68418 v3 I. Introduction This report is designed to provide a backdrop for cotton producers, the private sector and policy makers in transition economies to enable them to assess their current position relative to the global cotton market. We seek to highlight the successful facets that constitute cotton production in countries that are considered to be "success stories". Adoption or rejection of these models will obviously depend on the specifics of the economies of the various readerships, but it is clear that there are valuable parallels and lessons to be drawn from international experience and practice. Equally importantly, we have sought to show the trends in production and consumption throughout the world. With the increasing globalization of trade and improved access to markets, it is clear that events in the global economy and production changes in other growing countries have a direct impact even at the farm gate of a producer in Tajikistan. While long term price forecasting is problematic due to the actions of technical speculators, we can see that cotton remains a crop directly affected by the market fundamentals of supply and demand. With a lack of directly accessible hedging markets, there is only one direction for cotton producers in Tajikistan to go and that is to develop their competitive advantage through input supply efficiency, nurturing competition, maximizing yields, improving baled cotton quality and diversifying production. II. Cotton in the Global Market 2.1 Production and Consumption On the global level, production of baled cotton has been steadily increasing in recent years, although the increase in that share has not been uniform throughout the cotton growing regions of the world. World production (lint) 8000 7000 6000 China 5000 USA '000 MT India 4000 Pakis tan 3000 Uzbekis tan 2000 Others 1000 0 95 96 97 98 99 00 01 02 03 04 19 19 19 19 19 20 20 20 20 20 Figure 1 - World production Over the past 10 years, total world production has increased by 24%, most notably in mainland China (a 33% increase over the period). The year 2004 saw a spike in production as a reaction to high prices in 2003; prior to 2003, production increases were more modest, at about 2% for most countries. Perhaps of equal interest is each country’s market share in total production. The largest increases in market share have actually gone to Pakistan (11%) and China (7%), while India and other countries’ market shares have dropped by 7% and 1%, respectively. The largest loss in market share has been suffered by Uzbekistan (32%), due to a decrease in their own production and an overall increase in world production. Share of world production (lint) 35% 30% China 25% USA 20% India 15% Pakistan Uzbekistan 10% Others 5% 0% 95 96 97 98 99 00 01 02 03 04 19 19 19 19 19 20 20 20 20 20 Figure 2 - Share of world production As with production, consumption of baled cotton also increased during the period 1995 to 2004, indeed almost matching production, at 23%. However, the increase in consumption has not been as evenly spread as in production, with certain countries expanding production and others contracting. World consumption (lint) 9000 8000 China 7000 India 6000 USA '000 MT 5000 E.Asia/Australia 4000 EU/E.Eur/Turkey 3000 Pakistan 2000 Brazil 1000 Others 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Figure 3 - World consumption China experienced a dramatic increase in consumption over the past ten years (84%), while Pakistan, India, and other parts of the world (Others) experienced a much smaller increase (43%, 20%, and 23% respectively). Countries that experienced a decline in consumption included the United States (42%) and East Asia/Australia (14%), the latter due, in large part, to the Asian currency crisis. 2 Share of world consumption 40% 35% China 30% India USA 25% E.Asia/Australia 20% EU/E.Eur/Turkey 15% Pakistan 10% Brazil 5% Others 0% 95 96 97 98 99 00 01 02 03 04 19 19 19 19 19 20 20 20 20 20 Figure 4 - Share of world consumption The share of world consumption during this period has only increased in two countries: China and Pakistan (50% and 16% increase between 1995 and 2004, respectively). Aside from the increases seen in China and Pakistan (50% and 16%, respectively), most other regions of the world have seen a decline in market shares for consumption, with the largest loss being suffered by USA at over 50%. The primary reason that some countries have seen their total consumption rise, yet market share decline, is due to the phenomenal increase in consumption in mainland China. World production & consum ption (lint) 30000 25000 20000 '000 MT Production 15000 Consumption 10000 5000 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Figure 5 - World production and consumption Data collected during this period (1995-2000) indicates that production and consumption were largely keeping pace with the other. However, prior to 1995, production levels were higher than consumption, causing a world surplus in baled cotton. High stock levels in warehouse drove down the international price of cotton. By 2001, however, consumption began to outpace production. This, combined with crop disasters in various regions, drove international prices up. As a result of higher prices many countries have increased production, despite the fact that consumption has begun to lag. In 2003, world prices fell again, leading to further stockpiling. 3 2.2 Inputs In developed countries, input supply, technical services and technical innovation are provided by the private sector. The development of these sectors is based on demand from farmers, as opposed to supply- driven factors. The infrastructure that provides inputs to the farming communities is normally centered in local, privately owned farm supply shops, which stock everything from seed to chemicals to machinery. In many instances, these suppliers offer credit to local farms (we shall discuss below other forms of supply credit). Where farms are of a larger size, they tend to purchase their inputs direct from wholesalers as they are able to benefit from discounts for larger sized orders. The farmer of a sufficiently sized farm usually purchases his basic farming equipment (i.e., tractor, planters, rippers etc). Such transactions are normally based on leasing packages offered by machinery manufacturers through their local agents/dealers. One major advantage of leasing over an outright purchase, is that it gives the farmer the opportunity to continually upgrade his machinery without the complication of having to sell the older machinery (under the leasing package they give this old machinery back to the leasing company). The majority of leasing packages are based on the leaser maintaining a lien over the equipment during the life of the lease, as this enables the leasing company to solve collateral issues in its financing program. Unless a farm is very large, there are certain machinery operations that they do not own their equipment for, such as picking or aerial spraying. The capital cost of the equipment and the amount of use that the farm can make of the equipment in a growing season, means that it is more economical to hire contractors to undertake the necessary work. In countries such as America and Australia there are very active machinery contractor markets. Another reason for the existence of this type of service is that the farmer himself simply does not have enough time available to be able to undertake the work himself. There are several examples of the successful development of such independent machinery contracting operations in developing countries such as Benin, Ghana and Cote d’Ivoire. In countries where farms are relatively small, there has been a strong tendency for farmers to join together at the input purchasing stage in order to benefit from economies of scale and collective bargaining arrangements. Quite often this is organized through the creation of a separate company (in which farmers own shares) that purchases, stores and then distributes inputs to its members (or shareholders). The reason for the creation of a legal entity to undertake such operations is that it will develop its own financing arrangements and enter into obligations that are not attached to the shareholders. For farmers this can be advantageous as the operations of their input purchasing company do not reduce their own ability to raise seasonal finance (because they have only pledged part of their collateral base). Another advantage for shareholders is that they are able to offer inputs to non-shareholders and the profits from these sales can be used to reduce the unit costs of their own inputs. Of course, the ability to make efficient use of machinery services is dependent on the nature of land holdings. For example, fields need to be of a certain layout and size for large farming equipment to be used in an efficient manner. Where land holdings are based on a large number of small fields, machinery services are often uneconomical because of the time spent traveling between fields and the inability of the equipment to make long passes of the field. In developing and transition economies, the nature of land privatization means that there are a large number of small land holdings and, until such time as there is rationalization of land ownership or some move to co-operative style farm operations, the use of machinery will continue to be inefficient. Of course, the main reasons for the development of machinery services in countries such as Australia and America are centered on the cost and availability of labor. Neither of these considerations is currently a major motivation in most developing and transition countries. 