared: 83 percent versus79 percent of farms delivering to foreign versus domestic dairies suppliedextra-class milk (see figure 6.3). This is in line with qualitative evidencethat foreign companies have played a role in providing an example inquality improvement strategy.
A key issue is how opening of the dairy sector to foreign competitionand increased quality requirements has affected the survival and growth ofdairy farms. It is often argued that such forces can drive local companiesout of business, in particular the smallest. The latter may result directlyfrom their inability to compete in a liberalized market or because restruc-turing of the processing companies induces the restructured companies todrop small suppliers and to prefer fewer but larger suppliers to reducetransaction costs.
The Polish household survey provides findings that do not supportthese arguments—quite the contrary. Two hundred eighty-three house-holds in our sample delivered milk to dairy processing companies in 1995.Of these, only 36 (13 percent) stopped delivering milk between 1995 and2000. Ten of them (4 percent) stopped producing altogether while the restkept some cows for home consumption. Hence, 87 percent continueddelivering to dairies despite radical restructuring of the dairies and tight-ened quality demands. Moreover, some of those who stopped deliveringmight have stopped anyhow: the average age of those who stopped pro-ducing is 56 years, compared with 45 years for the entire sample.
WP 42 Case Studies
158
20
30
40
50
60
70
80
90
100
1995 2000
Shar
e of
farm
s w
ith e
xtra
-cla
ss m
ilk
no-FDI
FDI
FIGURE 6.3 Change in Share of Highest Quality Milk (EU Standard) in the FarmSurvey (Poland)
The size distribution changed, but only gradually (see figure 6.4). Threequarters of the households (211) had between 4 and 12 cows in 1995. Theshare of farms in the 4–12 cow category has reduced significantly withabout the same amount upgrading to a larger size as falling back to smaller,presumably subsistence farms producing solely for home consumption.More specifically, of the 211 household farms, 135 (65 percent) had stillbetween 4 and 12 cows in 2000; 35 (17 percent) had less than 4 cows in2000, while 41 (19 percent) had more than 12 cows in 2000. Farmerswith growing farms were significantly younger (42 years on average) thanthose whose farm size declined (51 years on average).
Slovakia
Preliminary evidence from interviews with Slovakian dairy farms showsthat other factors, besides assistance programs from the dairy compa-nies, may have contributed to improved conditions in the dairy sector.Figure 6.5 shows the increase in average milk yields for eight large-scaleSlovakian dairy farms since 1994. Although Food Farm and Agroviawitnessed an accelerated increase in milk yields after 1998, milk yieldsstarted to improve even earlier, that is, before most of the dairy compa-nies started implementing their assistance programs.
Bulgaria
Table 6.10 presents evidence from a 2003 survey of 240 Bulgarian dairyfarms (that have been producing milk since 1994 or earlier). Like inPoland, the majority of households (63 percent) have made on-farminvestments in the past 10 years. Furthermore, we find no evidence thatlarge-scale producers are more likely to invest than small-scale produc-ers. However, looking at the source of finance that was used to make
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
159
FIGURE 6.4 Size Distribution of Dairy Farms in Total Survey Sample (Poland)
0
5
10
15
20
25
30
35
1 3 5 7 9 11 13 15 17 19 21 23 25Herd size
Freq
uenc
y
1995
2000
WP 42 Case Studies
160
TABLE 6.10 Investments and Loans of Farm Households (Bulgaria)
Size (# of Cows) Invests (% of Total) Uses Dairy Loan (% of A) Uses Bank Loan (% of A)A B C
FIGURE 6.5 Change in Milk Yields in Eight Slovakian Dairy Farms
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
1994 1998 2003
Milk
yie
ld (l
tr/co
w/y
ear)
Podluzany
Ponitvie
Selice
Hronske
Zavar
Agrovia
Kamenica
Food Farm
investments, we see an important disparity with the results from thePolish survey. Access to supplier credit from the dairy company is verylimited; only two households have ever used credit from the dairy tomake investments. Furthermore, households do not have access to bankloans either. Under these circumstances, the high level of investments isquite surprising.
Figure 6.6 presents the size distribution of the farms in the survey.Only a limited number of farmers have quit the dairy operation. Thelargest decline is in the number of farms in the category having only onecow. The group of farms having more than five cows has grown the mostin importance. In other words, there is limited preliminary evidence ofgrowth in the small-scale Bulgarian dairy sector.
General
An important conclusion from the Polish farm survey is that foreign invest-ment plays an important positive role in the survival and growth of farmsindirectly, by initializing farm assistance programs and institutional inno-vations and providing an example of how such innovations can work. Onthe other hand, the Bulgarian survey shows that the direct impact of assis-tance programs on on-farm investments may be limited if access to theseassistance programs is restricted to a certain group of suppliers (large-scale).
GENERAL CONCLUSIONS
First, reforms and the restructuring of the agricultural sector during tran-sition has had an important impact on the dairy sector. Figures 6.7,6.8, and 6.9 show how milk production, the number of dairy cows, andmilk yields have fallen rapidly in the first years after the start of the reforms.Milk production and number of dairy cows have stabilized more or lesssince the middle of the 1990s. Moreover, milk yields in Poland and Slovakiahave increased to a level that is even above the pre-reform milk yield.
Dairy companies in all three countries have played an important rolein the restructuring of the dairy farm sector. The assistance programs thatthey offer to their suppliers are helping suppliers to have access to workingcapital, to make investments, and to upgrade the quality of milk deliver-ies. As such, these programs have been a crucial tool to stimulate restruc-turing in these countries.
The results of the Polish farm survey lead to an important conclusionon the impact of foreign investment. Foreign investment plays an impor-tant positive role on the survival and growth of farms indirectly, by ini-
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
161
0
10
20
30
40
50
60
70
80
90
100
0 1 2 3 4 5 >5Herd size (# cows)
Num
ber o
f obs
erva
tions
19942003
FIGURE 6.6 Size Distribution of Dairy Farms in Bulgarian Survey
tializing farm assistance programs and institutional innovations and pro-viding an example of how such innovations can work. Moreover, we donot find evidence that foreign-owned companies are more likely to cutoff small farmers from their supply base.
However, the Bulgarian survey evidence shows that the direct impactof assistance programs on on-farm investments may be limited if access
FIGURE 6.8 Change in Milk Production, Number of Dairy Cows, and Milk Yieldsin Poland, 1989–2001
0
20
40
60
80
100
120
140
160
1989 1991 1993 1995 1997 1999 2001 2003
Production
Yield
Dairy cows
Source: VUEPP (2003).
FIGURE 6.7 Change in Milk Production, Yields, and Number of Dairy Cows inSlovakia, 1989–2003
to these assistance programs is restricted. In Bulgaria, foreign investorsare offering assistance programs only to the larger suppliers with whichthey contract. Although domestic dairy companies claim not to applysuch a restrictive policy for their suppliers, the survey does not provideevidence of easier access to credit from domestic dairy companies.
This may lead to an important conclusion. In countries where the ini-tial size distribution is more equal (either only small farms like inPoland, or only large farms like in Slovakia), farmers are more likely tohave access to assistance programs of the dairy to which they deliver.However, in a country like Bulgaria, where the initial size distributionincludes a large number of very small dairy farms (less than five cows perhousehold) but a sufficient number of large-scale farms (former state orcollective farms), dairy companies are more likely to invest theirresources in maintaining the large-scale supply base than in upgradingthe small-scale sector.
