THE IMPACT OF UNITED STATES COTTON SUBSIDIES ON COTTON WORLD PRICES AND THEIR EFFECTS ON COTTON PRODUCTION IN ZIMBABWE

Brian Mazorodze Department of Agricultural Economics and Development Midlands State University

ABSTRACT Employing the Auto Regressive Distributed Lag Model (ARDL) and annual time series data covering the period 1980-2010, the study was mainly interested in empirically investigating the role played by United States cotton subsidies in explaining Zimbabwean cotton production as well as cotton world prices. The Policy Analysis Matrix (PAM) was used to find the comparative advantage of Zimbabwe cotton production and the results of this empirical study show that United States cotton subsidies have a negative and significant effect on cotton world prices while the correlation matrix found no correlation between world prices and Zimbabwe cotton production. However the impact was more pronounced in the short run than in the long run and the Policy Analysis Matrix shows that Zimbabwes cotton output prices are lower than social prices while the converse holds for cotton inputs. Data was obtained from the National Cotton Council of America database, United States Department of Agriculture (USDA), United States of America Farm Subsidy Database, World Development Indicators and FAO database. Keywords: Subsidy, Cotton, Prices

INTRODUCTION In a general context of declining cotton prices, USA subsidies are very often accused by non-governmental organizations (NGO) like OXFAM as well as some developing and emerging economies such as Chad, Mali, Brazil to lower cotton prices (OXFAM, 2002). Cotton is produced in more than 90 countries around the world (UNCTAD, 2012) and its market is dominated by China and USA. The former is the first producer in the world with 6.7 million metric tonnes while the latter is the first exporter with 3 million metric tonnes (Vados et al, 2004). In 2006/07, the four main producing countries were China, India, USA and Pakistan which accounted for approximately three quarters of world output and if we added Uzbekistan and Brazil, the six countries would account for 83% of world cotton production (Vados et al, 2004). Support to cotton producers has been greatest in the US, followed by China and the EU (Gillson et al 2004) and while cotton is a minor source of income in developed countries, it is a major source of income and export earnings for many developing countries (Gillson et al, 2004). The share of cotton in total exports from a number of African countries is especially high: 65 percent for Benin; 45 per cent for Burkina Faso; 42 percent for Mali; and, 34 percent for Chad and 7 percent for Zimbabwe (Gillson et al, 2004). African producers would be very competitive compared to producers in industrialized countries if the cotton market were not distorted by large subsidies (Goreux, 2004). During the period between 1980 and 1992, prior to the advent of World Bank sponsored Economic Structural Adjustment Programme, cotton producers in Zimbabwe were protected from adverse international price fluctuations through indirect government support (Cottco, undated). From 1994 to date the cotton industry has been deregulated from a state monopoly into a free market environment. Cotton is an important cash crop in Zimbabwe supporting the livelihoods of thousands of poor households (Rukuni et al 2006) and its production is almost totally smallholder driven and done under contract ginning companies (Jarvis, 2006). Approximately 30% of the locally produced cotton is consumed and the rest is exported and for this reason Zimbabwe becomes
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highly vulnerable to international prices. It contributes as much as 40 percent to total merchandise exports and more than 5 percent to total GDP. Much of the production is done in rural areas and the high dependence on cotton has important poverty ramifications especially when large price changes take place. Before 1994, the cotton market in Zimbabwe was government regulated and there were support mechanisms granted to farmers whenever the world prices were low. In this period the Zimbabwe cotton industry was protected from hash conditions from the world market. From 1994 onwards, the industry has been deregulated and there has been no longer government support a situation which left the industry open to the world market conditions. As a direct result of this together with trade liberalization, there exists a substantial need to look at how the cotton international market has affected the local market in developing countries like Zimbabwe. Thus, this paper is mainly interested in looking at how Zimbabwes cotton sector has been affected by international cotton market and United States subsidies. The United States of America has used subsidies as an instrument to boost their cotton production but this policy move has been a success at the expense of other economies, especially developing economies like Zimbabwe which do not have the capacity to subsidise their farmers. In the early 2000s, low cotton prices, combined with high support for the sector in some of the major producing countries forced some West African governments to support their cotton growers directly from the government budget, as the price of cotton on the world market fell below the cost of producing it (Baffes et al 2004). Therefore, this empirical test seeks to find the impact of United States cotton subsidies on cottons world prices as well as Zimbabwean cotton production.

