Why agricultural value chains fail

Part (3): The curse of the subsidy

During the last stages of the fertiliser subsidy, farmers were on

average using around 200 Kg of fertiliser per acre, which is way
beyond the recommended levels

Thursday, 15 December 2016

Agricultural subsidies are common and popular interventions by
governments. They are sometimes considered as essential
economic tools. However, there are plenty of examples showing
how they have miserably failed causing economic, social and
environmental negative externalities.

This led to question whether the real intentions behind the

subsidy are adequately justified. There is also evidence to suggest
that the policy makers might have got it wrong. One might
therefore argue that subsides, as an economic instrument might
not be an economic instrument to begin with. May be it is a
political instrument, disguised as an economic one.
Subsidies are attractive. Anything given free is preferred,
sometimes even things that are not essential. However that is the
human nature. Therefore farmers always prefer subsides. Farmers
face a production function that they would try to maximise as a
profit function under cost constraints. Anything that either
increases their revenue or reduces their costs is attractive.
Therefore agricultural subsides are either input oriented or output
oriented. Therefore subsides are an attractive intervention for a
profit maximising farmer.

Just like any other individual a farmer also thinks

about himself and he is rational. He is a consumer, even before he
became a producer. Just like we learnt in economics, more is
preferred to less and he tries to maximise his utility each and
every time possible.
Therefore giving a subsidy to a farmer and expecting him to be

responsible and think of economic, social and environmental

consequences is a joke. Rather the policy makers must think from
a farmers perspective in the beginning and map out how the
subsidy would be adopted, utilised and realised by farmers. This is
where the importance of evidence based polices comes in.
However, this is very limited in many developing countries. In
developed countries to certain extent the policy research is
somewhat mainstreamed to university research process.
Generally MSc or PhD research work is directly tied to a specific
policy intervention and would be funded by the government,
private or the combination of it. However many policy
interventions especially the ones that focused on agricultural
subsidies are hardly researched. Therefore such policies have a
higher probability to fail, resulting many consequences.
The objective of the article is not to brand every agricultural
subsidy as a bad decision. However there are plenty that have
clearly gone wrong. Yet they give us opportunities to learn new
lesson. These lessons might help the policy makers in the future
and they might also help to drive the ones that have derailed. I
will only take few examples.
Fertiliser subsidy and the sustainable agriculture
I believe this is the single most discussed and researched subsidy
scheme of Sri Lanka. Yet we are not sure whether we got it right. I
agree fully that this was an important subsidy scheme. The world
population was on the rise, and as many developing nations Sri
Lanka was also experimenting things to increase the production.
The main focus was on increasing the production or the
productivity of paddy. Once the research work proved that newimproved varieties of rice work very efficiently with the chemical
fertilisers, the Government decided to give a fertiliser subsidy.
The subsidy was very significant accounting for almost 90% of the

value.
The subsidy initially helped to increase the paddy production and
there is plenty of research work to prove that. However in the
middle of the way, especially since late 80s research work
started flowing in highlighting the negative environmental, health
and socio-economic impacts of the fertiliser subsidy.
The research work highlighted the fact that:
(1) farmers are overusing the fertiliser subsidy
(2) farmers are misusing the fertiliser subsidy by putting it to
other crops than paddy
(3) the soil conditions are degrading and paddy lands are
becoming less productive
(4) downstream water pollution is causing health hazards
(5) fertiliser subsidy administration and management process is
highly corrupt
(6) rice produce is becoming toxic
(7) farmers use of agro-chemical have gone up and causing
health hazards
(8) fertiliser subsidy itself is not contributing to any significant
production gains anymore and
(9) the subsidy was a heavy burden on the Government
expenditure.
Despite all these results the consecutive governments that came
in to power insisted on giving the fertiliser subsidy. International