4 A leading example of private sector involvement in the seed industry is found in Australia, where development of new seed types and their commercialization is undertaken by private sector companies. There is still some degree of public sector academic development, but the majority of the funding for this comes from the commercialization of their research in the form of marketing agreements with private sector distributors. 2.3 Costs of Production Obviously, the costs of growing cotton differ from country to country and from year to year. When attempting to compare costs of production between different countries (and therefore the impact on competitiveness), one must choose a standard that enables constructive comparison. The most comprehensive work done on collecting and analyzing cost of production information is undertaken by the International Cotton Advisory Council (ICAC). The information in this section is based on their study of 2004. If we consider the cost of production on a per hectare basis, studies show that these range from less than USD 400/ha in a number of countries to around USD 4,000 in Israel. The average across 30 growing countries, however, was USD 1,139/ha (total expenses including picking and ginning). Included in this figure is a “cost of land” and the world average rent for a hectare of cotton was USD 241, which would imply that an owner of land’s actual costs of production per hectare would fall to USD 898/ha. On an average basis, the additional income from the sale of seed after ginning reduces the net cost to USD 732/ha. In figure 6 we have shown the regional comparisons for production of seed cotton on a per hectare basis. Cost of production by hectare 2000 1800 1600 1400 1200 US$/ha 1000 800 600 400 200 0 N. S. Africa Asia Europe Australia America America Figure 6 - Cost of seed cotton production by hectare The largest difference between producing countries is in the yield differential between rain fed and irrigated cottons, as the yield per hectare in the latter is invariably far higher. Therefore, when one considers the costs of growing cotton in an international context, this should be done on a per MT of seed cotton basis. Equally, one should not necessarily consider that the lower the costs of production, the higher the profitability. The international price paid for cottons from different origins varies according to quality and general trade considerations. 5 Costs of production by weight seed cotton 0.8 0.7 0.6 0.5 US$/kg 0.4 0.3 0.2 0.1 0 N. S. Africa Asia Europe Australia America America Figure 7 - Costs of production per kg of seed cotton Calculations based on the cost of production per kilogram of seed cotton reveals that differentials based on costs per hectare have now closed and this is due to the difference in yields in the different regions. In general, those regions with lower costs of production also tend to have far lower yields. Interestingly, one should note that Australia, which was amongst the most expensive regions on a per hectare basis, is actually the lowest cost producer on the basis of a kilogram of seed cotton. The reason for this is that the Australian farmers have some of the highest yields in the world, yet remain some of the most efficient in terms of minimizing costs. It should be noted that they achieve this in this absence of any subsidies whatsoever—a strong argument that effective and sustainable agriculture can be achieved with protectionism or subsidy systems. Costs of production of Seedcotton 1.00 0.75 US$/kg 0.50 0.25 0.00 SA ey a lia ia i il n a al az in ta n d rk ra M U hi nt In kis Br Tu st C ge Au Pa Ar Figure 8 - Costs of production of seed cotton An analysis on the cost of production for individual countries shows that there is not a large difference between them. This might imply that there is little or no competitive advantage for any of the countries in relation to each other and therefore little need for such things as subsidy programs, etc. However, the calculations on the cost of production based on baled cotton weights reveals that competitive advantages 6 are most apparent when cotton is in its baled and tradable format. There are several factors that determine the relationship between baled cotton and seed cotton costs. Cost of production per kg lint 4.00 3.50 3.00 2.50 US$/kg 2.00 1.50 1.00 0.50 0.00 N. S. Africa Asia Europe Australia America America Figure 9 - Cost of production per kg lint The most important factors are the ginning outturn rate for the cotton (the percent of baled cotton to seed cotton) and the cost of ginning/handling. Here, once more, we can see that the Australians are still in the strongest position, despite the fact that their costs of labor and electricity are amongst the highest of the cotton producing countries. The reason that they still maintain their competitive advantage is that their ginning sector is extremely efficient, produces high outturns and is very competitive (keeping ginning charges low). 2.4 Land The issue of land tenure is not only emotive; it is the back bone of successful and sustainable agriculture. The main issue for a farmer is that his attitude to the management of his land is directly linked to his ownership of it. Ownership, of course, does not have to be based on freehold, it can be based on long term leases, so long as tenure of the lease is protected by law and is a legal asset (i.e. it can be conveyed or transferred and therefore has an intrinsic value). For example, land ownership in Australia (arguably the leading example of free market, non-subsidized farming in the world) is based on leasehold, not freehold. These leases, however, are able to be traded and pledged and are therefore considered to be an asset. One of the most important facets of farm sustainability is rational use of the land and management of it (drainage, for example). In a situation where a farmer does not have secure tenure of his land, he has no real vested interest in managing his land on a sustainable basis. In this situation, he will farm the land on an annual basis, attempting to maximize profit in any given season, as opposed to maximizing it over an extended period. Land also forms a cornerstone of most rural credit systems, with the pledge of the land as collateral for finance being a mainstay of a bank’s willingness to lend money. The basis of the reliance on land as a pledge is that it has an economic value (the value of the crops that can be grown on it). While immoveable property (such as houses) does have a value, they are a less tradable asset and are often actually attached to the farming land itself (which reduces a buyer’s willingness to purchase them). 7 Another advantage of taking farming land as a pledge is that it represents a farmer’s main source of income and therefore they have a strong vested interest in ensuring that they repay their credits. If they lose their land, then they lose their ability to earn income and provide for their families. A common problem in developing and transition economies is that the issue of land ownership has not been fully developed. This causes two major problems: first, it is a major impediment to the development of rural finance program; and secondly that sustainable land management systems are often not practiced by the farmers. 2.5 Ginning Ginning, the process for separating cotton fiber from cotton seed and removing foreign material, has changed little since its original invention the late 19th Century. Technological developments have concentrated on maximizing the percentage of fiber separated and the efficiency of the equipment used (reducing operating costs). The ability to maximize the percentage of cotton fiber (outturn) is ultimately dependent on the actual fiber content of seed cotton by weight. There are two methods for separating the fiber—saw and roller ginning. The latter method is mainly used for the ginning of long and extra long staple (LS & ELS) varieties of cotton, which have a higher fiber percentage by weight and, therefore, outturns are higher (in the region of 40 to 42%). This is a gentle method of separating the fiber from the seed and necessary to maintain the length of the fiber (staple). The other method is saw ginning, which is used for the ginning of medium staple cotton. The process largely depends on a number of spinning discs which have serrated edges (saws). The fiber is caught by the serrations and basically pulled from the seed. This is a less gentle process than roller ginning, due to the fact that the saws spin at much higher speeds than the rollers in the other method. Average international outturns from saw ginning in developed countries are in the region of 36%. Technical improvements in saw ginning focus on minimizing the cost of running the machinery and other operational parameters. In developed countries, the main costs are those for electricity and labor. Electricity costs are minimized through making the electrical motors as efficient as possible and by conditioning the cotton prior to ginning to increase efficiency. Labor costs have been reduced by the automation of seed cotton and baled cotton handling. A typical modern western gin operates with only three processing staff. The other major pressure on ginning operations actually comes from farmers, who need their cotton ginning as fast as possible in order to be able to sell it and, thus, close their financing. This pressure has led to modern gins operating at very high capacities for only a few months a year, the rest of the time lying idle. Another reason for farmers wanting to have their cotton ginned as soon as possible is that they suffer quality losses while storing seed cotton, whereas the quality is stable once the cotton has been ginned. The main damage to stored seed cotton occurs at humidity levels in excess of 11%, where the