Unbalanced International Coffee Market. Analysis of Global Market, and Outsourcing as Potential Sustainable Solution

Transcription

1 Patrick J. Nduwimana University of Arizona MAP 535 Fall Unbalanced International Coffee Market Analysis of Global Market, and Outsourcing as Potential Sustainable Solution ABSTRACT: For most countries in tropical and sub-tropical regions, coffee is the most valuable export commodity. It is a major source of revenue and foreign exchange for governments and their people. In the western world, coffee is one of the most consumed beverages, and the second most traded commodity after crude oil. However, its market is far from being perfectly competitive. There is generally over-supply of green coffee on the world market, and producers are greatly exposed to numerous risks. Besides producers and consumers, there are intermediary agents who play a determining role in the pricing mechanism. The purpose of this paper is two-fold. First, I will analyze the reasons for this market imperfection, the role of the intermediary agents, and the challenges facing producers and potential new market actors. Second, this paper will attempt to suggest a series of simultaneous actions that would foster the technology transfer and outsourcing of processing activities as sustainable solutions to correct this market s imperfections. I. Introduction: Scope and Motivation Coffee is the world s second most valuable commodity after oil. Its importance stems from both the volume of its trading, and the impacts it has on producers and consumers. According to the Fair-Trade Foundation s report (2002), from the producer to the final consumer, coffee can change hands up to 150 times, most of which accounts for paper trade. It also states that an estimated 160 million people are involved in activities ranging from growing, processing, transporting, trading and retailing of coffee for their livelihood in developing countries. Coffee is grown in more than 50 countries in tropical region and sub-tropical region all across the globe. Since coffee cultivation is labor-intensive, it constitutes a considerable source of employment for millions of rural residents most which would turn to subsistence agriculture or illicit

2 drugs (Case of Columbia, Fair-trade report, 2002). Moreover, over 6 million tons are exported each year to the consuming nations generating $8.7 billion for exporters. Coffee not only has a remarkable impact on international stage, but also it has a more far reaching impact on most producing countries. They rely on its proceeds for foreign exchange in addition to its contribution to the job market. According to the Oxfam report (2000), coffee accounts for 80% of total export for Burundi, more 50% for Ethiopia and Uganda, 43% for Rwanda, and more than 25% for the south American nations of Nicaragua, and El Salvador, and Honduras (Oxfam, 2006) From a political economy standpoint, coffee production has far reaching implications on policies regarding the social and economic well being of many producing nations.

3 For countries that rely on few or single export commodity, their ability to import and develop consumer market goods depends largely on revenues from export of that commodity. Accordingly, in order to deliver the desired high quality and quantity to consumers, producers must perceive a profit that allows minimum acceptable living standards. Unfortunately, millions of growers of coffee continue to produce for subsistence despite that they produce high-valued commodity. For lack of alternative cash crops, they increasingly continue to produce and supply to the market at the rate higher than demand. As a result, the producer-price and quality of coffee declined. While the producer and consumer utility has continuously decreased, few roasting companies has prosperously strived and continue to make big profits. In the following (section II), I will discuss the dynamic role played by of coffee-roasting companies on coffee market. Section III will discuss the trends of supply and demand of coffee market. In section IV, I will conclude and give recommendations for potential solutions to the problem presented. II. The Middlemen: Big Coffee Roasting Companies In the game of coffee trading, the major players are not just the producers and growers. Major roasting companies such as Sara Lee, Proctor and Gamble, Philip Morris, Nestle, Kraft Jacobs have established a reputable place in the field of coffee trading--these companies accounts for more than 50% of coffee consumed in the western world. The major roasting companies also constitute a bridge between producers and consumers and that bridge has become a determinant for the difference between prices received by producers and prices paid by consumers.

4 Price indicators of Green Coffee and retail price of processed coffee Prices in US cents/lbs of coffee Internati onal Prices Indicator U-K Retail price year The puzzling question is: Why are the retail prices (related to prices paid by consumers) so high and increasing, while the international indicator prices (directly related to prices paid to growers), stay low and take a decreasing trend. A possible answer to this question is that, unlike producers, these companies can take better advantage of the development of technologies. These large companies have built trading schemes that allow them to make profit regardless of variations in coffee production and price fluctuations through the futures market. II.1 Futures market Traders usually protect themselves through the futures market mechanism. The international price indicators which serve as benchmark for what producers receive, are determined at New York Stock exchange and London, where transaction take place in form of commodity futures between parties who don t possess the actual physical goods. This form of market system permits the big players such as the aforementioned roasting