NOTE1. Before the introduction of the EU standard classification system of milk quality
in Poland and Slovakia, milk quality tests in these countries were not based on germand cell counts (the basis of the EU classification system) but on other indicators—ascurrently is the case in Bulgaria. However, since the introduction of the EU classifi-cation system in 1999/2000, all dairy companies in Poland and Slovakia had toimplement the same tests and classify their milk according to the same system.
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
163
0
20
40
60
80
100
120
1989 19931991 1995 1997 1999 2001 2003
Production
Yield
Dairy cows
Note: All cattle are included in the data on “Dairy cows.” Source: FAO(2004); ZMP (2000); FAO (2000a).
FIGURE 6.9 Change in Milk Production, Number of Dairy Cows, and Milk Yieldsin Bulgaria, 1989–2003
REFERENCESARR and IERIGZ. 2001. Rynek Mleka. Stan I Perspektywy, Warsaw.Blanchard, O. 1999. The Economics of Post-Communist Transition. Oxford: Clarendon.Dolan, C., and J. Humphrey. 2000. “Governance and Trade in Fresh Vegetables: The
Impact of UK Supermarkets on the African Horticulture Industry.” Journal ofDevelopment Studies 37(2): 147–76.
Dries, L., and J. F. M. Swinnen. 2004. “Foreign Direct Investment, Vertical Integrationand Local Suppliers: Evidence from the Polish Dairy Sector.” World Development32(1): 15–34.
Euromonitor. 2003. Packaged Food Products Sector Slovakia. Euromonitor database.FAO (Food and Agriculture Organization). 2000a. Bulgaria: Investing in Private Dairy
Farming. Sector Review/Identification Report. FAO Investment Centre Divisions, Rome.——. 2000b. Food Outlook, November 2000, Nο. 5, FAO Global Information and
Early Warning System for Food and Agriculture, Rome.——. 2004. FAOSTAT [Online available: http://www.fao.org].Farina, E. M. M. Q., and T. Reardon. 2000. “Agrifood Grades and Standards in the
Extended Mercosur: Their Role in the Changing Agrifood System.” AmericanJournal of Agricultural Economics 82(5): 1170–76.
Foster, C. 1999. “The Impact of FDI in the Upstream and Downstream Sectors onInvestment in Agriculture in the NIS.” In Agricultural Finance and Credit Infrastructurein Transition Economies. Paris: OECD (ed.).
Gow, H., D. Streeter, and J. Swinnen. 2000. “How Private Contract EnforcementMechanisms Can Succeed Where Public Institutions Fail: The Case of JuhosucorA.S.” Agricultural Economics 23(3): 253–65.
Gow, H., and J. Swinnen. 1998. “Agribusiness Restructuring, Foreign Direct Investment,and Hold-Up Problems in Agricultural Transition.” European Review of AgriculturalEconomics 25(4): 331–50.
——. 2001. “Private Enforcement Capital and Contract Enforcement in TransitionCountries.” American Journal of Agricultural Economics 83(3): 686–90.
GUS. 2001. Statistical Yearbook, Central Statistical Office, Warsaw.Henson, S. J., R. J. Loader, and A. Brouder. 2000. “Food Safety Standards and Exports
of Perishable Products from Developing Countries: Fish Exports from East Africato the European Union. ”American Journal of Agricultural Economics 82(5): 1159–69.
Holloway, G., C. Nicholson, C. Delgado, S. Staal, and S. Ehui. 2000. “Agroindustri-alisation through Institutional Innovation. Transaction Costs, Cooperatives andMilk-Market Development in the East-African Highlands.” Agricultural Economics23: 279–88.
Johnson, S., J. McMillan, and C. Woodruff. 1999. “Contract Enforcement inTransition,” EBRD Working Paper 45, European Bank for Reconstruction andDevelopment, London.
Key, N., and D. Runsten. 1999. “Contract Farming, Smallholders, and Rural Develop-ment in Latin America: The Organization of Agroprocessing Firms and the Scaleof Outgrower Production.” World Development 27(2): 381–401.
Konings, J., and P. P. Walsh. 1999. “Disorganization in the Process of Transition.Firm-Level Evidence from Ukraine.” Economics of Transition 7(1): 29–46.
Mcmillan, J., and C. Woodruff. 1999. “Interfirm Relationships and Informal Creditin Vietnam.” The Quarterly Journal of Economics November: 1285–1320.
WP 42 Case Studies
164
Reardon, T., and J. A. Berdegué. 2002. “The Rapid Rise of Supermarkets in LatinAmerica: Challenges and Opportunities for Development.” Development PolicyReview 20(4): 317–34.
Reardon, T., J.-M. Codron, L. Busch, J. Bingen, and C. Harris. 1999. “Global Change inAgrifood Grades and Standards: Agribusiness Strategic Responses in DevelopingCountries.” International Food & Agribusiness Management Review 2(3): 421–35.
Runsten, D., and N. Key. 1996. Contract Farming in Developing Countries: Theoretical Issuesand Analysis of some Mexican Cases. Report LC/L.989, UN-ECLAC, Santiago, Chile.
Weatherspoon, D. D. and T. Reardon. 2003. “The Rise of Supermarkets in Africa:Implications for Agrifood Systems and the Rural Poor.” Development Policy Review21(3): 333–55.
Winters, A. L. 2000. “Trade Liberalisation and Poverty,” http://www.worldbank.org/poverty/wdrpoverty/winters.htm.
A Comparative Study of Vertical Coordination in the Dairy Chains in Bulgaria, Poland, and Slovakia
165
Restructuring and VerticalCoordination in the Dairy
Sector in RomaniaS I E M E N VA N B E R K U M *
167
EXECUTIVE SUMMARY
This chapter analyzes changes in the structure of dairy farms and in thedairy supply chain in Romania during transition, and in particular howvertical coordination in the supply chain has evolved. The analysis drawson data analysis, literature review, and interviews with two foreign-owned and two Romanian dairies.
Key conclusions are as follows:
� The sector is characterized by a very small scale of production: only 0.25percentofalldairyfarms—2,250innumber—have 10 cows or more.
� The milk processing industry is generally very fragmented: thereare around 550 dairies of which 250 have a capacity of less than1,000 tonnes/year.
� Only 20–25 percent of the milk production is being delivered for pro-cessing. Farm usage (family consumption and animal feed) and directsales on street markets are main outlets.
7
*Agricultural Economics Research Institute, LEI-Wageningen UR, The Netherlands. E-mail: [email protected].
The author thanks Jos Bijman, Department of Business Administration,Wageningen University, for his help in designing the questionnaire and other usefulsuggestions.
� All interviewed dairies contract many small-scale holdings and a fewlarge-scale farmers.
� All interviewed dairies offer their farmers assistance programs onfarming and milking practices and on matters pertaining to farmeconomics.
� All four dairies provide a service of prefinanced inputs and medium-terminvestment credits. Yet, except for the dairy owned by a farmers’ associ-ation, interviewed dairies offer these service only to the larger farms.
� Improving milk quality and securing the milk supply base are themajor reasons behind offering these assistance programs.
� Foreign direct investment and European Union integration have beenthe major driving forces behind changes in quality standards. Yet, thelack of enforcement of quality standards regulations on dairies andstreet market sales hinders industry efforts to raise the general milkquality level in Romania.