Nature of US Cotton Support Cotton is one of the principal USA program crops, along with wheat, rice, feed grains, soybeans, and peanuts. U.S. farm subsidies for cotton production have averaged $3.5 billion per year (Schnepf, 2010). These subsidies come in form of direct payments; counter-cyclical
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program (CCP) payments, marketing loan

benefits, step 2 payments, and other program

benefits. Marketing loan program benefits and CCP payments are price-contingent in the sense that payments are determined by market prices falling below their respective price. The USAs budgetary outlays for subsidies are authorised by Congress every few years through various Acts known as Farm Bills. In the early 1960s, the USA storage policy aimed to reduce fluctuations in cotton prices on the world market. This policy was reformed because it did not fit with free-market principles and was expensive. As a result, the USA cotton stockpile fell to about 30 percent by 1970 and to 20 percent by 1990 (USDA, 2001). The 1985 Farm Bill replaced support managed through public stockholding with a price support mechanism known as deficiency payments. The 1996 Farm Bill marked an important stage in USA subsidy policy by introducing direct payments to producers which were decoupled from production. The Act (which encompasses all agriculture including cotton) aimed to spend US$47 billion between 1996 and 2002, with US$35 billion as direct income payments to farmers (Gillson et al, 2004). Since world prices have been lower than anticipated when the 1996 agricultural law was passed, Congress has had to make additional appropriations to prevent the price received by cotton farmers from falling below the price target of US$1.59 per kilogram retained in the 1996 and 2002 Farm Laws. The main channels of support under the 1996 Farm Bill were decoupled payments, market price payments, insurance, export subsidies and emergency payments. For decoupled payments, by signing a Production Flexibility Contract (PFC) a farmer who produced a quantity of cotton during a reference period ending in 1995 received in 1996, and in each of the five subsequent years, a payment determined by this. These were designed to compensate cotton producers for the loss of some market price support under the 1996 Farm Bill. Market price payments, which consisted of market assistance loans and loan deficiency payments, were designed to compensate cotton farmers for the difference between the world price and the loan rate when the latter exceeds the former.
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Export subsidies were made to cotton exporters and domestic end-users of cotton when USA prices exceed North European prices and the world price is within a certain level of the base loan rate. For export-subsidy payments to be made, the USA price must exceed the Northern European cotton price by more than US$0.0275 per kilogram for four consecutive weeks (Gillson et al, 2004). The objective of USA export subsidies was to bridge the gap between higher USA domestic prices and world prices, so that USA exporters would retain their competitiveness. In 2002, the USA presented the 2002 Farm Bill and government support could increase from 32 percent of average farmer income under the 1996 Farm Law to 45 percent under the new law, since the new law modifies the nature of several types of subsidies (Shurley, 2002). The 2002 Farm Bill substituted the PFC payments with a direct payment. Payments were based on historical planted area and yield rather than actual production. A farmer who has increased production in recent years receives more than one who has reduced it. Direct payments were independent of market prices and were set at US$0.15 per kilogram for 2002/03. The Farm Bill also introduced anti-cyclical measures, which were implemented when the effective price was below the target price. The 2002 Farm Bill continued to offer the loan deficiency payments which are issued when world prices adjusted by quality and location are below the loan rate. It is estimated that total direct income and price support in the USA amounted to US$2 billion in 2002/03. Review of Related Literature There is a profuse literature about the impact of United States of America (USA) or European Union (EU) subsidies on world cotton market. Numerous previous studies have attempted to measure the impact of cotton subsidies on world cotton prices and production in emerging economies and most of the research papers tend to support the idea that United States cotton subsidies are detrimental to cotton production in developing countries as well as world prices. On the other hand, models supporting that all commodity prices are liberalised, not just cotton, are not directly comparable because of both growth and relative price effects. However, the
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results do serve to provide an initial insight into the magnitude of likely impacts. Quirke (2001) conducted a study on the economic effects on Australian cotton production of the removal of all production and income assistance to cotton producers in China and the USA and found a drop in both United States of America and China cotton production, an increase in the world cotton prices and an increase in Australian cotton production. The model utilises trade and production data for 1999 and considers United States of Americas assistance to the cotton sector equal to US$0.31 per kilogram and US$0.59 per kilogram for China as one of its main assumptions. An International Cotton Advisory Committee (ICAC) (2002) World Textile Model agrees with Quirke (2001) that removal of subsidies would cause an increase in cotton prices. The Centre for International Economics (2002) simulates the effect of full liberalisation of textiles trade, as well as that of eliminating subsidies to cotton production and exports of cotton fibre. They estimate that for 2000/01 the elimination of quotas and tariffs on yarns, textiles and clothing would raise cotton prices by 4.1 percent, while the elimination of subsidies would raise them by 10.7 percent. In 2003 the International Cotton Advisory Committee (ICAC) did another study to find out the effect of subsidies on world prices. In this study they used a shortrun partial equilibrium analysis to estimate the impact of direct subsidies in the cotton sector. This model makes a number of assumptions. First, given that there is no measurement of the supply response to prices in all subsidising countries, it assumes USA elasticity for all subsidising countries. Secondly, demand response to higher prices resulting from a removal of subsidies is measured by the price demand elasticity provided by the ICAC Textile demand model (-0.05). Thirdly, a measurement of the supply response of other countries to higher prices resulting from the removal of subsidies is assumed to be 0.47. The analysis concludes that average cotton prices in the absence of subsidies would have been 30 percent and 71 percent higher in the 2000/01 and 2001/02 seasons respectively.