color of the cotton fibers can be affected. Any yellowness of the original seed cotton is dramatically worsened during storage at humidity levels in excess of 13-14%, especially where storage is in excess of 45 days. It should be noted, however, that the degree of quality losses related to seed cotton storage in transition economies is less due to prevailing weather conditions and the seed cotton storage systems that are used in those countries. In developed countries, with the cost of labor and land being high, they are unable to store the seed cotton in manners that enable close control of the humidity of the picked cotton. In the other countries, however, these are not prevalent factors and therefore the method of storage is better and with less loss. 8 However, there is one important factor that must be highlighted with ginning outturns and that is that most cotton in developing and transition countries is hand picked. This generally means that the percentage of foreign matter is much lower than in developed countries (which use machine picking). This means that the ginning outturns in the former type of countries should be higher purely based on the fact that there is more cotton fiber in seed cotton by weight (because the percentage of foreign matter is lower). A common misconception is that lower ginning outturn rates in developing and transition economies can be efficiently solved simply by the introduction of more modern ginning equipment. However, great care must be taken in any such approach. First, an assessment must be made of the suitability of domestic seed types to modern ginning. Although this is a complex question, the most important factor is the degree of fiber to seed coat attachment. Modern ginning machinery involves ginning cotton at very fast cyclical rates and, if the fiber attachment to the seed coat is strong, then the result of ginning this type of cotton will be that a large percentage of fibers will snap along their length or will lead to fibers pulling off seed coat (which will then pass into the baled cotton). The effect of either of these results will be the lowering of the price of the baled cotton. Secondly, the increased operational efficiency of modern ginning equipment is reflected in its price. A modern two stand saw gin can cost up to USD 8 million once installed, whereas a gin manufactured locally may cost as little as USD 1 million. The savings to be gained from a modern gin are mainly in the use of labor and electricity. Nonetheless, as these are generally much cheaper in developing and transition economies this efficiency does not actually result in any major savings. In fact, the extra cost of capital (be that in finance or depreciation) invariably outweighs any savings that can be gained. However, the efficient management and operation of gins in non-developed countries can often result in much higher outturns at very little extra cost. Perhaps the best example of this can be seen in Kazakhstan, where saw gin outturns average 36% and higher for local medium staple varieties. These outturns are achieved using old Soviet manufactured gins which have been renovated with relatively low capital investment. The reason for the high ginning outturns is that the gin operators are private and their profitability is linked directly to their ginning outturns in two ways. Firstly, as purchasers of seed cotton the higher the ginning outturn that they achieve the higher their profits. Secondly, the higher the gin outturn they can achieve, the higher the price that they are able to offer for seed cotton and therefore the greater amount of cotton that they are able to buy in the competitive seed cotton market that exists in the country. 2.6 Quality assessment The international standard for assessing cotton quality (based on trade practice) is that used by USDA. Nearly all end users purchase on terms related to USDA classifications and HVI (high volume instrumentation) testing. HVI testing is basically a mechanical classification of cotton using a computer based system for the assessment of quality. Its accuracy is dependent on the operation of the equipment by highly trained professionals and extremely careful maintenance/calibrating of the machinery. Where traders are purchasing from countries that use different classification systems, they sort the purchased cotton into shipment parcels based on the USDA and HVI classifications. Prior to 2000, many traders continued to trade on what were referred to as “private types”—effectively their own classification systems. These types were based on physical samples of cotton and were the basis for the quality of cotton transacted under the contract. However, due to the increasingly competitive nature of the textiles market and increasing sophistication of production, many end users have now switched to buying on USDA classifications and HVI results. 9 While there is a problem for traders in purchasing and selling on different quality standards, there is also a potential financial advantage. If the purchasing standards enable a trader to purchase a spread of qualities within one classification (based on USDA classifications), then they are able to split the purchased cotton into the different qualities at a point before delivery (usually at the port). In splitting the consignments and selling at differentiated prices, they are effectively able to reduce their average purchase price. Of course, the process of splitting shipment parcels involves a large amount of time and expense and this affects the overall profitability of such operations. In a situation where the advantages of such operations are low, this will negatively affect the trader’s willingness to purchase the growth and this will be reflected in the price. The main problem with this dichotomy in sales and purchase classifications is that it is a major barrier to end users purchasing direct from the country of origin. If they were able to purchase on classifications which they were accustomed to using, then they would be much more prepared to purchase direct from the origin. The current classification sales systems operated in developing and transition countries mean that this dichotomy continues to prevail and this is a major barrier to their further development in the international free trade of cotton. However, the most important thing to note with classification issues is the nature of the quality certificate itself. As with trade in other commodities, the importance of the quality certificate lies in the confidence of the buyer and seller (and financier) in the accuracy of the certificate itself. Part of the reason for the success in the use of USDA and HVI certification in America and Australia is the confidence that traders, farmers and end users have in the accuracy of the certificates. This confidence means that the basis of the trade actually becomes the certificate itself, as opposed to physical samples of the cotton that is being sold. Any quality claims that are then brought by purchasers are based on the difference between the cotton delivered and the USDA/HVI classification. With cottons from developing and transition economies, quality claims are based on the difference between the delivered cotton and the physical sample of the cotton that formed the basis of the sales contract. This is a far less accurate claims procedure and is yet another reason why end users are increasingly switching their procurement to being based on USDA/HVI classifications. Movement to the international standard for developing and transition countries can be achieved by a two stage approach. Firstly, the recognized standards authority of the country needs to officially adopt the USDA classification system and have this adoption registered with the various cotton quality arbitration authorities (such as the Liverpool Cotton Association and Bremen Cotton Exchange). The second stage is the most important and that is either the creation of a separate cotton classification authority or the registration of international, independent quality assessment companies as being authorized to issue quality certificates in the country. In the first case (creation of a new authority), it is strongly advised that this should be based on the creation of a joint venture(s) with an international assessment company. The importance of the involvement of an independent assessment company is that it will ensure the confidence of traders and end users in the quality certificate that is issued. As we have mentioned above, it is this confidence that is paramount in the operation of a successful quality certification operation. Another important facet of modern classification systems (and how they link to marketing) is that classification has to be undertaken on a bale by bale basis. Given that cotton is a natural fiber, it is subject to the vagaries of weather and its handling at picking and subsequent storage. As we shall note below, one of the most important factors for end users is the even running quality of cotton. Differences in running quality in a parcel of cotton that is being processed can negatively impact the efficiency of a mill. In most developing and transition countries, cotton is classed and sold in units determined by weight made up of consecutive bales from a gin. In order to maximize sale prices and stimulate demand from end users as a premium growth, quality assessment needs to be undertaken on a bale by bale basis, with each bale being 10 given an individual identification number. This then enables the marketing of cotton based on the sale of units containing bales of the same quality. 