� Poor milk quality is a major constraint to further development of thesector. To address this, key policy issues refer to improved access toextension and medium- and long-term capital, a proper enforcement ofquality standards, and a supportive legislative framework for establish-ing cooperation among farmers. Extension packages tailored towardsmall- and medium-sized farms could importantly raise productivityand quality of production at these units. A grant aid scheme couldincrease small-scale farmers’ access to capital necessary for production-and productivity-increasing investments. A strictly implemented andcontrolled system of quality standards should create a level playing fieldfor all dairies in Romania and contribute to a higher quality level.Government support to help establish producers’ organizations wouldincrease the level of organization of small-scale farmers, which is animportant tool in strengthening their bargaining power in the supplychain, leading to improved access to input and output markets.
INTRODUCTION
This chapter provides an analysis and documentation of the changes thathave occurred during the transition in the vertical coordination in theRomanian dairy supply, and their effects on the various agents in thechain. The analysis focuses on vertical relations between farmers and dairyprocessors, with some attention paid to linkages with other stages of thesupply chain such as input suppliers.
A key problem for sector development is the low and unstable qualityof milk delivered. Investments for quality improvements are seriouslyhampered by the typical small-scale structure of the Romanian dairy sec-
WP 42 Case Studies
168
tor with low productive holdings. Some companies have taken initiativesin vertical coordination, including assistance programs. This chapterevaluates the impact of these programs on quality, yields, production,and market access, and identifies government actions that could com-plement and increase the effectiveness of the companies’ farm assistanceprograms and improve the sector’s competitiveness.
This chapter starts with a brief description of the structure of the dairysupply chain in Romania. Next, it presents the components of the dairysector and its associated milk flows. Further, emerging vertical relationsare described based on interviews with four dairy companies in Romania,held in spring 2004. The interviews focus on the types of and conditionsfor vertical coordination between farms and processors. This chapter pro-vides an analysis of the consequences of vertical coordination for variousagents in the chain. This chapter concludes with a number of recommen-dations for key policy changes and investment priorities for promotingthe beneficial effects of increased vertical coordination and avoiding ormitigating possible negative effects, from the perspective of both equityand efficiency.
STRUCTURAL FEATURES OF THE DAIRY SUPPLY CHAIN
Industry Structure at Primary Level
Romanian milk production traditionally has been concentrated in theprivate sector. In 1989 the state farms accounted for 18 percent of pro-duction, with other large farms accounting for 28 percent and familyfarms for 56 percent. By 2001 the share of family farms had grown to 97 percent, while that of state farms was 2 percent and other large(privately owned) farms 1 percent. Milk production is, therefore, verymuch focused on small-scale family units.
The privatization process at the farm level resulted in a very frag-mented farm structure. Just over 95 percent of farms have one to twocows (table 7.1). These farms have 83 percent of all milking cows inRomania. Only 0.25 percent of all farms—2,250 in number—have 10 cowsor more. Around 85,000 milking cows, or 5 percent of the total herd ofmilking cows, are on these larger farms.
Industry Structure at Processing Level
At the processing level, the current industry consists of ex-state firmsthat have been privatized, plus a developing small-scale private sector,which has matured since 1990. At the end of 2003, most formerly state-owned enterprises were privatized or liquidated, while 10 were still ina process of privatization. Simultaneously, many new dairies have been
Restructuring and Vertical Coordination in the Dairy Sector in Romania
169
WP 42 Case Studies
170
TABLE 7.1 Size Structures of the Livestock Farms, May 1, 2001
Farms Cows
No. of % of No. of % of Average Specification Farms Total Cum. % Head Total Cum. % Head / Farm
Source: 1999 data from National Institute for Statistics (2002); 2004 data from MAPAM.
established over the years, but also many have ceased to exist (see table7.2). Data from 1999 indicate that at that time there were 973 dairy pro-cessing enterprises in total. Most of them were very small in terms ofnumber of employees: 909 enterprises were reported to have less than 50 employees; 64 dairies had more than 50 employees. Since the end ofthe 1990s, the number of dairies (in operation) has come down toaround 600, with a fall of 40 percent of the number of smaller dairieswith less than 50 employees. Yet, the structure of the processing sectorremains very fragmented. Comparing 1999 and 2004 data on employ-ment shows that the size distribution in the industry remains veryskewed: more than 90 percent of the units have less than 50 employees.In 2004 around 250 dairies have a production capacity of less than1,000 tons of milk per year each.
An important development is that some foreign investment has enteredthe sector, especially from France, the Netherlands, Greece, Germany, andSwitzerland. Some of the foreign-owned companies belong to the larger
dairy processors in Romania. Table 7.3 lists a number of companies,which are estimated to have taken in more than 20,000 tonnes in 2003.Most of these companies have several factories and produce in differentlocations across the country. The six largest dairy companies of the coun-try account for around 25 percent of the dairy processing sector intake (seealso figure 7.1). Three out of the six largest dairies are foreign owned:Friesland, Hochland, and Danone. Furthermore, Friesland is the majorityshareholder of Napolact since mid-2004, after having acquired 40 percentof shares already in 2002.
Restructuring and Vertical Coordination in the Dairy Sector in Romania
171
TABLE 7.3 List of Large Dairies Companies in Romania
Estimated Intake Name of Company Majority Owner FDI Since in 2003, in Tonnes
Friesland România Friesland, Netherlands 2000 80,000S.C. Napolact Friesland, Netherlands 2002 80,000Hochland România Hochland, Germany 1998 30,000Danone Danone, France 1998 25,000Prodlacta Domestic 25,000Raraul Domestic 23,000
Source: MAPAM (2004).
The structure of the dairy industry may change very rapidly in theyears to come. The outlook of European Union (EU) accession calls,among others, for complying with EU quality norms and standards. In2004, only 17 dairies produced according to EU standards. These fac-tories represent 15 percent of the milk processing capacity in Romania(MAPAM 2004). Around 75 dairies—representing 25 percent of theindustry’s production capacity—are subject to restructuring invest-ments with Phare or SAPARD assistance in order to enable them tofully adapt the EU acquis requirements. The remaining companies donot produce according to EU norms and are not included in supportprograms for improvements. The majority of these firms—around 500in total—will have to close down their operations by accession, becausethey lack the financial means to invest in the necessary modernizationof equipment.
MILK FLOWS WITHIN THE SECTOR
Figure 7.1 provides an overview of the dairy sector, its components,and associated milk flows. Data refer to the year 2000, but more recentstatistics indicate rather stable milk production and consumption
WP 42 Case Studies
172
trends over the years 1998–2003.1 Figure 7.1 has been compiled withthe use of several sources of data, including those of the MAAP(Ministry of Agriculture, Food and Forest) and Friesland România. Thefarm usage and direct sales component of the diagram in particular(right-hand side) has been produced using a high degree of estimation.
Farm Production (May 2001)1,188,387 Milk Production Enterprises
1,735,979 Cows
RetailDistribution
FoodProcessing
FoodService
Exports - Milk equiv.(3.5% fat) = 32 Th.T.
Milk Collection System(21% of Milk Production)Increasingly owned by
Note: Figures marked * may be subject to 50 percent variation. Source: Leat and van Berkum (2003).
Unaccounted391 Mn. L.
Liquid Milk134 Mn. L.
Butter7.2 Th.T.
Cheese34 Th.T.
Direct SalesStreet Milk280 Mn.L.*
(26%)
Farm AnimalFeed
590 Mn.L.*(12%)
FamilyConsumption2020 Mn.L.*
(41%)
PowderedMilk
8.6 Th.T.
Fresh DairyProducts79 Mn.L.