The Food and Agricultural Policy Research Institute (FAPRI) (2002) also examines the impact of reforms in the cotton market. The FAPRI modelling system was a multi-market, world agricultural model. The model was extensive in terms of both its geographic and commodity coverage. The FAPRI model produces world prices by equating excess supply and demand in the world market and is driven by two major groups of exogenous variables. First, policy indicators in the model can be altered for policy analysis. Secondly, the model incorporates forecasts of macroeconomic variables, such as gross domestic product, inflation rates, exchange rates and population. The cotton simulation holds these constant. The FAPRI model assumes complete liberalisation of all commodity sectors, that is, removal of trade barriers and production and export subsidies. For cotton, world prices increase by 15% over the 19 year period of the simulation, as compared with 2002 levels. USA cotton production, consumption and net cotton exports decline by 11 percent, 2 percent and 13 percent respectively. EU cotton production falls by about 79 percent and net cotton imports increase by 143.1 percent. As world prices rise, Africa increases its cotton exports by 12.3 percent above the baseline level. The International Monetary Fund (IMF) economist Tokarick (2003) uses a partial equilibrium estimate removing support for cotton and other commodities. Agricultural support is

represented by four types of measures in the model: tariffs, export subsidies, production subsidies and input subsidies. The model was used to simulate removal of each type of support. Support measures for cotton were constructed from budget data maintained by the United States Department of Agriculture. Four elasticity parameters were used: the domestic price elasticity of demand; the domestic price elasticity of supply; the import demand elasticity in the rest of the world; and the export supply elasticity in the rest of the world. Demand elasticities were assumed to be -0.75 and supply elasticities were assumed to equal 1.5. Each of the four simulations was performed on a multilateral basis and, as such, all countries were assumed to liberalise at the same time. For cotton, the model predicts that removal of price support would lead to a 0.8 percent increase in world price, and removal of production
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subsidies would lead to a 2.8 percent increase in world price. No estimates are provided for the effect of removing input subsidies in the cotton sector. Sumner (2003) did a simulation model to address the likely impact that USA cotton subsidies had on cotton markets over the marketing years 1999 to 2002. He did this by simulating what prices and quantities would have obtained had USA subsidies not been applied during those years. He compared the actual prices and quantities that occurred in marketing years 1999-2001, as well as under the 2002 baseline scenario with alternative scenarios developed under the alternative policies and found that the removal of all subsidy programs would lead to a reduction of USA production of an average of 27.4 percent (or an average of about 4.3 million bales) over the nine years presented. Over the full nine year period, removing all the subsidies would raise the USA market price by 15.2 percent (about 6.9 cents per pound), removing them during the period 1999-2002 would have raised the USA market price by an average of 15.1 percent or about 6.2 cents per pound and removing the subsidies would raise the market price by about 15.3 percent in the 2003 to 2007 period. In 2004, Goreux conducted a study to find how the USA subsidies affect the world cotton market. In his study, he used a standard partial equilibrium model of the cotton market to quantify the impact of rich country subsidies. His findings were that farmers in non-subsidising countries get the world price (pw) for their cotton while those in countries that subsidise receive the world price plus subsidy (pw+s), elimination of subsidies means that all farmers get pw, representing an initial fall in the price facing farmers in former subsidising countries and no change for others. Consequently, farmers in former subsidising countries produce less. The change in production in each country represents a movement along its supply curve from Q to Q and can be calculated using the relative change in price (pw/ (pw+s)) and the price elasticity of supply (s). Changes in individual countries can then be added together to give the total leftwards movement of the world supply curve (from Q to Q), reflecting the fact that some production in former subsidising countries is effectively withdrawn from the market.
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Traore (2007) also used the Autoregressive Distributive Lag model to find the impacts of USA subsidies on world cotton Prices. He used the structural model which allowed him to consider all the driving forces on a specific market (supply, demand, stocks...) and equilibrium conditions. In his study (Traore 2007) found strong evidence of negative impact of subsidies on cotton price both in the short run and in the long run.