5 companies to protect themselves through hedging (a mechanism whereby one can balance futures purchases or sales in an exchange against an equal and opposing commitment in the real physical good). For example, the system of forward sale (agreement to buy or sale a good at a pre-agreed future point in time) allows the traders to gain or loose independent of availability of the actual good at the time of transaction. Since the trade date and the delivery date are separate, so much can happen, but only producers and consumers can be affected. Examples can be seen during the coffee market s collapse, and the 1997 Brazilian coffee frost. The retail prices don t follow the same trend as prices indicator prices (see graph above), and that put producers at greater risks A large portion of coffee trade, takes place in form of paper trade. Accordingly, the big companies can protect themselves from risks of price fluctuations. An estimated, 90% of coffee trade is in papers, and only 10% remaining is for the physical coffee exchange, according to the Fair-Trade Foundation s report (2002). The development of information technology, electronic trading, and satellite weather monitoring, has stimulated a faster pace of trading and speculation. The market activities are concentrated in the hands of few big roasting companies, while the burden of cost and exposure to risks of market fluctuations, weigh on grower. II.2 Producer s vulnerability So much can happen in the real world that affects the physical goods (coffee), from which the poor producers have no power to protect themselves against. Here is a case of Burundi (not an isolated case) illustrating the causes of stagnation of quality and productivity suffered by poor growers, according to Ndayikengurtse (2000): 1. Natural disasters (Droughts, excessive rain, Hurricanes, diseases).

6 2. Lack of sufficient funds 3. Lack of input due poverty worsened by social unrests, and epidemics. 4. Macro-economic policies (Exchange rates, pricing policies determined by governments and politicians) 5. The plant itself (coffee tree) has life time for adequate productivity (4-25years) It is easier to understand how a natural causes, social unrests and epidemics affect coffee productivity and commercialization. However, it requires an analytical mind to sketch the effects of macroeconomic policies on coffee. It is harder because these policies are often regarded as indirectly correlated to production. They nonetheless directly affect commercialization of coffee as an export commodity. II.2.1. Exchange rate Lets look at the effects of exchange rate for instance. For illustration, we can use the example of Burundi where the peg exchange rate has been historically low and suddenly the value of US dollar doubled from 388 FBU to 633FBU, within a single growing season of Real exchange rates in Burundi Equivalent of a US$ in Burundi local currency Real rate Years

7 Coffee in Burundi is almost exclusively cultivated for export. Only approximately 1% of production is consumed locally. As Barkan (1994) wrote, over-valued exchange rate negatively affects producers of exportable goods, while acting as subsidy for importers. When devaluation takes place, only those with pre-agreements makes profit. Generally in countries like Burundi, international prices are set in dollars, but growers are paid in national currency at a price determined by the government. When the national currency is overvalued, the producers of internationally traded goods receive few units of local currency for a given amount of good produced. For instance, if the official rate is fixed at 200 shillings for US$1, at a price equivalent to US$1 per kg of coffee, the local grower should receive 200 shillings, holding everything else constant. But, when the shilling is overvalued, and the official exchange rate (arbitrarily determined by government) is then set at 100 shillings for US$1, the 1kg of coffee will only be worth 100 shillings. In such conditions, the commodity is no longer providing the same revenue. Therefore in a long run, the incentive to invest in production and quality can vanish (Barkan, 1994). II.2.2 Pricing The main objective of a hedging mechanism is to protect parties involved in the transaction from the risks of future price fluctuations. With such shielding system, the shocks of market s collapse are transferred to producers and consumers. Table1 demonstrates two important observations. First, the price differences between countries like Kenya vs. Brazil, and countries like Burundi vs. Tanzania, are remarkable. In booming years like , it s striking that the difference reached 200%. This difference is due to liberalized systems as compared to centrally planned systems. In turn there are implications have implications on pricing and support programs adopted by governments. Some countries like Burundi and Tanzania choose