2.7 Finance 2.7.1. Crop financing In USA and Australia, farmers finance their cotton growing operations from their own cash resources and through the operation of an overdraft facility with their local bank. An overdraft facility is a bank account that enables the farmer to have a negative balance on the account, because it is guaranteed through provision of a pledge or mortgage. Typically, the farmer will offer the bank a lien over his moveable (e.g. farming equipment) and immoveable (e.g. house) property. Based on a valuation of this property, the bank will offer the farmer a maximum amount of credit upon which they can draw. Drawdown against the overdraft facility is executed through the issuance of bank checks or direct debit cards. The advantage of this type of financing is that interest is only paid on the overdraft for that period of time and for that amount of money for which the account is in debit. In other countries, those lacking operating overdraft facilities, the farmer borrows a specific amount of money against the value of his pledged property (the same types as above). The disadvantage for the farmer is that he is liable for interest on the total amount of the credit from the moment that it is granted. The problem here is that he may well not need the full amount of credit for the whole period, as his costs are cumulative during the season. 2.7.2 Supplier credits Many input suppliers, in order to maximize their sales, offer farmers a non-bank form of credit—supplier credit. In this instance, they will deliver the inputs to the farmer at a given price, inclusive of the cost of finance for the goods for a given period. The fact that the majority of supplier credits are not backed by the provision of collateral and effectively leaves the supplier with 100% repayment risk. Decisions to offer a supplier credit are based on the credit worthiness of the farmer and the repayment history that the farmer has with the supplier. Generally, the relationship will start with the supplier offering credit for only a certain percentage of the total value of inputs. Based on successful repayments and established credit history with the supplier, the percentage of the value of the inputs that the supplier is prepared to finance, increases over time. The costs of supplier credits tend to be higher than credits from banking institutions. This is because the supplier has a higher risk of default (not having any collateral) and the interest rate charged has to include provisioning for bad debts. Of course, in the case of a default, the supplier has the option to recover his money through legal proceedings, but this involves costs and he will not be able to recover in all cases. The reason that farmers want this form of credit (and are prepared to pay a premium for it) is that their collateral may not be sufficient to be able to raise credit adequate to cover all their farming operations. 2.7.3 Pre-export finance Where a farmer (or group of farmers) has a relationship with a cotton buyer, they are sometimes able to raise pre-export finance. This is a credit that pays for their seasonal finance and is basically a payment from the buyer in advance of delivery of the physical cotton. The cost of the finance depends on the perceived re-payment risk and the country risk. The latter risk is not something within the control of the farmer and is an assessment that is made by the buyer or their own bank and mainly consists of the risk of the farmer not being able to export their cotton due to internal political risks. Generally this form of finance is not used by farmers in the more sophisticated countries (as they are able to access finance 11 domestically), as it is often more expensive and also often results in further discounting of the price of the cotton (or fixed pricing). An example of a successful operation of pre-export financing can be seen during the 1993 to 2000 period in Kazakhstan. However, due to an increase in the availability of domestic financing, the prevalence of this sort of financing has reduced there. This finance mechanism is the main input recovery scheme that is used in West African developing countries. It generally involves a financing institution or commercial bank, which registers farmers’ debts and recovers the finance extended through payments made by the seed cotton off-taker, with this money being credited to the individual farmers’ accounts upon delivery of the seed cotton. 2.7.4 Export finance Export finance is a complicated area of structured financing and the benefit to farmers can be that they can access payment for their goods while their cotton is still in the country of origin. There are two main methods—collateralized warehouse financing and discounted letters of credit. In the former situation, the farmer delivers his cotton to a warehouse (preferably customs bonded) and ownership of the cotton effectively passes to the buyer, even though the term of delivery under the contract may provide for delivery at some destination outside of the country of origin. In this instance it should be noted that the transfer of ownership is effectively in the documentation—the warehouse receipt and the quality certificate. For the transaction to be successful, the warehouse receipt normally needs to be backed by some form of collateral guarantee from the warehouse operator and the quality certificate needs to be issued by an independent party acceptable to both buyer and seller. Letters of credit are basically bank promissory notes, in that the issuing bank (the buyer’s) undertakes to pay the recipient bank (the seller’s) upon presentation of a number of documents. As long as these documents are presented by the recipient bank to the issuing bank in accordance with the terms of the letter of credit, the issuing bank is bound to pay against the presented documents. These operations are subject to international law under UCP 500 and the documents are subject to Incoterms 2000. Given that the transactions are bound by international provisions, certain banks are then prepared to “discount” issued letters of credit. This means that they are prepared to pay the recipient bank prior to delivery of the goods in return for assignment of the letter of credit. The discounting bank charges a fee for this service and this is dependent on their view of counter party risk (mainly the seller). However, in a situation where a seller is able to discount his incoming letter of credit, he is able to receive money for his goods in advance and therefore pay off his other outstanding financing arrangements. The decision to do this is dependent on his “financing spread”, i.e. the difference between the cost of his existing finance and the costs involved with discounting the letter of credit. 2.8 Pricing The major international index for the price of cotton is determined by the New York Cotton Exchange (NYCE). While it is actually only an exchange that provides for the sale of American medium staple cotton, it has become an indicator that clearly affects all other cotton growths in the world (see figure 10). The prices of cottons from other origins are based on the indices produced by Cotton Outlook, a company based in Liverpool, UK. 12 90.00 80.00 70.00 60.00 50.00 NYCE c/lb A 40.00 30.00 20.00 10.00 0.00 97 98 99 00 01 02 03 04 05 19 19 19 20 20 20 20 20 20 Figure 10: NYCE versus “A” index Although the methodology used by Cotton Outlook for compiling the indices is complicated, in general terms they receive information from cotton trading companies around the world on a daily basis indicating their sale price offers for various growths for that day. This “basket” of offers is then averaged and posted as the daily quote for each growth. The price is based CIF North European Port, although in reality it has come to be regarded as a delivered mill price by the trade. There are two main indices that Cotlook produce—the “A” and the “B”. The difference is that they represent the offering prices for different qualities of cotton, with the “A” being for higher grades. The “A” is the average price of the five most expensive growth constituents that are being quoted at that time. As cotton is a seasonal crop and the harvesting seasons in various countries differ, at certain times of the year some growths are not available and therefore are not being offered. Similarly, on occasions, trading companies do not wish to quote a price for certain growths and if there are insufficient offers, then that growth will not be quoted in the Index. Apart from the origin of the cottons, the major difference between NYCE and the Cotlook indices is that the former represents an open market traded price, whereas the latter are indicative prices. There is a fundamental problem with the Cotlook system in that those parties who are contributing price quotes have a vested interest in the prices that they supply. Traders who are long of cotton (i.e. have physical, fixed price stocks) will want to provide high quotes, whereas those that are short (i.e. do not have physical stocks or have them at unfixed prices) will want to provide low quotes. While it could be argued that these counter posing pressures may well cancel each other out and lead to the production of an accurate indicative average price, the seasonality of cotton sales and purchases means that this is often not the case. However, in the absence of other means of assessing traded prices for non-USA growths, the Cotlook system remains the best alternative. With regard to the NYCE price, it must be noted that a fundamental distortion is caused by the existence of the American Government Farm Bill. This is a system of subsidies and discounts that disconnect farm gate prices and producer returns from the true potential price for cotton. Indeed, we can see in figure 1.1 that the NYCE has generally lagged behind the “A” index since 2001, the main reason for which has been the effects of the Step 3 (export subsidy program) which has been very active in enabling the sale of the increase in production of cotton in USA in relation to the contraction in domestic demand over the period. 