Milk, Cheese andSour Cream
Dairy Processing Sector Intake1040 Mn.L.
Farm Usage and Direct Sales3890 Mn.L.*
(79% of Milk Production)
FIGURE 7.1 Overview of Romanian Milk Sector and Milk Flows
It has been suggested that the real quantity of milk used on farm anddirect sales could vary by ± 50 percent. This in turn suggests that totalmilk production in Romania could be anything between 3,000 millionliters and 6,800 million liters (i.e., ± 40 percent of the estimated figureof 4,930 million liters).
In 2000, approximately 1.2 million producers produced 5.1 milliontonnes (4,930 million liters) of milk. Similar production levels in the EUare achieved by Ireland and Denmark, while the EU(15) has a total milkproduction of 122.6 million tonnes. Imports with a milk equivalent of68,000 tonnes (in 2000) represent only 1.3 percent of total consump-tion.2 Exports with a milk equivalent of 32,000 tonnes are less than 1 per-cent of total supply. Since the start of transition and up to 2002, importshave exceeded exports, leading to Romania being a net importer of dairyproducts. Yet, the level of imports has always been very modest, whileexports have never played an important role.
It should be noted that a major feature of the current Romanian dairysector is the low utilization of total milk production by processingenterprises, with only 21 percent of estimated milk production beingdelivered for processing (see figure 7.1). A high proportion of milk isretained on farms for family and livestock usage, and significant quan-tities are sold directly to consumers, frequently through street markets.Farm family consumption is estimated at approximately 41 percent,farm feeding of animals is 12 percent and a further 26 percent is solddirectly by producers through street markets and as direct sales to low-income consumers. An estimation of the scale of milk production,which does not go for processing, is subject to a high degree of varia-tion. The high level of farm usage and direct selling is a consequence ofseveral factors, which include the small-scale structure of production, aconsequential lack of commercial orientation among many producers,an underdeveloped milk collection system, the big difference betweenthe procurement price and the street market price, and the unreliabilityof milk payments made by some processors with delays in payment toproducers of up to three months (see Leat and van Berkum 2003). It isalso likely, however, to be the result of difficulties in regulating directsales—especially those on the street. A major challenge in the com-mercial development of the dairy sector will be to increase the suppliesof good-quality raw milk to the processing sector in a cost-effectivemanner.
The following section focuses on four dairy companies and theirstrategies for guaranteed and quality supplies. These stories are exam-ples of how dairies try to overcome the obstacles for good-quality rawmilk deliveries.
Restructuring and Vertical Coordination in the Dairy Sector in Romania
173
VERTICAL RELATIONS BETWEEN THE PROCESSING COMPANIES AND PRIMARY PRODUCERS
The companies interviewed are two foreign and two Romanian compa-nies (see box 7.1). The two foreign companies are among the largestdairies in the country. The Romanian companies are a large- and a small-sized dairy. The companies were questioned about their contract partners(who are they?), the support they offer to farmers (what kind of supportand to whom?), and the agreements made in contracts (on quality, quan-tity logistics, and finance support). This section concludes with an impactanalysis of vertical coordination on the quality level of milk, production,market access, and structure of the sector.
Contract Partners, Milk Collection Arrangements, and Quality Improvement Instruments
Contract Partners
All four companies take in milk from individual farmers. Most of themilk is delivered based on a written contract, in which in most cases theprice setting and payment system are arranged. Promilch has a writtencontract with the farmers’ association ISPA, its major shareholder and byfar its most important milk supplier, and not with individual membersof ISPA (which are around 2,000 in number). In addition to individualfarmers, Friesland also contracts intermediate traders. Yet, this is not ona regular basis and, when done, this is only a very small (<5 percent) pro-portion of Friesland’s total intake. All four companies do business with thevery small farmers with one or two cows. The two foreign-owned com-panies, Friesland and Danone, also contract larger farms (which havefarmers with more than three cows in the Romanian context), some ofwhich can supply 300–400 kg of milk daily on average.
In general, dairies in Romania do not document milk delivery con-tracts with small-scale farmers in a notary’s deed because transactioncosts are too high. Friesland, for instance, has about 40,000 small farm-ers (with one or two cows); Raraul has approximately 8,000. Usually,dairies readjust farm prices three to four times a year because of infla-tion and the market situation (due to high seasonality of the productionthere is a big difference between summer and winter production andthus prices). Farmers therefore consider contracts as rather noncommit-tal; terms are changing frequently and each time terms change farmersfeel free to decide to switch dairies, definitely when one dairy offers bet-ter conditions than the other. Dairies, however, do make up contracts ina notary’s deed with the larger farms, in an attempt to bind them. This
WP 42 Case Studies
174
Restructuring and Vertical Coordination in the Dairy Sector in Romania
175
B O X 7 . 1
Company Profiles of Dairies Interviewed
PROMILCH, located in the Iasi county (Northeast Romania), was started as a pri-vate company by three local people. In 1999, the farmers’ association ISPA joinedwith investments in equipment. These investments were possible through the DutchPSO support program. Gradually ISPA Eco SRL, a limited liability company fullyowned by the ISPA members, expanded its share to 65 percent of the total shareholding. The factory in its present form opened in 2001 and it processes mainly milkdelivered from the ISPA collection centers (85 percent). In winter, the quantity ofmilk processed is 6,000 liters/day, which increases to 11,000 liters/day in spring andsummertime. The plant has a capacity of 15,000 liters/day, or 5,400 tonnes/year.Promilch focuses largely on fresh dairy products. Its markets are small local shopsand one or two local supermarkets.
RARAUL is a former state company, built in 1960 for producing mainly milk pow-der and butter. These are still the most important products, together with cheese.The enterprise was privatized in 1994 through a system in which employees couldbuy shares. Presently, five to six people own 67 percent of the shares, while 5 per-cent of the shares are owned by a farmers’ association and the rest by employees.In total there are around 270 shareholders. The company is located in the North ofRomania and processed around 70,000 kg of milk per day in 2003, from 7,000–8,000farmers. Major clients are in the processing industries. Around 50 percent of thecompany’s dairy products is exported.
DANONE—the large multinational dairy, originating from France—enteredRomania in 1998. The company processes around 70,000–90,000 kg of milk a day intodesserts. Danone acquires milk from all over the country, from small farmers whosemilk is collected in (around 60) collection points at local level and from larger farms.From the collection points and large farms, the milk is transported to regional col-lection centers for further transport to Bucharest, where the only processing unit inRomania is located. This factory is a greenfield investment and modern equipped.Danone’s products are sold all over Romania, mainly through large internationalretail chains.
The Dutch Royal Friesland Foods owns FRIESLAND România. Friesland Foodsbought the Nutricia Dairy & Drinks Group at the end of 2001. Nutricia entered theRomanian market in 2000 by acquiring Somesana, who held a strong position inNorthwest Romania, with fresh products and cheeses. In 2003, Friesland Româniaprocessed approximately 200,000–250,000 kg of milk a day, in five factories. Thecompany acquires milk through 1,050 collecting points (from approximately 40,000small farmers) and from some 600 larger farms (with own cooling facility). Productsare sold through various shops around the country, including the international retailchains. The company has an own distribution network, with depots in almost everyregion in the country.
is surely done if dairies provide farms with development assistance (seebelow).