8 to treat the proceeds from export commodities as national assets, therefore extracting as much taxes as possible. In return, they should be committed to providing assistance to producers. Everything from planting to exporting is centrally planned, which explains prices received by producers that tend not to be directly linked to market prices. On the other hand, in a good year, countries like Brazil and Kenya that adopted more liberalized systems, growers receive relatively higher market values for their crops, but must also absorb the shocks in bad years. Price fluctuation the second observation from table 1. The percentage change from one year to the next is alarming in Kenya and Brazil. In general these countries have more liberal market-oriented economies. Growers of exportable commodities have choice of their production frontier and profit maximization. However, when a disaster hits or the market collapses, they absorb the full shock. Although, it is believed that they would save or invest their revenues in good times, it is hard to adjust a price drop of more than 150% from one period to the next. This has happened to Brazil growers when price dropped from US$1.56/lb in 1986 to 48cents the next year. Meanwhile, growers in centrally planned agricultural economies, never suffer from a full shock of price drop. For example, the highest price drop in Burundi never goes beyond 20%, and 27% for Tanzania. Choosing which policy path is more beneficial is a matter of politics and personal opinions which will not be discussed in this paper. Table1. Prices paid to growers in exporting Member countries in US cents per lb (Arabica) % Change from Previous year % Change from Previous year % Change from Previous year % Change from Previous year Year Brazil Burundi Kenya Tanzania

9 Source: International Coffee Organization From an international perspective, macroeconomic policies put producers of exportable commodities at competitive disadvantage in many ways. With lower marginal value of their product, they cannot cover their production cost. In an everdeclining coffee market, producers cannot make long term investment geared towards quality and quantity improvement. If they don t improve the quality and quantity, they cannot compete with other producers who perceive higher value for the same good, which put them at further disadvantage. And when there is less coffee on the market, the final consumer end up paying more for a cup of coffee. And the vicious circle is complete.

10 III. Increased Supply and Constant Demand, and exposure to Risks. III.1. Over production drives Marginal value product down In recent years, the amount of coffee on international market has increased dramatically. Brazil and Vietnam are the leading producers followed by Ivory cost, Columbia, and Uganda. Just between 1995 and 2000, Vietnam tripled its output and became the number two producer of Robusta coffee after Brazil, and it holds 10% of coffee market. Expectedly, this sudden increase of Coffee robusta drove its prices to a sudden drop. When the price of Robusta goes down, the prices of Arabica decreases as well because they are considered as substitutes. Supply demand graph.1 Price of coffee Original price Original supply curve New price New supply curve Demand curve Quantity of coffee Unfortunately, the prices of green coffee dropped from the original price, and demand remains unchanged. Producers have to supply a higher quantity of coffee for a given price. In these circumstances producer the surplus is diminished--he trapezoid area between the original price and new price become the dead weight loss. Keep in mind that, that there is a time lag between the trading date and the delivery date. The real coffee price may drop at delivery date, but the transactions have already taken place several months prior. Therefore, the trader who bought at a high price earlier

11 must now sell it at cost plus margins. In the end, the drop is directly transferred to producers and consumers either in terms of quantity or quality perceived. In the above graph above, the triangle between the original price and the demand curve remains unchanged. The dead weight loss area goes to the middlemen. Recent studies cited by café direct (2006), reveal that while the coffee market floats around $55 billions, only 8 billions go to the producing nations. Producer prices Versus consumer prices 1800 Prices of coffe in US cent per pound International Prices Indicator Price Paid to Growers (Burundi) U-K Retail price years III.2. Global events that accelerated the imbalance This unbalanced market structure prevents consumers from paying the optimal price and put producers at greater risks, meanwhile it benefits the middlemen. Two major events can explain this unbalance. 1. Prior to 1989, there was a quota system that was established with the purpose of protecting and stabilizing the coffee market. The system was later abandoned

12 due to the pressure from the emerging powerhouses, such as Brazil and Vietnam. Unfortunately, due to geographic location of most producers which causes seasonal synchronization, coffee is often time ripe and harvested at the same time. This phenomenon put producers at great risk because they must sell as soon as they harvest. On the one hand, the buyers (roasting companies), and traders can take advantage and buy at the lowest price when the market is then flooded all at once. On the other, they can sell to final consumes when the market is auspicious because those companies have the ability to process and conserve coffee. 2. The pressure for market-oriented and structured economies from World Bank and other sponsoring institutions has permitted an increase in coffee and other exportable agricultural commodity supply. However, it has arguably exposed producers to greater risks (Fair-Trade 2002). Liberalized economy means crops are no longer managed through central planning. This liberalization would be essentially good in a perfectly competitive and stable market. It would allow growers to play an active role, take responsibilities, and maximize their revenues for their crop. Unfortunately, the coffee market is not perfect and risks too harmful for growers. They are exposed to price fluctuations, and the possibility of total absorptions of all shocks when the world prices collapse (Fair-trade, 2002). III.3 Can this imbalance be corrected: The new market trends There have been numerous attempts to correct the skewed price distribution of coffee. The most notable is the establishment of the Fair-trade program. This program is designed to give producers of export commodities opportunities to sell their product at reasonably higher prices. This has had promising results and has potential to change the market s trend. For instance, Proctor and Gamble has agreed through its millstone