13 The importance of international pricing for governments in developing and transition economies is that, in order to stop capital flight and minimize export tax avoidance, they need to introduce minimum pricing policies. The problem with such policies is that they often result in effective fixed pricing, especially where marketing is undertaken by government agencies. The staff of such organizations has no active interest in maximizing sale prices or avail themselves of the opportunity of rent seeking in regard to the price differentials. The only way to avoid such problems is to place the management on profit sharing contracts linked to price maximization or to use a transparent, competitive sales mechanism (such as baled cotton auctions—discussed below). While there are an enormous number of factors that determine the international price as represented by the NYCE, it is important for governments and growers in transition and developing countries to at least have a basic understanding of what lies behind the price. In essence, cotton (like many other commodities markets) is mainly a “sentiment” market—which is to say that what moves prices are the feelings or sentiments of those parties that trade in cotton. However, it must be noted that sentiment moves the market in the short term and only represents changes to the medium to long term view of the market. The main basis for these medium to long term views are called market fundamentals. The most important fundamentals are supply and demand (production and consumption of baled cotton). Supply can be affected by the area of cotton planted, weather conditions during the season and weather at harvest time. Demand is affected by a number of factors, the main ones being economic growth, exchange rate fluctuations, prices of competing products (e.g. man made fibers) and political instability. In the NYCE futures (as opposed to physicals spot) market, there is another group of factors that can affect the market price and these are referred to as “technicals”. In simplest form, these are market movements that are due to trading decisions made by parties (normally “speculators”) that may not be directly connected with market sentiment or a change in the fundamentals. These decisions are determined by moves in the market price quoted on the futures contract and are a result of the automated nature of the trading of options. While the original move in the market may have been as a result of market sentiment or fundamentals, the effect of the technical trades can distort the movement. For example, when a party buys or sells an option, they often place a “stop” on that trade. A stop is an automated trade which means that, when an option reaches a certain price, it is automatically bought or sold at that price. This is a tool that speculators use to manage their open futures positions and means that they do not have to physically manage their positions on a permanent basis. The problem for the market and physicals’ traders is that a relatively small move in the market can be magnified by the action of these stops. If a sufficient number of speculators have stops in a similar range, the liquidity of their trades can force the market higher or lower than it would normally have traded based on the original market movement. The importance of understanding the “shape” (the volume of speculative positions) of the futures market for producers and governments in transition and developing countries is that they are able to analyze whether a market movement is short or long term. Generally, large market swings (“volatility”) caused by technicals re-adjust themselves over time to mirror the actual fundamentals. While it may appear that an understanding of NYCE is not important for countries or growers trading under the Cotlook indices, it must be remembered that Cotlook is affected by NYCE. NYCE is effectively in competition with Cotlook, in that a mill has the option to buy American cotton, as opposed to other growths (especially given the excess production in America). Even though a mill in a given country might be price disadvantaged in purchasing cotton from America (due to transport costs), his competitors in the textile market will not be and therefore the price for American cotton is relevant to him. While there is no direct mathematical connection between the two pricing systems, we can see that they are connected in the international context. On the basis of market indicators (e.g. price), many farmers make their cropping choices in advance of the season and their reactions tend to be predictable. For example, the world reaction to the price rises in the 14 2003/2004 season was to increase the area planted with cotton in order to benefit from the increased prices. However, this reaction was not based on a rationale decision process, mainly because it was not in line with the fundamentals. What the fundamentals of the time showed was that, while consumption is increasing at around 1% annually, production is largely keeping pace with this and also there are still large stocks of cotton being carried over at the end of each year. It was true that the price of oil had increased and that further instability in the Middle East was causing the price of oil to remain high (which directly affects the price of man made fibers). However, the market had already adjusted to take into account these fluctuations and the world stocks of man made fibers were of sufficient size to enable manufacturers to assume some of the extra replacement costs in the short term. The actual reason for the 2003/2004 price hike was bad weather during the season and at harvest—what we were effectively seeing was a “weather market,” not a move in price based on fundamentals. The net effect, of course, (in the absence of another weather market) was a drop in price for the 2004/2005 season, but this time based on the fundamentals (increase in supply in the face of relatively inelastic demand). In the above example, we have shown how a market has reacted to changes in various parameters and how this has had a negative effect on producers (largely due to their own mistaken decision making process). This consideration of the various market parameters and assessment of the impact that it will have on the market is termed as having a “market view”. The importance of an informed market view is that it enables producers to take rational and educated decisions in advance of the growing season. The author’s long term market view at the moment is based on the following fundamentals: a) consumption of cotton is likely to increase over time b) that the world’s population will continue to increase c) that the cost of oil is likely to increase or stabilize around the USD 50/barrel level d) demand on agricultural land for the production of food stuffs will increase e) farm subsidy systems practized by Europe and the USA (amongst others) will be reduced The market view that flows from these factors are that there is long term strength in the current market price, with a medium term tendency to the higher side. Market sentiment is tight at the moment based on supply and demand factors and therefore any short term change in supply (e.g. bad weather) or demand (e.g. economic slowdown in China or revaluation of their currency) would have a strong effect on the market price. What this means is that we are likely to see quite high price volatility on an annual basis. The main threat currently to medium term prices comes from a global recession and the unclear status of the international textile market so soon after the Multi Fiber Agreement. Given this market view, producers in developing and transition countries would be best advised to concentrate on increasing the efficiency of their growing operations, maximizing their yields on reduced hectarage, improving the quality of their baled cotton and methods of marketing, as opposed to increasing the size of their cotton planting. In fact, the best way to hedge their price risk in the face of potentially volatile markets would be to reduce area (while increasing yield) and diversify into other non-related commodities. 