Collection Arrangements
The small farmers either deliver their milk to collection points by them-selves or their milk is transported by a milk collector to a collection point.The larger farmers are visited by a tanker collection. Collection and trans-port costs per kilogram of milk are estimated relatively high, especiallyin the winter when production is seasonally low. It is interesting to notethat the four companies use different systems in organizing their milkcollection and transport. Raraul and Promilch, for instance, take care ofthe collection and transport by themselves. Estimated collection costs ofthese companies are between 10 percent and 20 percent of all costs(depending on the season). Friesland and Danone have outsourced thetransportation of milk (and their products) to independent conveyors. Thecollection points and centers that supply Danone are all owned by privateentrepreneurs. Friesland owns collection points/centers, in which it hasrecently invested much in milk cooling and quality testing equipment.Also Raraul and Promilch/ISPA invested in cooling facilities and milk con-trol equipment in milk collection centers. Before the companies did theseinvestments, the centers did not exist or they were only very poorlyequipped. Table 7.4 summarizes the contract partners and collectionarrangements of the four companies.
WP 42 Case Studies
176
Quality Improvements Through Payment and Control System
Improving the quality of milk delivered is of key importance to furtherdevelopment of the Romanian dairy sector and in the interest of everydairy that wants to produce high-quality dairy products. The companiesinterviewed encourage the improvement of the milk quality mainlythrough its milk payment system, linking the payment to quality grades.Friesland pays the small farmers according to fat content, measured at the
TABLE 7.4 Contract Partners and Arrangements for Collection and Transport
Danone Friesland Promilch/ISPA Raraul
Contracting small farmers � � � �Contracting large farmers � � �Owning collection centers � � �Arranging transport farm–collection center � �Arranging transport collection center–dairy � �
Note: � means “yes” or “applicable to.”
collection points by the company itself. The larger farmers are paid on thebasis of fat and protein content, density, and germ counts. The latter farmsare included in the company’s quality system and the milk supply is reg-ularly controlled at the farm. Danone offers a relatively low base price (10 percent below the market price), but offers bonuses when a farmerdelivers milk of above-average quality, according to protein content andgerm count, and also for constant delivery. In this way farmers can reacha mark-up of 35 percent above the average market price. Milk quality con-trols take place at the (larger) farm and at the collection points.
Prices paid by Raraul to farmers are linked to the quality of the milkdelivered. Milk samples are taken at the farm through the collector, andthese samples are analyzed at the collection points. The factory appliesthree quality grades: milk at the third grade is penalized by a 15–20 percentprice cut. Promilch’s payment to ISPA farmers is determined accordingto quality and is based on individual samples tested through modernequipment available at the association-owned milk collection centers.Facilities at the milk collection centers allow measuring fat content, den-sity, and acidity grades for each individual supplier. This system motivatesand stimulates farmers to improve their milk quality. For the bigger farm-ers, a premium price based on increased volume delivered is negotiatedwithin the contract with Promilch.
Higher prices for better quality milk should encourage farmers todeliver their milk to the dairy that is paying for quality. However, thereare signs that the four selected dairies face a tough competition for milk.All interviewed companies indicate that, although price arrangements areset in a contract, prices are negotiated frequently. Friesland claims it isalmost continuously negotiating with its suppliers about the milk priceand points at the farmers’ attitude that contracts are not considered bind-ing! ISPA reports that prices are established monthly, taking into accountthe market developments. Promilch/ISPA has a one-year contract for thefarmers with more than 10 cows but (re-)negotiates prices (at least) everysix months.
If prices (or even deliveries) depend on quality, the organization ofquality control is of key importance to the trust farmers have in the system.In case of our selected dairies, milk collectors do quality control before themilk is mixed with other farmers’ milk. Subsequently, the milk is furtheranalyzed in milk collection centers and in the dairy laboratories. Frieslandclaims it has a transparent system. The samples to determine the quality ofthe milk are made available for testing and checking by the responsiblepublic inspection services. Also Promilch/ISPA reports that there are sev-eral stages of quality control: the milk collector controls at the farm ondensity and acidity of the milk, while the farmers’ association (through
Restructuring and Vertical Coordination in the Dairy Sector in Romania
177
the laboratory staff in the field) in addition controls on fat, protein, drymatter, and added water at the collection center. Furthermore, the factorycontrols the entire intake itself through its own lab. On top of that, atleast monthly the laboratory of the Veterinary Direction and periodicallythe laboratory of the Consumers’ Protection Office are controlling themilk. Danone and Raraul indicate that they use a similar quality controlsystem and are governed by external inspection.
The interviewees, however, complain that the public inspection servicesare not accurate enough to control every dairy in operation. It seems tothe interviewed companies that public inspection discriminates against thedairies that are most quality aware, by applying higher standards to themthen to others. Furthermore, the public authorities are accused of weakinspections at open-air street markets where milk and cheese are soldnoncooled and not checked on basic food safety requirements (see alsosection on impacts of vertical coordination).
Support to Primary Producers
Extension Services
Friesland uses several ways to support their farmers with the aim ofimproving the quality of milk supply and guaranteeing a stable supply(see table 7.5). For instance, the company has 36 milk inspectors out inthe field, who visit farmers and advice them on milk hygienic circum-stances, cleaning practices, and fodder management. This service is inprinciple open for every farmer who delivers milk to Friesland.
The ISPA farmers association, majority shareholder of PROMILCH,employs staff providing extension services to its 2,000 members. Servicesprovided are various: from supporting farmers in making feeding plansfor their herd to a full business plan. In its early days, much extensionwork focused on convincing farmers to improve hygiene in their milkingpractices. The association distributes leaflets with practical informationand hints on cultivating feed, storing milk at the farms, cleaning prac-tices, and so forth. ISPA staff visit farmers individually and organizemeetings, trainings, on-farm demonstrations, and trials through whichknowledge exchange is enhanced.
Raraul has made several efforts to improve farming conditions in orderto improve milk quality. One example is that the company buys foddersupplements and sells these at reasonable prices to its farmers. Anotherexample is that Raraul distributed pregnant heifers to farmers some yearsago. This program, however, was not successful because only a few farmerscould qualify for receiving the animals. In order to get a heifer, farmershad to prove they had good animal practices. Those farmers who were suc-cessful financed the purchase by prefinanced milk supply to the factory.
WP 42 Case Studies
178
With SAPARD assistance, Raraul intends to set up training centers in thecounty for education purposes. Raraul considers farmers’ education ingood animal practices essential to increasing yields as well as improvingthe quality of the milk. To this aim, Raraul also has invested in coolingfacilities in collection points.
Danone offers advice services to its farmers. First, a farmer can get adviceon drafting his business plan and assessing his opportunities for expand-ing his farm. Second, Danone offers technical advice on feeding, hygiene,improving the fertility rate of the cows, and other technical farm manage-ment issues.
Restructuring and Vertical Coordination in the Dairy Sector in Romania
179
TABLE 7.5 Elements of a Farm Assistance Program by the Dairies Surveyed
by deducting milk moneySupport to purchases of simple inputs � �
by prepayment of milk deliveranceInvestment support by small loans � � �Support in receiving bank loans � � �
(e.g., guarantee by your company)
Investment Financing and Other Input Arrangements
Friesland supports only the larger and loyal farmers who want to makeinvestments to improve or expand their businesses. Investments sup-ported by Friesland were mainly in milk-cooling facilities at the farm,while in a few cases updating the milking parlor and improvements ofthe cowshed were supported. Occasionally the company offers the banka guarantee, if the farmer is able to give Friesland a collateral. In mostcases, however, Friesland’s investment support is through prepayment ofa farmer’s milk, for the purchase of necessary inputs. Friesland has noprogram in which it stimulates farmers to use production-increasinginputs, except that it offers good quality of fodder for reasonable prices.Farmers may use delayed payment for feed purchases or Friesland maydeduct part of the milk money for a number of months.