13 project, to sell Fair-trade coffee and guaranties a minimum price of US$1.26 instead of US$.52 per pound that would have been paid to growers in Moreover, many national governments are adopting market-oriented economies that allow growers and exporters to reap what they sow. Fair-trade trend is especially good because it opens doors new participants in the market. Small roasting companies are able to buy directly from producers, thanks to adoption of market-oriented economic policies. Although these new development are leading in the right direction, there are still many corrections need to balance coffee market. A series of policies and actions should be simultaneously deployed from all major players. IV. Conclusion and recommendations Coffee is produced in tropical and sub-tropical regions of the world. Coincidentally, these regions correspond with the poorest regions, whereby production of agricultural export crops is rather an absolute necessity for the economic and social stability of the producing nations and their people. In an unstable market for coffee, compounded with imperfect market structures, producers of such a high valued, laborintensive commodity are not able to optimally benefit from it. Consumers in the western world who praise coffee for its taste and stimulating qualities continues to pay high prices, leaving the big roasting companies and traders, as the sole profit maximizers. International market liberalization, as well as restructuring of the economies of producing nations is arguably good steps forward. These measures alone however, lack the capability to correct this market imperfection. In order to effectively make a difference, these measures must be accompanied but proper economic policies. These policies should give a competitive edge to growers and allow their countries to attain

14 higher levels of prosperity by trading the goods they produce efficiently for the goods its people seek to consume (Barkan 1994, p.133). Governments and major multinational organizations such as the WTO (World Trade Organization), IMF (International Monetary Fund), World Bank, ICO (International Coffee Organization) should take more proactive roles in insuring a more competitive market structure. The World Bank and the IMF who are the major sponsors for development projects in producing countries should synchronize their efforts with the WTO to insure the implementation of non-distorting macroeconomic and pricing policies. WTO, ICO, and the majors coffee buyers (roasters) should work to guaranty a fair and competitive market from the farm to the retails stores. The ICO and major market players could expand this coffee market in ways that could increase both consumer and producer surplus in various ways. First, it should be the priority for ICO to boost consumption of coffee in producing countries. Today, less than 5% of the world s coffee is consumed in the tropical regions where it is produced. ICO can promote investment in processing facilities at production points. According to FOA (2004), the top ten coffee-producing developing countries' share in green coffee exports remained unchanged at about 67 percent between and , but their share in roasted coffee declined from 8.5 to 1.8 percent during the same period. Not only will local processing operations make coffee affordable for local consumers, but it will also create the much-needed employment in rural areas. This would also create a market for other consumer goods and services, and lay a foundation for economic and social stability. A more inclusive mechanism would require ICO, IMF, World Bank, and national commercial banking systems to set up a trading method where local dealers and exporters could hedge against exchange rates and disasters. This will only work in

15 conjunction with an insurance system, which will be leverage for growers and would protect them from the risks of natural disasters. This is a poreto optimum solution. It increases the utility of producers and consumer without decreasing the benefit of traders and roasting companies. All in all, there is a need for solution that takes into consideration the socio-economic well being of producers. When producers such a high-value, stimulating beverage, have sustainable living, they would be able to produces coffee of high quality and quantity to satisfy consumers. References: Fair-trade foundation, Bitter Coffee: How the Poor are Paying for the Slump in Coffee Prices Fair-Trade Foundation, Spilling the beans on Coffee Trade OCIBU (Coffee Board of Burundi) Epoch Times International, March29, 2005 Burundi: la filiere Café sera liberalisee a 100% en 2006 Joel D. Barkan, Beyond Capitalism vs. Socialism in Kenya & Tanzania Zdenek Drabek Josef C. Brada, ERAD, 1998 (World Trade Organization, Economic research and Analysis Division Exchange Rate Regimes and the Stability of Trade Policy in Transition Economies FAO, The State of Agricultural Commodity Markets (SOCO) Oxfam International Research Report, July 2006 Modeling the Impact of trade Liberalization Claudine Ndayikengurutse, La Gestion de Risque de Prix Liée à la Commercialization du Café au Burundi

16 la filière café se restructure