Clearly, literature review has shown that most of the studies used partial equilibrium models, general equilibrium and econometric models. Partial and general equilibrium models try to answer the question; what would have happened if all the subsidies were removed? In contrast, an econometric approach will answer the question of statistical significance and causality between subsidies and the world cotton price. This approach gives more statistical and comprehensive results and for this reason was adopted in this study. The Model The Auto Regressive Distributed Lag Model (ARDL) approach was chosen over the Ordinary Least Squares (OLS) and Maximum Likelihood technique because of its advantage of yielding consistent estimates of the long-run coefficients that are asymptotically normal irrespective of whether the underlying regressors are I(1) or I(0) (Pesaran 1999). The Auto Regressive Distributed Lag Model (ARDL) for this study can be more specifically written as; Wpt = 0 + 1Wpt-1+ 2USSt + 3USSt-1 + 4USSt-2 + 5T + 6 Polt + 7Polt-1 + 8GDPt + t 1

From the above equation, the right side consist of the fundamentals which affect cotton world prices where Wp represents world cotton prices, USS are the United States subsidies, T is the time trend reflecting technical progress, Pol is the price of polyester while GDP is the gross domestic product of OECD countries. Regressing equation 1 will yield the short run impacts and to find the long run impacts, we use the formula adapted from Traore (2007);
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 = 3 + 4/1- 1

Where is the long run USA subsidies elasticity, 1 is the elasticity of lagged world prices, 3 is the short run USA first lag elasticity while 4 is the short run USA second lag elasticity. 4.2.1 Model Expectations The table below shows the model expectations in terms of expected covariates signs. Table 1 Expected Sign Description

Cotton price for the previous year impact

With high prices, we expect more farmers to grow cotton and flood the market the next year thereby decreasing cotton prices

USA subsidies that year

of themore following year. we expect more With subsidies, cotton growers to enter the market a situation which will lower cotton prices. With more subsidies, we expect more cotton growers and more cotton supply

USA subsidies the previous

USA subsidies second lag

which will drive cotton prices down. With more subsidies, we expect more cotton growers to flood the market hence

Time trend (T)

decreasing cotton prices. With time, we expect technical progress to lower costs of production hence lower

Polyester prices that year

cotton prices. If polyester price fall we expect demand of polyester to increase at the expense of cotton demand thereby decreasing cotton prices also.
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Polyester prices the previous year

If polyester price fall, we expect demand for polyester to increase at the expense of cotton demand thereby decreasing cotton

OECD GDP that year

prices as increases well. As GDP we expect demand to increase and as result of this, cotton prices will increase.

The first table shows the short run impacts of United States cotton subsidies on cotton world prices and cotton production in Zimbabwe. Table 2 Auto Regressive Distributed Lag (ARDL) Empirical Results Coefficient Cotton price for the previous year USA subsidies for that year USA subsidies for the previous year USA subsidies for second lag Time trend (T) Polyester prices f o r that year Polyester prices for the previous year OECD GDP for that year -0.180 -0.986 -0.321 -0.148 2.095 0.995 0.187 -0.218 t-statistic -0.784 -2.747** -0.806 -3.52 1.778** 2.727* 0.530 0.227

** Significant at 5% significance level * significant at 10% significance level R2= 0.623 As expected, subsidies have a negative and significant impact on cotton price in the short run. However the model results indicate that the elasticities of the USA subsidies are relatively small. On the demand side, polyester prices have a positive and significant impact on cotton price, much more important than USA subsidies. The positive effect of polyester price on cotton traduces the substitution effect between the two fibres. An increase in polyester price results in a shift of demand in favour of cotton. Finally, a clear negative trend is identified in cotton lagged prices.
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Long Run Impacts In a traditionally ARDL modelling framework, the long run (or equilibrium) impact of subsidies on cotton price is given by the formula given earlier: = 3 + 4/1- 1 Table 3 Long Run Coefficients Variable USA subsidies Polyester prices *** Significant at 10% level As in the short run, subsidies have a negative and significant impact on cotton price. However, the long run elasticity is smaller than the short run. So the impact tends to dampen throughout the time: a shock at a given period is not accumulated over time. The coefficient of polyester remains positive and significant. Coefficient -0.4 0.15 T- statistic -2.61*** -2.76***

