Dynamics of Agri-food Supply Chains in Transition Countries Johan F.M. Swinnen The World Bank Sarajevo Conference May 24-26, 2004

Background Breakdown of the relationships of farms with input suppliers and output markets. Breakdown of the relationships of farms with input suppliers and output markets. Contracting and vertical coordination in supply chain emerging to overcome these obstacles Contracting and vertical coordination in supply chain emerging to overcome these obstacles Processes have been an engine of growth in most advanced ECA countries. Processes have been an engine of growth in most advanced ECA countries.

Key Issues / Questions How important / general is this process ? How important / general is this process ? Which models ? Which models ? Which conditions are required ? Which conditions are required ? Effects ? Effects ? Who gets the benefits ? (What about small farmers ?) Who gets the benefits ? (What about small farmers ?) Which role does FDI play ? Which role does FDI play ? Implications for government policy and international organizations ? Implications for government policy and international organizations ?

Methodology Series of case studies, interviews and surveys Series of case studies, interviews and surveys Different sectors (dairy, cotton, fruits & vegetables, …) Different sectors (dairy, cotton, fruits & vegetables, …) Different countries across ECA Different countries across ECA

1. Important ? Yes.

Farms selling on contract in Central Europe (% of all) Farm Comp. Family Farms Hungary Czech Slovak

Dairy in North Poland ALL dairy companies assist suppliers (farms) through : ALL dairy companies assist suppliers (farms) through :  Input supply programs  Credit programs  Extension services PART : Bank loan guarantee programs PART : Bank loan guarantee programs Programs for SMALL and LARGE suppliers Programs for SMALL and LARGE suppliers

Dairy in Bulgaria, Slovakia, Poland

CIS 5 country study : 40% of agri-food processors offers credit to suppliers 5 country study : 40% of agri-food processors offers credit to suppliers Kazakhstan cotton : 71% of cotton farmers contracts with ginner, with assistance packages Kazakhstan cotton : 71% of cotton farmers contracts with ginner, with assistance packages

How Important ? Sugar sector : 80 – 90 % of CEEC sugar sector is FDI, using contracts & farm assistance programs Sugar sector : 80 – 90 % of CEEC sugar sector is FDI, using contracts & farm assistance programs Dairy & oilseeds sector : significant FDI, and most companies implement programs, with strong spillover effects on domestic companies Dairy & oilseeds sector : significant FDI, and most companies implement programs, with strong spillover effects on domestic companies Supermarkets : Some, but not generally Supermarkets : Some, but not generally After 1998 : VC in Russian food chain by domestic investments from outside agriculture After 1998 : VC in Russian food chain by domestic investments from outside agriculture Kazakhstan : grain trading companies investing upstream; cotton ginning : contracting mostly with small farms,... Kazakhstan : grain trading companies investing upstream; cotton ginning : contracting mostly with small farms,...

2. Multiple Models & Motivations Commodity specific Commodity specific Transition-stage specific Transition-stage specific  Securing basic supplies  Quality ! Many constructions (simple & complex) Many constructions (simple & complex) Key is “Non-traditional” design (also e.g. Warehouse Receipt Systems) Key is “Non-traditional” design (also e.g. Warehouse Receipt Systems)

Reasons for Contracting – CEE CzechSlovakHung Contract price higher1210 Avoid price uncertainty62133 Guaranteed sales Immediate payment7113 Easier to get credit009 Contract - inputs or TA1062 Other420

Reasons for Contracting Kazak Cotton Farmers

Agri-business Motivations for Vertical Integration Early stage : Securing basic supplies (ex: pre-finance, inputs, …) Early stage : Securing basic supplies (ex: pre-finance, inputs, …) Advanced : Upgrading quality of supplies (ex: technical and management assistance, investment loans, loan guarantees, …) Advanced : Upgrading quality of supplies (ex: technical and management assistance, investment loans, loan guarantees, …)