fertiliser companies enjoyed the spillover benefits in importing

fertiliser on behalf of the Government. When a particular
government wanted to reduce or abolish the fertiliser subsidy for
paddy it became a political advantage for the opposing party.
Sometimes the fertiliser subsidy was at the top of the political
mandate during the election times. This was there even during
2015 elections. Ultimately the fertiliser subsidy became a political
innervation rather than an economic intervention.
However, despite all challenges in terms of politics, the present
Government decided to abolish the subsidy program overnight.
The replacement was a coupon system. Decision to move away
from the fertiliser subsidy is a good decision and some of my
research work supports this. However, the transition from the
subsidy program directly to a market oriented program or a
coupon-based program is not well planned.
Research work clearly suggests that removal of the subsidy total
from all the areas of paddy production can threaten the paddy
production in the short run and might increase the rice prices.
Therefore a gradual removal program was suggested which would
span around three to five years. However none of these
suggestions were taken into consideration.
During the last stages of the fertiliser subsidy farmers were on
average using around 200 Kg of fertiliser per acre. This is way
beyond the recommended levels of the Department of
Agriculture. The coupon system would give Rs. 25,000 per year
per hectare. The coupon system is basically to encourage farmers
to adopt the recommended fertiliser levels for paddy and
substitutes the additional requirements (based on the land fertility
states) by organic fertiliser.
There is no any concrete research work done to show whether
farmers have gone back to the recommended fertiliser levels and
adopted the usage of organic fertiliser for the additional

requirements and whether the farmers are actually using the

coupon to buy fertiliser. However, my personal engagements with
many farmers suggest that
(1) the coupon is not enough to buy the required fertiliser (which
is true since they were used to applying more)
(2) the organic fertiliser is hard to find/hard to manufacture
therefore the cost of cultivation has gone up
(3) fertiliser prices in the market is too high for farmers who do
small scale cultivations (they dont have economies of scale)
(4) short term supply of paddy had gone down with decreased
area of cultivation
(5) rive prices have gone up with decreased supply of paddy in
the short run and
(6) farmers are using the coupon to buy other things and
sometimes this involves alcohol consumption as well.
Therefore it is to a certain extent is clear that things are not going
well as they expected. However I believe that this is something
economists expected. If any policy maker is interested in reading
there is plenty of research work available from the African region
on how to transition from input subsidy programs especially from
fertiliser subsidy programs. My intention was not to highlight
those studies but to point out what should have been done.
One of the main objectives of moving away from fertiliser
subsidies is to allow the private fertiliser markets to develop and
encourage farmers to adopt organic fertilisers. The coupon
system is a temporary intervention to help the transition.
However, all the other countries did the research work to evaluate
the anticipated challenges I explained before. It helped them to

understand the ability of the private fertiliser market to develop,

farmers affordability of unsubsidised fertiliser, the land responses
to decrease fertiliser use, farmers short term responses to subsidy
removals such as less cultivation and prices increases, other uses
of coupon money instead of buying fertiliser and the ability of the
organic fertiliser supply chain to cater the increased demand.
Now the question is what did we do? I still think we are not too
late. Still this is at the early stage, research can be planned to
assess all these changes. It will possibly give us the right
directions to go. Some policymakers need to make that call
independent economists like us cant do this alone unless the
research work is funded.
Agricultural crop insurance program
Crop insurance is something that is very important but hardly
given any priority. Sri Lanka started its crop insurance program
with paddy. In an ideal situation a crop insurance is something
that should be demanded by the farmer, not pushed by the
government. However, the argument is that our farmers are with
little capacity to pay for insurance even if they really need it and
even a little damage to crops can either increase the prices
heavily or threaten the food security status. Therefore rather than
allowing the farmers to decide on the crop insurance based on the
perceived risks the government made it mandatory. This is not
something new, many developing countries do this initially, until
the private sector involves in the insurance market.
However, the previous Government made a decision to tie the
crop insurance program into the already existing fertiliser subsidy.
The insurance premium was taken from the framers when they
collect the fertiliser subsidy. This is however, was not an ideal
proposition since farmers with different levels of risks were paying
the same premium. Therefore, farmers who did not see any future
danger in their cultivation were not motivated to pay the