Table 4 Correlation matrix Cotton prices Cotton production in Zimbabwe

Cotton prices

Significance
0.861

Cotton production in Zimbabwe

Significance 1 0.861
0.033

0.033

Source: researcher

From our data, the correlation coefficient of cotton world prices and cotton production in Zimbabwe is 0.033 and the value is insignificant. This value shows that there is no
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correlation between cotton production in Zimbabwe and world cotton prices. This shows that the quantity of cotton produced in Zimbabwe is not associated and affected by cotton world prices. Policy Analysis Matrix (PAM) The policy analysis matrix employed in this study was built on quite a number of assumptions listed in the following order; cotton production in Zimbabwe is smallholder driven, Smallholder cotton yields average 0.79 tonnes per ha, the average fertiliser application rate is 150kg/ha, the cost of 50kg fertiliser at market price is USD 30, the costs of herbicides and other chemicals applied is an estimated value of USD 80, one labour day attracts a wage of $1.00 at market prices; however labour employed is predominantly family labour hence the shadow price for labour will be pegged at 75% of existing market price, Seed costs USD 15/ 5kg, the 75% has been used under the assumption that family labour is usually comprised of varying age groups and experience, hence productivity per hour varies, there is no existing land market in the country hence the price for land a hectare is an estimate based on annual land tax figures and pre land reform rates, hence the value use is $35.00, Other expenses include management and technical services, interest on the capital invested, all repairs, general farm overheads and depreciation cost of fixed items on the farm including buildings, roads and farm machinery which are USD 100. Social values include an average land rent per ha which is US$ 241, an average value of seed per ha of US$ 166, a price of US$ 1.14 per kg, tradable inputs costing $254/ha and the cost of domestic factors which is pegged at $328/ha.

Table 5. PAM Employed Revenues Financial prices Economic Prices Divergences 671.5 732 -60.5 Tradable Inputs 342 254 88 Non tradable Inputs 183 328 -145 Profits 146.5 150 -4.5

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A measure that is going to be concentrated on is the Domestic Resource Cost ratio (DRC) which shows the efficiency or comparative advantage of a crop production. From table 6 below, the DRC value indicates that the cotton production system at smallholder level in Zimbabwe is economically efficient as far as utilisation of domestic resources is concerned. This shows that Zimbabwe has a comparative advantage in cotton production indicating that the crop is beneficial in terms of the domestic resource cost ratio. Other measures of system competitiveness include private profitability and the private cost ratio (PRC). From the same table, the private cost ratio indicates that at the current level of technology and policy intervention the system is competitive. Table 6 PAM Results Indicators Nominal Protection Coefficient (NPC) Nominal protection Coefficients for input Effective Protection Coefficient Domestic Resource Cost Ratio markets Private cost ratio Source: Researcher The policy analysis matrix (PAM) framework discussed above indicates the gross efficiency and ineffectiveness of Zimbabwe cotton production system. Even though there are negative incentives to produce cotton (low output prices NPCO and high input prices NPCI), the DRC and PRC values show that the cotton production industry is efficient and has a comparative advantage. The cost of domestic factors used is higher than the value added indicating efficiency in the allocation of resources. The results of this empirical test indicated that there exist a negative and significant effect between United States subsidies and cotton world prices. An increase in United States cotton subsidies would cause cotton world prices to fall. However, the correlation matrix failed to find a correlation between Zimbabwean cotton production and cotton world prices. This stems from the fact that Zimbabwe is a relatively small economy such that cotton world prices would be exogenously determined. The findings
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Values at 2010 prices 0.91 1.3 0.69 0.69 0.56

of this study are in tandem with Traore (2007) who used the Autoregressive Distributive Lag model and found United States cotton subsidies to be detrimental to world cotton prices. They also tally with Quirke (2001) who found out that the removal of US cotton subsidies would cause world cotton prices to increase implying a negative relationship between the two variables. This research paper therefore contributes to identify the impact of US cotton subsidies on cotton world prices and their effects to cotton production in developing economies like Zimbabwe.

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