2.9 Marketing Cotton is perhaps one of the most complicated commodities in the world to market successfully. In other commodity markets, the tendency in the past 50 years has been for end users to purchase increasingly from producers, with a subsequently decreasing role for traders. Examples of this can be seen in the development of supermarkets’ outsourcing and extremely active metals exchanges (especially in Europe). In the cotton sector, however, traders still play a pivotal role, especially in the marketing of cotton from developing and transition economies. The reason for their continued role is the existence of high transaction costs—ones that end users are prepared to pay a premium to avoid. Of course, this is not to 15 say that traders do not play an important role, but it highlights the necessity to minimize transaction costs and therefore strengthen the connection between end users and producers. Examples of transaction costs are uncertainty in delivery times, inaccuracy in quality certification, lack of bale by bale classing and sale, opaque marketing systems, transport difficulties and overly bureaucratic export procedures. Firstly, let us explain the nature of the demand profile from the textile sector. Cotton has many quality parameters (the main ones being color, trash content, strength and fineness) and they all affect the efficiency and therefore profitability of a spinning/textile mill. For example, if the strength of the cotton is low or variable there will be a high number of breaks on the spindles in the spinning room, reducing efficiency dramatically. The problem for end users is that the price of cotton which is of high quality is very high, which means that the resultant yarn is expensive. In order to minimize costs, the vast majority of end users mix different types of cotton together to produce their yarn/textiles (trying to maximize the use of cheaper cottons). Given this use of different cottons, end users rely on traders to supply them from a number of origins. However, the advantage for producers of cheaper cottons is that end users tend to purchase these cottons in relatively large volumes and so there is the ability to supply them directly. Within each different type of cotton, the most important factor for end users is uniformity, i.e. that each bale is of a consistent quality for each parameter. The reason for this is that the mill is adjusted to operate within certain given parameters and if the cotton is not of even quality, then the operational efficiency of the mill will decrease (and costs will therefore rise). The role that traders play here is that they ensure that they deliver to the mills parcels of goods that are of even running quality. Cottons from developing and transition countries all suffer from one problem and that is that their cotton is not of even running quality. This is due to the way in which cotton is grown, handled in seed cotton form and ginned. If this problem can be overcome, then end users will start to purchase and source direct from origin. One of the reasons for decreasing participation of traders in developed countries has been the increasing size and sophistication of cotton farmers. Corporations such as Boswells in the USA now farm thousands of hectares of cotton and have entered into direct contracting relationships with major textile concerns throughout the world. Due to the size of their operations and their ability to control the timing and quality of their production, they are able to offer end users the type of service that enables direct relations. Where the land holdings of farmers are smaller (for example in Australia) and therefore production lower, farmers tend to work together in marketing their cotton in what is termed a “pool”. As opposed to selling their cotton to traders as a principal, these cotton pools enter into agency agreements with traders, who act as their sales agents. In this situation, the traders receive a percentage of the value of the final sale to an end user. The advantage of this form of marketing is that it enables farmers to enter into a reactive relationship with end users and they are therefore much better able to assess and reply to changes in demand. It should be noted that the farmers in the pool operate individually and therefore there is no shared responsibility either at production or marketing. Effectively they pool their production so that they have parcels of goods of sufficient volume that they are able to service one or a number of end users. The most successful mass marketing tool that has developed for cotton is the baled cotton auction system. The best example of such a system is the NYCE, which is now a highly sophisticated market, involving the sale of not only physical bales, but also futures contracts, options, swaps and other cross market derivatives (which we shall discuss briefly below). In its simple form, a cotton auction is a place where a large number of sellers are able to access a large number of buyers in a transparent situation and where there the open competition amongst buyers ensures maximum sales prices. The advantage for buyers is that, while farmers may be fragmented by number and over a large geographical area, their production is brought to one point of sale—the auction. This means that buyers do not have to spend large amounts of time and money traveling around and sourcing cotton from a large number of sellers (a major transaction cost). 16 In order for an auction or exchange system to operate efficiently, it is crucial that the quality and availability of parcels of cotton that are offered for sale are dependable. While this is ultimately the responsibility of the seller, the confidence of buyers in the auction system is dependent upon it. Therefore, any auction has to introduce stringent physical and monetary sanctions on parties using the auction that are applied if they are found to be in breach of a concluded auction contract. While NYCE is the leading example of a fully developed cotton auction system, the leading example of a developing one is the Commodities Exchange system in Turkey. Although this started out as merely a quotation forum (i.e. a place where the prices of cotton sales were reported, not concluded), its use as a marketing platform is increasing. Many traders and end users now purchase Turkish cotton from the exchange, as opposed to concluding contracts directly with farmers. The reason for this is that they have a higher degree of confidence in performance of the contract if they conclude it through the exchange (because the cotton clearly exists and they have financial protection through the exchange which they cannot achieve via the Turkish legal system). Another advantage of an auction system is that it leads to the creation of a truly indicative price for cotton from the relevant origin. As we have discussed above, the problem for developing and transition countries is that the price for their cotton is based on reported offer and bid prices, which may or not be accurate. The further problem is that, in order to relate these prices back to non-CIF delivery terms, they have to make theoretical deductions. This is a very inaccurate method of relating prices to the reported market price, where higher demand from certain points of delivery may actually mean that these deductions are not applicable. For example, the rough cost of transport to Russia for Central Asian cottons is in the region of USD 80/MT. However, the general sales price in the Russian market is USD 40/MT (or lower) off the “A” Index, which would indicate that the discounts at which the cotton is being sold may be in the region of USD 20 to 40/MT too high. Sale through an auction system would result in a price truly indicative of the demand in the Russian market. As we have mentioned above, the trend in other commodities markets is for end users to enter into direct purchasing relations with producers. This is also true in cotton, but has only begun to develop in the past five years or so. Several major international textiles companies (IKEA, for example) are trying to enter into production agreements with cotton producers in order to improve dependability of delivery and quality. There is no doubt that this will be an increasing trend and will involve production agreements and increased use of auctions (where they are available). A specific area of marketing that is likely to develop for transition and developing countries is with “Fair Trade” goods. These are marketing initiatives based on the procurement of produce direct from producers in such countries (at prices higher than they generally receive from the mass market) and then sold on this basis in developed countries. The transactions are generally handled by NGO and non-profit making organizations. Generally these products are more expensive than traditionally sourced goods (due to lack of economies of scale and higher transaction costs). However, consumers in developed countries are prepared to pay these premiums as they believe that they are helping to benefit producers in developing and transition countries. To date, the main developments in fair trade products have centered on cocoa and coffee. With the help of the international development community, it is hoped that other commodities (such as cotton) could also be brought within this system. 2.10 Price Hedging/Risk Management The ability of a farmer to manage his market risk (from planting to sale) is an integral part of his sustainability over the medium to long term. In its most simple terms, this is achieved by reserving profits in good years to cover cash shortages in the bad years—a simple approach to price stabilization. 