Danone, on the other hand, has made prefinanced inputs the corner-stone of its farmers’ development program. The company supports farm-ers who are aiming at improving their business through small-scaleinvestments in, for instance, spare parts of field machinery and milkinstallations, and through purchases of feed compounds (concentrates),
milk powder (as cattle feed), and detergents (of milking equipment). Afarmer may apply for prefinanced inputs only after he has deliveredgood-quality milk to Danone for at least six months. By countervaluingthe investments in required inputs, Danone buys the farmer’s estimatedmilk production in advance: normally the prefinancing does not exceedthe value of one year of production, yet the advance may extend to twoor a maximum of three years of production. Because Danone gives secu-rity to the input suppliers, they are willing to deliver the inputs to thefarmers.
In addition to prefinanced inputs, Danone is willing to provide farm-ers with medium-term credits for investments in, for instance, milkinginstallations and animal purchases. A farmer can qualify for investmentcredits if he is a stable supplier to the company and if his farm has a cer-tain minimum size. In principle, Danone offers investment credit assis-tance only to the medium and larger farms, targeting at farms that candeliver around 400 kg/day (in due time).3 Furthermore, together withhis requests for support, the farmer sends in a business developmentplan. If Danone accepts the plan, the company and the farmer make upa contract in which the conditions for the loan are laid down. Danonenormally takes the farm housing and/or land as guarantee for non-deliverance of milk or breach of contract. The contract is signed in anotary’s deed.
ISPA also plays a role in helping farmers with credit, but as its membersare predominantly small-scale farmers, borrowers are largely farmers withonly a few milk cows. The association uses a Dutch fund—received fromRabobank on very attractive terms—and provides small loans to farmerswho want to invest in animals, (re-)construction of stables, and/or equip-ment. Farmers qualify for a loan through an interview in which theyhave to indicate their business plan. An average loan is around 400 euros,with a maximum of 2,000 euros. ISPA loans are to be repaid after a 6-to 18-month grace period for animals, and a four-year grace period forconstruction investments. Farmers do not have to provide any collateral;the milk delivered is considered the “collateral.” Eligibility criteria forloans include several elements. First, the farmer needs to have a durablerelation with ISPA. In practice ISPA requires a delivery period of at leastsix months but preferably one year. It is important that a farmer uses anappropriate fodder base at his farm and agrees upon a commitment forfurther expanding the farm. ISPA personnel, who generally have a closecontact with all individual members, need to confirm the assessment oneligibility. The requirements, however, are not too strict and are subjectto ISPA staff assessments. Trust and reliability are important. ISPA dealswith the default risk by having a solidary liability of both the loan bene-
WP 42 Case Studies
180
ficiary and the milk collection center staff who guarantee the reliability ofthe borrower.
IMPACTS OF VERTICAL COORDINATION
Quality Improvement: Driving Forces and Obstacles
Companies surveyed in this chapter indicate that improving milk qual-ity is the main driving force behind their assistance programs. By offeringassistance to farmers, the dairies want to secure their milk supply base bothin quality and quantity terms. Quality improvements are also encouragedthrough quality-related payment systems. Furthermore, timely payment ofmilk delivery is an important instrument to enlarge the dairy supply baseand to show that the dairy is a reliable partner. Through these linkages,dairies hope to get farmers’ loyalty in return. Vertical coordination, then,is expected to affect quality and volume of milk delivery positively.
Through quality improvements of their raw material, dairies aim atstrengthening their competitive position and being able to open up newmarkets for the sector, such as access to the large retail chains. Companiesrealize that also in Romania the retail sector will become the major mar-ket channel for dairy products. The retail sector demands guaranteed sup-ply of high-quality products. In order to use the full potential of theRomanian milk sector, quality improvements are a sine qua none. If not,the sector’s competitiveness will be weakened, which will result in furtherimport penetration.
Next to market forces, EU integration drives changes in the qualityawareness in the supply chain. Presently, milk quality norms set by theRomanian government only refer to minimum requirements to guaran-tee that the milk is safe for human consumption. These Romanian stan-dards are generally lower than EU standards. Normally, however, dairiesmeasure milk quality in terms of fat and protein content, density, andsomatic count. Yet, the number of Romanian dairies that use the latterquality norms as a base for milk payments is, according to the inter-viewed dairies, still low.
At the same time, efforts of those dairies that are trying to encouragefarmers to improve the quality of milk delivered are undermined in severalways. Most (small) dairies accept low-quality milk and yet pay farmersattractive prices. These dairies generally do not invest in quality improve-ment measures and do not request quality-improving investments fromthe farmers. Farmers are not encouraged to make any investment in qualityimprovements and do not have the financial means to do so. Low-qualityproducts can still be sold, because a majority of consumers are not so dis-cerning yet. There are even accusations that inspection institutions apply
Restructuring and Vertical Coordination in the Dairy Sector in Romania
181
double standards, allowing dairies to operate without production licenses,to sell their products without paying taxes, and to produce without obey-ing basic quality standards. This has a very destructive impact on industryefforts to increase the quality of milk delivered. Interviewees indicate thatthe price differences between high- and low-quality milk is not as big dur-ing the winter months when production is seasonally low. During thesemonths, there is much competition between the “good” and “bad” dairiesin order to secure their supply. Contract enforcement is a problem becausemost agreements with the smaller farmers are not in a notary deed, whilefrequent price adjustments incite farmers to reconsider their business rela-tion with their dairy and to switch dairies.
Street market selling is another obstacle to rapid improvement of thequality of dairy products in Romania. An estimated quarter of all milkproduction is sold directly to consumers at typical peasant street marketsas fresh dairy products, including cheeses (see figure 7.1). Formally, theissues of health of the animals used to produce the products and thehygienic quality of the products sold are controlled by veterinary andlocal authorities, yet the quality of products sold are generally consideredfar below EU standards (Leat and van Berkum 2003). As long as such out-lets exist and the terms on which products are sold accepted, farmers havelittle incentives to improve milk quality.
Impact on Yields and Production
Impacts of the contractual arrangements on farm level are difficult to indi-cate, because this brief research did not include interviews with farmers.Yet, it may be assumed that when a farmer takes the advice, uses betterfodder, and is granted small loans for investments in more productivecows, housing, and/or milking parlor equipment, his cows will yield moremilk and production will increase. Examples of dairy farmers in Leat andvan Berkum (2003) indicate that farmers, who are willing to learn, canachieve better performances even when they have access to modest devel-opment assistance. In the same vein, relatively small changes in the indus-try’s practices can have a major impact at farm level. An example fromFriesland is illustrative in this respect. In 2001 the company bought aRomanian dairy, which utilized less than 50 percent of its capacity andhad a bad reputation with respect to paying its farmers. Without chang-ing anything but paying on time, Friesland succeeded in taking in 20–30 percent more milk within a time period of three months. If farmers areconvinced that a processor is reliable in making its milk payments, pro-ducers are generally prepared to deliver (more of) their milk.