Supermarket Assistance to farms Available evidence indicates that modern retailers introduce similar packages “if they have to” to secure quality supplies. E.g. Available evidence indicates that modern retailers introduce similar packages “if they have to” to secure quality supplies. E.g.  Central America (Berdegue et al)  Croatia (Reardon et al)

Transition Region is Special Collapse of farm output and livestock numbers creates discrepancy between processing capacity and supply Collapse of farm output and livestock numbers creates discrepancy between processing capacity and supply History of poor quality History of poor quality This makes it a “SUPPLIER’s MARKET” (compared to other regions) This makes it a “SUPPLIER’s MARKET” (compared to other regions)

Some Examples of More Complex Models

Integrating Multiple Stages : INTERBREW ( Brewing Multinational) Core business = brewing Forced to vertically integrate to ensure quality malt/barley/seed General strategy applied differently in different countries b/c of local conditions Bring in co-foreign investors to assist with non-core activities and set up farm assistance programs Programs interlink markets Brewing Co. Malting Co. Barley farm Seed supply

Proces./Retail – guaranteed supplier loans: JUHOSUKOR in Slovakia & KONZUM in Croatia Retailer/processor provides loan guarantees for bank loans to suppliers Retail/Processing Co. Bank Farm

Dairy Processor Becomes Financial Institution: DANONE in Romania Processor takes on banking function:  provides loans to farms  based on business plans  takes collateral Provides payment guarantee for input suppliers Processing Bank Input Supplier Farm

Lending with distributed risk: RABOBANK - SPVs Financial institution is foreign investor Special purpose vehicle (SPV) to distribute risk equally among partners Ex. where group of small farmers formed cooperative to participate in SPV Processing co. BankInput Supplier SPV Farm

3. Contract Enforcement is essential for ANY model Crucial to make VC sustainable Crucial to make VC sustainable Not obvious: Many cases and stories where contract enforcement problems undermines VC Not obvious: Many cases and stories where contract enforcement problems undermines VC Private enforcement mechanisms can be more important than public institutions Private enforcement mechanisms can be more important than public institutions

4. Effects Important Direct Effects : Important Direct Effects :  Enhanced QUALITY (& higher prices)  Increased PRODUCTIVITY  (eg CIS study) Important Indirect Effects: Spillovers Important Indirect Effects: Spillovers  Contract replication by other companies  Farm assistance replication  Household level spillovers

Change in yields in Central Europe

Change in Quality Dairy in North Poland

Household Spillover Effects Reduced risk (guaranteed price for contracted crop) in absence of insurance markets Reduced risk (guaranteed price for contracted crop) in absence of insurance markets Improved access to credit (cash for contracted crop) with imperfect capital markets Improved access to credit (cash for contracted crop) with imperfect capital markets Increased productivity of non- contracted activities, through improved management and better input use Increased productivity of non- contracted activities, through improved management and better input use

5. Foreign investment (FDI) Conceptually, no need for FDI Conceptually, no need for FDI Empirically: Empirically:  FDI is driving force for contract innovations  Domestic spillovers are important Several exceptions: FIG investments (Russia, Kaz), Cotton Kazakhstan Several exceptions: FIG investments (Russia, Kaz), Cotton Kazakhstan Crucial factor appears access to outside finance (and management strategy) Crucial factor appears access to outside finance (and management strategy)

6. Will small farms survive ? Key concern Key concern Lots of stories and intuition Lots of stories and intuition Usually based on little evidence Usually based on little evidence

The Key Concern Modern supply chains (or “The supermarket revolution”) will push a large share of farmers, in particular small farmers, out of the market as they fail to meet the requirements to sell to these chains (“The supermarkets”) Modern supply chains (or “The supermarket revolution”) will push a large share of farmers, in particular small farmers, out of the market as they fail to meet the requirements to sell to these chains (“The supermarkets”)

The Key Concern Small farmers may ‘fail to make the grade’ because : 1. Fixed component in transaction costs makes it more costly to deal with many small farmers than with a few large farms 2. Small farms are constrained financially (internally and/or externally) for making necessary investments