17 Successful examples of such price stabilization funds have been achieved through the operation of farmers’ groups in Benin and Burkino Faso. In countries where there are stable land markets or sound banking institutions with low inflation, the farmer may decide to either invest in land or place such monies on deposit. Of course, where a farmer has a land parcel of suitable size, they are able to hedge their seasonal risk through diversification of crops and holding livestock. However, the drive by farmers and end users to manage their related price risk has led to the creation of futures markets. Effectively, if a farmer knows his costs of production, he will seek to sell a volume of cotton equal to his costs (as a futures contract) in advance of delivery. In the absence of organized, traded futures markets (as discussed below) many producers attempt to achieve the same result through the forward sale of their crop at a determined price at the beginning of the season to a seed cotton or baled cotton off-taker. This practice of forward sales outside of a futures market is regularly practiced throughout Western Africa. With his price locked in, at least the farmer knows that he will not lose money in that season (his cost having already been covered). If the market rises or falls after this point, the market movements will merely affect the amount of profit that he makes. For an end user, they have to conclude long term sales contracts in advance of delivery of their cotton. This leaves them with a major risk in pricing their contracts and therefore they would prefer to lock in the cost of their cotton as soon as possible. Given this interest, sales of futures contracts were introduced on the NYCE. In modern exchanges, negative movements in the values of futures contracts are managed by the payment of what are referred to as margin calls. Future contracts are not expected to be honored until they mature. However, if the value of the contract falls over time, the lost value is covered by the purchaser with the margin call (the difference of the two prices). Since its original inception, the futures market has become ever more complicated with the development of a large number of products now available at the exchange. The most notable of these are the use of options (calls and puts), which are basically the sale (or purchase) of the right to sell or buy a cotton contract at a given price. The best analogy for options is the insurance market, whereby people purchase insurance to cover their risk in the situation where a certain event occurs. In the case of options, there is a cost which is similar to an insurance premium, in that the cost of it is dependent on how likely a price move is. The advantage of options, as opposed to futures, is that all a buyer (or seller) needs to do is to pay the premium and is not required to make margin calls (which can amount to several million dollars depending on the size of the transaction and the change in the market). For buyers and sellers of American cotton, NYCE and its futures/options market is a “perfect” hedging tool. This means that the commodity which they are buying or selling is replicated by the contracts that are available at the NYCE. NYCE is also a viable management tool for Australian farmers, as their cotton is priced according to NYCE and based on the same quality standards. For parties involved with other growths, NYCE is an “imperfect” hedge in that their cotton is sold according to a different pricing structure and often according to different quality standards. The other problem for these parties is that the currency in which they trade the cotton or incur costs of production is not US Dollars. This latter problem can be overcome by the use of currency hedging markets or by cotton derivatives (which are futures contracts based not only on the change in the NYCE price, but also in relation to the base currency). This latter option is only available to farmers or traders operating in freely convertible and internationally traded currencies. For traders in non-US cottons, NYCE can be used as a price risk management tool and this is known as “basis trading”. The general principal here is that when a trader fixes the price of his sale or purchase, he takes a futures or options position to lock in his basis. In this situation, the basis is the differential between the price at which he bought the cotton and that which he has sold it for. Due to his position on 18 NYCE, a rise or fall in the market will be countered by the option or future and he has therefore managed to guarantee his profit level, even though one part of the transaction may not have a price fixation (which would normally leave him with a market risk). 2.11 Organic/GMO cotton As a global growing phenomenon, the production of organic and GMO crops deserves consideration. The production of organic crops has its main concentration in the production of food stuffs. Its popularity with consumers is based on the perceived health benefits that come from eating food products that have not been treated with chemicals and that have been grown and harvested “naturally”. While cotton is obviously not a foodstuff, the branding and marketing of organic cotton textiles and clothing is based on a niche market. Consumers, who are prepared to pay a premium for the product, do so on the basis that they are consuming products that have a less harmful impact on the environment, not that they benefit from any intrinsic health or lifestyle changes themselves—the altruistic principle. While farmers can benefit from an increased price for organically grown cotton, they do face a very large number of problems in attempting to do this. Firstly, to be able to obtain organic certification for their land (and hence for their cotton), a period of at least five years must pass without the farmer using any chemicals or pesticides on his crop. The negative impact on yields is dramatic and the farmer also faces much higher risks of total crop failure (possibly due to pest infestation). The main problem for the farmer is that, during this five year period, he suffers from low yields, yet cannot benefit from a price premium because his land has not received organic certification. Secondly, once a farmer has achieved organic certification, he is only able to sell to a very limited market in order to achieve his price premium—a market where his bargaining power is very low. Of course, he can sell to the general market, but will only receive a normal price and will therefore suffer losses (due to the decreased yields). Thirdly, while a farmer may receive a price premium at the farm gate, the total profit in the value chain is clearly not spread evenly amongst the various participants in the supply chain. Typically, a farmer may be able to sell his organic cotton at a 100 to 150% price premium, but the final textile is generally sold at a 600 to 800% premium. Despite the above problems, growing organic cotton in developing and transition countries may well be a viable and attractive option. The reason for this is that, in many countries, for economic or financing reasons, chemicals and pesticides may well have not been used for several years (although there are potential pollutants still existing in the soil, e.g. DDT). In such a situation, soil sampling will clearly demonstrate this and therefore the registration period may be lessened from five years. Added to this, due to the current existence of low yields, the introduction of organic practices may well not lead to large falls in yield. The price premiums available, therefore, would not be heavily discounted against yield losses. The use of GMO seeds has been the cause of enormous controversy throughout the world. To date, there is no clear evidence whether there are any adverse effects to health from the use of GMO seeds in the food chain. However, the valid counter argument to this is that insufficient time has passed for such negative impacts to become evident. There is little doubt that the yield potential of GMO seeds is much higher in many crops and the use of GMO pest resistant strains can have clear impacts on crop losses due to pests. As we have mentioned above, cotton is not a food product and therefore many would argue that the potential danger of using GMO seeds is therefore negligible. In fact, many countries have started to introduce GMO cotton seeds and have seen enormous increases in yields. It is estimated that 26% of the world cotton area will be sown with GMO or biotech cotton varieties in 2005/06, which will account for about 35% of total world production (Figure 11). In Brazil, they have seen almost a 200% increase in yields in the past 10 years, the majority of which is due to the introduction of GMO seeds types. India has 19 seen yield increases in field trials of up to 400% and currently 5% of their cotton area is sown with GMO (although this is expected to double in the 2005/06 season up to 1 million hectares). World cotton area - Biotech share 25% 20% 15% 10% 5% 0% 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 Figure 11 - Biotech cotton share of total world area However, despite the potential benefits from GMO cotton, caution is clearly necessary. It is obvious that the potential ecological imbalance that might result from GMO crops cannot yet be assessed. The impact of possible cross-pollination with other crops in agriculture is a real threat, even when one is considering non-food crops such as cotton. More importantly, by-products from cotton seeds are used as a major source of protein and feedstuffs, especially in the livestock sector. In areas of the world such as Central Asia, it should also be noted that it is still common practice to use cotton seed oil as an additive in traditional dishes and therefore GMO cotton is intrinsically linked with the food chain. 