The general picture for the Romanian dairy sector is that yields areincreasing but slowly (figure 7.2). Total production has not increased
WP 42 Case Studies
182
much because the cowherd has decreased slightly over the years. Whetherassistance programs have contributed to these results is very doubtful: theinitiatives as reported by the four surveyed companies seem too few tohave a noticeable impact on the average yields in the country. Also on adairy company level, it is hard to identify any impact on intake perfarmer. Again, the number of farmers receiving assistance is fairly low.Furthermore, the supply base of most dairies changes continuously as a significant part of small-scale farmers deliver milk to dairies on an on-and-off basis, selling also part of their production on the street mar-kets, and switch from one dairy to another.
Access to Input and Output Markets
Vertical coordination improves access to inputs for farmers. The dairiesincluded in this survey provide farmers with extension service and adviceon various husbandry issues, hygiene standards, and farm economics.Training, extension, and knowledge exchange are important inputs in acountry where the governmental extension service system still needs verymuch restructuring and modernization to comply with the present needsof a privately run farm sector.4 Some companies act as an intermediatebetween the farmer and input producers, which enhances access to com-pound feed, fertilizers and/or machinery, small equipment, and spareparts. Dairy companies have a much better bargaining power with theinput supplier than an individual farmer has, negotiating discounts
Restructuring and Vertical Coordination in the Dairy Sector in Romania
Animal number (000 head)Total milk production (000 tonnes)Milk production per cow (kg/cow)
Source: National Institute for Statistics (2002), Chapter 13 Agriculture.
FIGURE 7.2 Cowherd, Milk Production, and Milk Yields in Romania, 1990–2001
while offering input suppliers much more secure payment guaranteesthan farmers can. Furthermore, farmers have improved access to (small)loans for (small) investments, if financial support of investments isincluded in the assistance program. However, most dairies seem verycautious in providing farmers with loans; they select farmers eligible forloans very carefully. Except for the farmers’ association ISPA, dairiesselect only the larger, loyal farmers for (some form of) company creditsupport. This illustrates that, when it comes to support in terms ofinvestment finance, dairies discriminate against the small farms. At thesame time, it should be emphasized that in the case of the three largercompanies the total number of farmers included in the farmers’ assis-tance programs is relatively low. For instance, Danone reports that nomore than 10 new participants enter its development program everyyear. Friesland refers to “some cases” in which the company providedloans for investments.
With respect to access to output markets, the dairies surveyed have con-tracts with supermarkets, some of which are international retail chains.This enlarges the market for dairy products from Romanian farmers.
Vertical Coordination and Foreign Direct Investment
The development of foreign investment in the dairy processing industryis of significant importance. Romania has received some foreign investorsin the dairy sector since 1998 when Danone came in. Since then, severalforeign companies have followed, such as Friesland (former Nutriciagroup, Netherlands), Parametro (Greece), Hochland (Germany), andDorna Lactate (Switzerland). These investments show that foreign com-panies see good prospects in the Romanian dairy market in the long term.There are several important impacts on the Romanian dairy sector that canalready be identified as arising from these foreign investments (see alsoLeat and van Berkum 2003). One clearly observes that the competition inthe market has increased. More firms with better products are entering themarket and competing with the existing established businesses. Increasedcompetition from internationally operating companies has encouragedseveral developments. More competition has fueled a growing tendencyof specialization in the sector. Until privatization started, every dairy unitproduced the whole range of dairy products, in order to utilize all the milkdelivered and to serve the local community with a full range of products.Pressure from competitors has forced processors to use scarce resourceson as large a scale as possible, and concentrating on processing fewerproducts is one way of achieving this. The increased competition hasalready had, and will continue to have, an impact on the number ofsmall-scale producers, which will decrease. Furthermore, the foreign
WP 42 Case Studies
184
investment has resulted in an increasing number of products being avail-able to the consumer. Moreover, because these companies want to acceptonly good-quality milk, they have initiated further efforts to implementstrict quality standards along the dairy chain.
Winners and Losers
Although the larger farmers have some privileges in assistance programswith respect to investment fund eligibility, there are no signs that thepresent vertical coordination arrangements in the Romanian dairy sup-ply chain exclude small farmers. Despite high transaction costs, dairiesare willing to collect the milk from small plots, largely through collectionpoints. The two foreign dairies interviewed in the survey explicitly indi-cated that they would like to reduce the number of small-scale suppliersand work with larger suppliers. Yet, there are very few dairy farms withmore than five cows in Romania (see table 7.1). For the moment, dairieshave to accept this situation until restructuring and consolidation in thesector begins. In the meantime, the larger dairies want to assist their sup-plying farmers in improving their conditions for producing higher qual-ity milk by providing advice, improving access to inputs includinginvestment means, and enhancing access to output markets. Farmerswho are willing to learn and develop get chances to further develop theirbusiness. The companies, however, restrict such support to the moreloyal and larger suppliers, because of the high transaction costs and prob-lems of contract enforcement. The result is that this assistance onlybenefits a small number of farms and has only limited impact on sectordevelopment.
The dairy sector is very fragmented: around 95 percent of all dairyfarmers have one to two cows. Therefore, in order to have an impact ondairy sector development, assistance programs should be targeted atupgrading small-scale farms too. Initiatives taken by the dairy associationISPA show that an effective organization of small-scale dairy farmers canprovide its members with basic farm-level support on matters of key impor-tance (feeding, milk quality, and hygiene) and a secure market outlet.Furthermore, by investing in further processing, this association adds fur-ther value to raw milk and strengthens the market position of its members.This example shows that small-scale farmers have future opportunitieswhen effectively organized.
CONCLUSIONS AND POLICY RECOMMENDATIONS
The key problem for sector development is the low and unstable qual-ity of milk delivered. Investments for quality improvement are seriously
Restructuring and Vertical Coordination in the Dairy Sector in Romania
185
hampered by the typical small-scale structure with low productive hold-ings. Vertical coordination through private contractual arrangements,which include assistance programs, attempts to tackle major bottlenecksfor quality and productivity improvements. In the dairy sector inRomania, vertical coordination through contracting is not widespreadyet. Foreign companies have taken initiatives in this field, which to datehave been followed by only a few Romanian dairy factories. So far, theimpact is limited in terms of number of farms assisted as well as in yieldsand production increase. Government policies on a number of issuescould help to complement and increase the effectiveness of the compa-nies’ farm assistance programs and at the same time address the issue ofcompetitiveness of the sector. The key focus of public policy should beto help bring the small farms into the private supply chain. Some rec-ommendations for policy change and government involvement are sug-gested in the following text.
Establish Extension and Information Service
The sector suffers from low milk quality from small-scale, low-productiveholdings. Many issues contribute to that situation, such as low feed qual-ity, a lack of quality and hygienic orientation on the farms, and a lack ofbasic husbandry skills. A well functioning public extension and informa-tion service can contribute importantly to improving the general knowl-edge level in the sector and increasing quality awareness. On-farm trainingshould focus on how to change working practices so as to improve milkquality. Similarly, such measures may also affect productivity positively,as less milk will be lost due to bad hygienic practices.