Evidence ? Many stories but little ‘hard evidence’ Many stories but little ‘hard evidence’ What exists suggest that What exists suggest that  We should take this concern seriously  But the reality is much more complex and nuanced than assumptions

Evidence – part 1 Interviews with agri-food companies confirms preference for larger suppliers Interviews with agri-food companies confirms preference for larger suppliers Specialized wholesalers and supermarkets prefer to work with (relatively) large FFV producers in Croatia (Reardon et al 2003) Specialized wholesalers and supermarkets prefer to work with (relatively) large FFV producers in Croatia (Reardon et al 2003) Danone and Megle in Bulgaria and Romania have strategy focused on >20 cow farms Danone and Megle in Bulgaria and Romania have strategy focused on >20 cow farms CIS study finds 60% of processors have minimum size for some of its farm assistance programs CIS study finds 60% of processors have minimum size for some of its farm assistance programs

Evidence – part 2 Examples of company programs to small farmers being quite successful. Eg. Examples of company programs to small farmers being quite successful. Eg.  Croatian F&V suppliers to supermarkets  Kazak cotton  Polish and Romanian dairy  e.g. Friesland Romania works with 40,000 small farms through 1,000 collection centers; contracts include farm assistance packages

Impact on Loans and Investment Small farms in Polish Dairy sector

Impact on small farms – Poland dairy

Evidence – part 2 CIS study finds that processors do not discriminate on size for providing basic programs (agronomic support, physical inputs, prompt payments, …) CIS study finds that processors do not discriminate on size for providing basic programs (agronomic support, physical inputs, prompt payments, …) Both Polish dairy study and CIS study find that FDI companies are not more likely to cut small farms as suppliers (the opposite) Both Polish dairy study and CIS study find that FDI companies are not more likely to cut small farms as suppliers (the opposite)

More importantly Modern dairy companies focusing on high- quality market (incl retail sector) tend to assist small farms; compared to market channels targeted to informal and low quality sales which do not Modern dairy companies focusing on high- quality market (incl retail sector) tend to assist small farms; compared to market channels targeted to informal and low quality sales which do not In Lithuania, all credit which small dairy farms get is through the dairy companies (cannot get access to bank loans or public assistance, incl SAPARD) In Lithuania, all credit which small dairy farms get is through the dairy companies (cannot get access to bank loans or public assistance, incl SAPARD)

Why work with small suppliers ? In some cases processors have no choice : small farms represent most supply (eg Poland, many Balkan countries, Transcaucausus, Kyrgyz, …) In some cases processors have no choice : small farms represent most supply (eg Poland, many Balkan countries, Transcaucausus, Kyrgyz, …)  Eg. Romania: 95% of dairy farms have 1-2 cows. => Small Farm Paradox ? => Small Farm Paradox ? “processing companies stressed that willingness to learn, take on board advise, and a professional attitude were more important than size in establishing fruitful farm-processor relationship” (CIS study) “processing companies stressed that willingness to learn, take on board advise, and a professional attitude were more important than size in establishing fruitful farm-processor relationship” (CIS study)

Supply Chain Revolution or Evolution ? Several factors suggest that the impact of the supermarket revolution on farmers, including small farmers, may be less dramatic in some contexts, and may have positive effects in transition countries Several factors suggest that the impact of the supermarket revolution on farmers, including small farmers, may be less dramatic in some contexts, and may have positive effects in transition countries

A. Supermarket is part of chain For vast majority of farm output there is no direct link with supermarkets: FFV is 15-20% of ag output. Most farm produce (milk, grains, sugar, cotton, etc.) is processed before it reaches retail sector. The impact on these farms will be indirect through the food processing sector. For vast majority of farm output there is no direct link with supermarkets: FFV is 15-20% of ag output. Most farm produce (milk, grains, sugar, cotton, etc.) is processed before it reaches retail sector. The impact on these farms will be indirect through the food processing sector. The effects may be more similar to that of FDI in food processing. These effects have been positive in several cases for small farms The effects may be more similar to that of FDI in food processing. These effects have been positive in several cases for small farms