2.12 Textiles The development of domestic textile industries throughout the world over the past 50 years has seen a general trend of production swinging its concentration to the Far East and Asia, away from the traditional manufacturers in the European and Western markets (its traditional centre from the times of the Industrial Revolution). This swing in production and processing has largely been due to rising labor costs and the strengthening of labor trade union movements (which used political pressure to improve workers’ conditions and therefore the increasing the costs of manufacturing). Up until the 1980’s, the major increase of production in the Far East and Asia was in low to medium quality textiles, with high quality processing and textile finishing remaining in the West. However, since the 1980’s, high end production has also moved to the Far East, normally accompanied by foreign direct investment (FDI), with Western manufacturers creating offshore subsidiary companies in the new manufacturing markets. It should be noted that this manufacturing is not only differentiated between high and medium/low quality, but also specifically between the yarn/textiles and finished garment markets. The former market is the most competitive, with processing occurring throughout the Asian region and the latter having started to become more competitive in the last 10 years, as quality control has improved. The most important thing to note about the development of domestic textile industries throughout Asia is that they were often not simply based on simple competitive advantage. The existence of international 20 trade quotas and bi-lateral trade agreements (based on political considerations) has been at the very heart of the development of many textile sectors. For example, the dramatic increase of textiles production in Vietnam and Cambodia in the past 20 years, partly due to the cheap cost of labor, was mainly connected with the interest of various countries with the economic strengthening of these economies. It should be further noted that, while textile quotas could be regarded as trade protectionism, for those countries which had quotas, it effectively gave them guaranteed sales markets and volumes. Therefore, one can argue, their development of textile industries was not necessarily based on sustainability or competitive advantage. Some countries, on the other hand have been very successful in developing their textile sectors on relatively sustainable principles. For example, India and Bangladesh have managed to create strong textiles sectors based on domestic and imported cotton processing. Here they have managed to build on their domestic advantage of being cotton producers, but also benefited from their strategic freight position (on the west to east container routes). Whilst it is true that they initially introduced tax incentives and preferential rates for some inputs (such as electricity), the continued existence of these incentives has not been integral to their continued competitiveness. However, the fundamental nature of the international trade in textiles has now dramatically changed. In January 2005, the system of textile quotas was removed by the EU and the USA and now trade is considered to be “free”. While many herald this as a breakthrough for free trade, countries currently considering development of a domestic textiles industry should be extremely wary. If a country like Cambodia (which has a well established textile sector) is worried about losing up to a million jobs in the textile sector because of the removal of quotas, there is clearly cause for concern. The basis of this concern is multi-faceted, but there are two main contributing factors. Firstly, manufacturers, in those countries that have already developed their textile sectors, have already made their capital investment and, in large part, have depreciated their assets already. This means that their basic costs of production will be much lower than any new entrant. For example, a modern spinning mill costs in the region of a minimum of USD 10 million. Based on a 10 year depreciation of the asset, this means that the processor has fixed costs of USD 1 million per year based solely on depreciation. Processors in the other markets, while they will have to undertake slightly higher costs in repair and maintenance of their older assets, do not have to cope with such depreciation. Secondly, the question remains as to how “flat the playing field is” and to what extent the post-January 2005 situation is actually based on free trade. While there is total disagreement about whether China is subsidizing cotton, one thing that has to be borne in mind is the relative undervaluing of their currency versus the US Dollar. It is clear that this enables them to literally swamp export markets and can also be noted in the expansion of their textile sector. Despite negotiations between China and various international institutions and governments, it is not clear whether this apparent advantage will be negated by a revaluation of the Chinese currency in the immediate future. Another matter that has to be considered is that there is unlikely to be any change in the American Farm Bill at least until 2007 (when it is next due for review). Due to the structure of the Farm Bill and the export (Step 3) program, the practice of cheap American cotton being exported on preferential credit terms is likely to continue for the foreseeable future. The net effect of this is that countries benefiting from such exports will have an arguably “unfair” competitive advantage over those who are attempting to develop domestic textile industries based on their perceived competitive advantages (such as domestically produced cotton). III. Linking Performance and Outcome Performance of cotton sectors globally vary quite a bit depending on a number of output and performance criteria, such as profitability, sustainability, investment and future competitiveness, contribution to 21 poverty reduction, and the capacity to evolve and adjust to the world cotton market. Figure 12 represents a visual representation of performance levels based on the abovementioned criteria. Countries are mapped according to the main features of their cotton sector. The horizontal axis is a measure of the degree of liberalization and competitiveness in the sector, while the vertical axis measures the degree of autonomy of farmers. The countries are positioned on this graph according to the two above mentioned criteria, i.e. (i) the degree of liberalization and competitiveness in the sector (conversely, the degree of control by the state and public entities), and (ii) the degree of autonomy of farmers (“ independence”) in the decision-making process. Each country is represented on the graph by a bubble and a two-letter abbreviation for his name (BF: Burkina, AUS: Australia, TJ: Tajikistan, etc.). The abbreviations for country names are given in the graph’s legend. Tentatively, the size of the “bubbles” is proportional to the current volume of cotton lint exports by the given country. According to the nature of the x-axis, one can see a gradient from right to left with the different organizational models that were described above: state-run and public companies, mixed companies (cotton companies or marketing boards), concessions, free contracting with fully open and competitive system. Some country strategies have been or are currently evolving. They are represented by an arrow. In this graph, countries fall into four quadrants: (a) Upper right quadrant: the “good performers”, i.e. countries that are leaders in cotton production and exporting (Australia, Brazil), with high yielding profitable farms and a dynamic private sector-led cotton sector. The US could be mapped to this category a few years ago but today they have been moving massively to the left on the graph, in the sense of becoming uncompetitive and requiring state involvements through massive subsidies. Greece is also an interesting case. (b) Upper left quadrant: the “slow movers”, i.e. countries who have improved over time their cotton sectors performances (Burkina, Zambia, Cameroon) by opening their cotton sectors – formerly state managed – to the private sector and allowing a limited degree of competition. (c) Bottom left quadrant: the “sleeping giants” i.e. countries where the historic model which has made the success and expansion of the sector for decades (Mali, Uzbekistan) has failed o adjust and puts today the sector in a very fragile, and unsustainable position, with threats on its future competitiveness by lack of private sector, capital investment and technology improvements. A nuance must be brought for Uzbekistan who seems to be engaging (d) Bottom right quadrant: the “wild guys”, i.e. countries where reforms have been carried out too quickly, without putting in place the necessary regulatory framework (Ghana) and/or without enforcing it (Benin) It is clear that outcomes and performances tend to improve consistently when one moves from the lower left of the graph to the upper right, indicating that there is a fairly high correlation rate between outcomes and performances. One can take this analysis one step further by remarking that the closer the country from the median, the better the performances and outcomes. One of the main conclusions that can be drawn from this analysis is that indeed the sector’s structure is linked to and can explain to a large extent the performances in the cotton sectors. In addition, some key lessons can be drawn across country situations and experiences. They are summarized below. 22 3.1. What works? Successful cotton sector models tend to have some or all of the following characteristics: • Individual farms/farmers controlling their assets and able to make economic decisions • Strong and representative farmers organizations • Professional operators (often J/V with international companies), bringing capital and technology • Legal/regulatory framework, existing and enforced • Producer price setting formula (when farmers sell their seed cotton) • Competition, but with rules of entry • Government focused on key functions • Transparency and accountability 3.2 What does not work? Cotton sectors in crisis or recession, or clearly unsustainable (economically, socially or environmentally) generally tend to have some or all of the following characteristics • Lack of a fair and predictable pricing system for farmers • State involved in production/ginning/selling activities • Producers lacking ownership and empowerment • Arrangements lacking transparency and political interferences • Lack of competitive pricing of inputs, ginning and financial services 23 AUS: Australia FIGURE 12: MAPPING OF COTTON MODELS BF: Burkina Faso BN: Benin Independent farmers BR: Brazil CM: Cameroon GH: Ghana GR: Greece ML: Mali AUS MOZ: Mozambique TJ: Tajikistan TZ: Tanzania USA USA: United States BR UZ: Uzbekistan GR ZB: Zimbabwe ZM: Zambia BF ZB CM TZ ZM State Competitive Control Model ML BN MOZ UZ TJ GH Dependent Farmers