The structure and functioning of that system will, however, need tobe reviewed in the light of changes taking place in the agriculturalresearch and education sectors to ensure that the knowledge and tech-nology transfer from the research and education sectors is efficient. Inaddition, the development of extension packages tailored toward small-to medium-sized farms and to semi-subsistence households could domuch to raise the productivity and quality of production at these units.The strengthening of the links between the extension service and theagricultural schools through, for instance, an “entrepreneurial skillscourse,” could also be beneficial. Presently, the Romanian governmentis investing in improving its agricultural knowledge and informationservice.5
Improve the Farmer’s Access to Capital
Productivity and quality of production are also low because of a lack ofuse of capital. Farmers have little or no financial means of their own to
WP 42 Case Studies
186
invest in working capital and have difficulties in getting access to loansfor investment in housing and other fixed assets. This survey pointedat some examples in which dairy processors assist farmers in thesefields. The examples also show that—with the exception of the farmers’association—dairies have a preference for supporting the larger farmersand consider small-scale farmers generally not creditworthy enough to be included in their financial assistance programs. However, given the very low levels of capital used, small investments in, for example, ani-mal housing, a cart, or machinery to cultivate the land, may result veryquickly in increased labor and land productivity on small-scale farms.Investments in better milking equipment, cleaning products, and so forthmay make a difference in terms of the quality of milk produced. The lat-ter may also lead to more liters being sold for processing, because theprocessor will reject less milk. Investments like these are very importantto the small-scale farmer for improving working conditions and increas-ing productivity. A grant aid scheme could be established to help farm-ers have improved access to financial means. Investments like the onesmentioned could be funded by a farm improvement scheme with grantaid provided within the structure of an approved Farm ImprovementPlan (FIP). In such a FIP, a farmer formulates his wishes/objectives withrespect to necessary improvements on his farm and substantiates whythey should be eligible for grant assistance. A medium-term businessplan is an integrated part of the FIP. The Romania government may useSAPARD funds to finance FIPs.
Develop, Implement, and Control Quality Standards
It has been noted that there is a striking difference between dairies interms of milk quality awareness. In this situation, dairies that demand thattheir farmers deliver a higher quality of milk face significant competitionfrom dairies with a much lower quality awareness. Because of Romania’spresent low prosperity level, domestic consumers may accept these qual-ity differences. Yet, it is a government task to ensure uniform appliedquality standards that guarantee at least a similar level playing field forall dairies, and a minimum food safety level. All dairies should operatewith appropriate production licenses and comply with basic quality andfood safety rules.
Unregulated milk and dairy product sales, especially those on streetmarkets, could compromise public health initiatives. For instance, bru-cellosis and tuberculosis are significant risks to public health. The poten-tial seriousness of the risk suggests that it should be tackled from bothends of the food production chain. On-street sales should be regulatedand licensed so that the observance of health, hygiene, and milk quality
Restructuring and Vertical Coordination in the Dairy Sector in Romania
187
conditions by vendors can be monitored. The size of the market andpotential for relocation would, however, make such monitoring difficult.All milk producers should, therefore, be registered and subject to on-farminspection of production, health, and hygiene standards. The compul-sory testing of milk for bacterial and cell counts, resulting in possibleimposition of limits, would further protect public health.
Stimulate the Establishment of Producers’ Associations
The ISPA example illustrates what an effective organization of small-scalefarmers can achieve. Presently, there are only a few farmers’ associationsin Romania, mainly because of a distinct mistrust of farmers. Yet, thereare many reasons why cooperation could be advantageous to small-scaledairy farmers.
One good reason is to invest collectively in collection centers.Establishing well-facilitated collection centers for milk is a major require-ment for developing the competitive performance of the Romanian milksector. Leat and van Berkum (2003) provide an example of the type andlevel of investment required to establish a small-scale collection centerfor approximately 250 small farmers. Total costs of establishing a collec-tion center, including a secondhand cooling tank and a centrifuge, wouldimply an investment of around US$7,000–7,500, or $30 per farmer when250 farmers line up with each other. This example is based on the expe-riences of ISPA and represents good information on this type of invest-ment. It shows that the level of investment required from each farmer canbe relatively modest if sufficient numbers invest and only appropriatefacilities are provided.
Establishing a cooperative in order to invest in a collection center hasmore positive side effects. Small-scale farmers have no bargaining powerwhen dealing with processors and/or input suppliers (including financialinstitutions). By joining forces, farmers would be able to negotiate betterterms with parties from other stages in the chain. Furthermore, dairies mayreduce transaction costs importantly when they do not have to deal withall small-scale farmers individually, but instead with one legal person—anassociation—that represents a group of small farmers.
Romania has a cooperative law (Law 36/1991) that allows the forma-tion of legal entities in Romania that can operate according to generalcooperative principles. However, that law has serious drawbacks, such asthe prohibiting of commercial activities and the obligation to pull all theland and production resources (see Davies and van Berkum 2003). Anew law on agricultural cooperatives adopted at the end of 2004 (Law566/2004) does not seem to have such drawbacks and could, therefore,have an important impact on the development of small-scale farming in
WP 42 Case Studies
188
Romania. Furthermore, public extension services could help increasefarmers’ awareness of the benefits of associations and could include train-ing of those who are to assist in cooperative development. Start-up grantsto help cover temporarily the operational costs could strongly encouragethe establishment of farmers’ associations.
NOTES1. See, for instance, USDA (2002 and 2003). Estimations for 2004 indicate a 5 per-
cent increase for the full year due to robust feed availability (USDA 2004).2. Imports—largely from the Republic of Moldova—have come down very drasti-
cally since June 2002 when Romania adopted the so-called “third country require-ments” which required that only countries and plants approved to export to the EUmarket are eligible to export to Romania.
3. In the interview, the company’s representative mentioned that Danone’s assis-tance program is targeted at farms with 20 cows or more. According to available sta-tistics, this would refer to less than 1,000 farms all over Romania.
4. See also Davies and van Berkum (2003).5. On January 28, 2005, Romania signed a loan agreement with the international
bank for reconstruction and development (IBRD) for the support of, among others,a project on the Modernization of the Agricultural Knowledge and InformationSystems (MAKIS), in which one of the main tasks is to establish an efficient and effec-tive extension system.
REFERENCESDavies, S., and S. van Berkum. 2003. “Policy Themes Identified in the Sector Reviews.”
In The Romanian Agrifood Chain: On the Road to Accession, ed. S. van Berkum, S.Davies, and S. Popov. Bucharest: Ministry of Agriculture, Forest, Water andEnvironment.
Leat, P., and S. van Berkum. 2003. “Dairy Sector Analysis.” In The Romanian AgrifoodChain: On the Road to Accession, ed. S. van Berkum, S. Davies, and S. Popov.Bucharest: Ministry of Agriculture, Forest, Water and Environment.
MAPAM (Ministry of Agriculture, Forest, Water and Environment). 2004 (January).Statistical Information on the Situation in the Dairy Processing Industry. Bucharest: MAAP.
National Institute for Statistics. 2002. Romanian Statistical Yearbook. Bucharest: NIS.——. 2005. Agricultural Census 2004. Bucharest: NIS.USDA Foreign Agricultural Service. 2002. Romania Dairy and Products, Annual 2002,
Gain Report RO2018.——. 2003. Romania Dairy and Products, Annual 2003, Gain Report RO3016.——. 2004. Romania Dairy and Products, Annual 2004, Gain Report RO4018.
INTERVIEWSFriesland Romania: Mr. G. de Boer, country managerDanone: Mr. Petrisor, managing director raw material acquisitionPromilch/ISPA: Mrs. E. Baladur, director general of ISPARaraul: Mr. M. Vranau, director general
Restructuring and Vertical Coordination in the Dairy Sector in Romania