B. Farm structure is mixed Share of large farm companies (% land use) Slovakia90 Czech Rep 74 Hungary45 Romania18 Croatia5 Poland15 Russia85

C. Next step in major changes Agricultural restructuring in transition countries (Output, trade, employment, FDI, food industry restructuring, ….) has been dramatic over past 15 years Agricultural restructuring in transition countries (Output, trade, employment, FDI, food industry restructuring, ….) has been dramatic over past 15 years

Revolution or evolution ? Change in ag employment

Revolution or evolution ? EU – CEEC trade in ag and food products

D. Retailers and vertical coordination may play positive role for key weaknesses Key weaknesses of ECA farms : Key weaknesses of ECA farms :  Shortage of finance for investments  Quality  Access to high value markets Retail investments and coordination with supply chains may assist farms in these areas Retail investments and coordination with supply chains may assist farms in these areas

7. Implications for policy Create right conditions for business investment Create right conditions for business investment Competition policy ! Competition policy !

Competition is VERY Important Induces horizontal spillovers and the spread of farm assistance packages Induces horizontal spillovers and the spread of farm assistance packages Constrains (potential) rent extraction in chain Constrains (potential) rent extraction in chain E.g. Kazak cotton story: competition among processors for suppliers induces assistance programs, collection center investments, etc. E.g. Kazak cotton story: competition among processors for suppliers induces assistance programs, collection center investments, etc.

Bad Policies are Worse than Bad Weather VC may survive defaults due to unforeseen and one-time events (eg bad weather in Kazakhstan) VC may survive defaults due to unforeseen and one-time events (eg bad weather in Kazakhstan) However, inappropriate government intervention may destroy VC However, inappropriate government intervention may destroy VC  Eg Ukraine in 1990s

Implications for investments and projects Traditional Public goods : eg Traditional Public goods : eg  rural electricity (Azerbaijan),  rural roads (Romania), … New instruments: Focus on New instruments: Focus on  Chain Finance,  Quality & Bringing small farmers ‘on board’  Example

Finance The Chain Warehouse receipt programs Warehouse receipt programs Leasing Leasing Reverse Factoring Reverse Factoring …. ….

How to benefit small farmers ? Bring / Keep them in Bring / Keep them in => LOWER TRANSACTION COSTS Ensure fair distribution of rents Ensure fair distribution of rents => EMPOWER THEM

Reduce Transaction Costs Lower transport costs (eg improvement of rural infrastructure) Lower transport costs (eg improvement of rural infrastructure) Reduce number of transactions by intermediary institution between farm and processor/input supplier Reduce number of transactions by intermediary institution between farm and processor/input supplier  collection points  Milk (ex Poland, Romania, …)  F&V (supermarkets in Latin America, …  farm associations, but need instrument/incentive system to ensure homogenous (and high) quality  ….

Empower the (Small) Farmers Stimulate ASSOCIATIONS of farms Stimulate ASSOCIATIONS of farms  Bargaining with companies  Lobbying the government Stimulate COMPETITION in the chain (input suppliers, processors, traders, …) Stimulate COMPETITION in the chain (input suppliers, processors, traders, …) Organize INDEPENDENT institutions for product quality assessment Organize INDEPENDENT institutions for product quality assessment

Quality Control and Rents in Kazak Cotton Chain Extra payments for clean cotton ? NO (99%) Extra payments for clean cotton ? NO (99%) Fines for ‘dirty’ cotton ? YES (100%) Fines for ‘dirty’ cotton ? YES (100%) Is your cotton mixed with that of other farmers ? YES (100%) Is your cotton mixed with that of other farmers ? YES (100%) Can you inspect quality of processed cotton from your seed cotton ? NO (97%) Can you inspect quality of processed cotton from your seed cotton ? NO (97%) Who assesses the quality of your cotton ? GINNER’s LAB (100%) Who assesses the quality of your cotton ? GINNER’s LAB (100%)

Quality Control and Rents in Kazak Cotton

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