insurance premium.
However money collected was enough to make the crop insurance
program self-sufficient as claimed by the previous Government. I
have argued about this in two separate articles. The point I was
trying to make was the forced insurance is not a good thing in the
long run and tying the crop insurance program in to a subsidy
scheme is not good at all. There are still many pending cases of
insurance claims and many claims are influenced (either
politically or bureaucratically).
Things all went south when the Government decided to transform
the fertiliser subsidy into a coupon system. The Government was
not able to make any arrangements for the crop insurance
program to continue. There isnt a way to collect the insurance
premium. The private sector involvement at this point is also very
low therefore the Government was forced to continue the crop
insurance program by using the crop levy collected from the
financial institutions. If the private sector involvement was
significant in the crop insurance sector, the money from the crop
levy could have been used to back up the risks of the insurance
cover. However that might not be possible anymore.
The crop insurance program, which was piggybacking on the
fertiliser subsidy, was an indemnity based insurance program.
This way it was easy to manage. However this indemnity based
insurance program is not efficient and what is ideal is an indexbased program, something like the weather index based crop
insurance program. However the involvement of the subsidy in to
crop insurance mix prevented the implementation of an efficient
index based crop insurance program.
Illusion of guaranteed pricing and Government purchase
Guaranteed price schemes are a common type of out-put subsidy.
This is most of the time to ensure that farmers get a fair price at

the farm gate level. This type of a subsidy is based on the

Governments ability to buy the particular commodity at the
guaranteed price and then hopefully storing them and releasing
to the market appropriately (without allowing the market prices to
fluctuate frequently). The most popular guaranteed price program
in Sri Lanka is for paddy. This has been there for a while, going
through ups and downs under several government regimes.
Two main components of such a program require careful analysis
in order to look at the success of it. First the buying capacity of
the Government has to be backed up by proper storage facilities.
Much research work suggests that the amount of paddy being
bought at the guaranteed price only accounts for a very little
amount of the total production. In terms of the distribution per
district the amount that the guaranteed price scheme buys is
insignificant. Sometimes the ability to buy runs out very quickly
within couple of days and most farmers are unable to sell their
produce at that price. There are farmers who would stay in a line
for several days and see they are not accepted due to capacity
constraints. They then simple sell it to a collector or a miller close
by for pennies.
The Government holds its own storage facilities for the most part.
The Paddy Marketing Board sometimes hires private warehouses
when they run out of storage facilities. However there is enough
public information to confirm the poor quality storage facilities in
most of these warehouses.
The management of the guaranteed price program is utmost
important. How and when to release the stored paddy are the
important questions. Ideally this paddy should be released to
competitive mills under competitive prices. However to what
extent the competitive process exists is a matter that deserves
through investigation. It is important that this should be looked at
from the whole value chain perspective.

The Government is giving a significant subsidy for farmers by

offering them a guaranteed price. However if the same paddy
ends up in larger conglomerates then that will affect the ultimate
prices faced by the consumers and the Government loses as well.
In an ideal situation the paddy bought at a guaranteed price
should have been released for several small and medium scale
mills at a competitive price so that small business benefit from
the subsidy as well.
The administration of the buying process of the guaranteed price
program for paddy is managed by couple of individual officers,
who have the discretion power. Discretion power on the other
hand is the source of corruption and bribery.
Subsidies on mechanisation in agricultural value chains
Mechanisation could be the answer to many issues in agricultural
value chains. Mechanisation could increase the production
efficiency, facilitate value addition and answer the labour scarcity
issues. However, inventing in machinery is not affordable for all
farmers. Hence in promoting mechanisation in agricultural vales
chains governments often give subsidies. When the subsidy for
mechanisation is given it is important to carefully look at the
value chain and see whether the incentives for using machinery is
there. The classical example is the pepper export value chain.
The majority of pepper from Sri Lanka goes to India. Pepper can
be processed either using the feet or by using a machine. Using
feet takes time and sometimes results in contamination.
Therefore the Government administered a subsidy scheme for
machinery. However, the subsidy program never became popular.
This is because the incentives for quality improvements are not in
place. The exporter does not provide any price premium for
processing the pepper using the machines. Therefore there is
little incentive for a farmer to invest in machinery and pay
interest even at a subsidised rate.

Therefore what should be done is to promote machinery where

the incentives for value addition are visible. The 2017 Budget for
agriculture carries a proposal to provide subsidies for
entrepreneurs to introduce machinery. However the condition is
that the business must bring in value addition using the subsidy
for machinery. This is a very practical budget intervention. It has
recognised the importance of promoting the use of machinery
where the incentives for quality improvements (or any type of
value addition) are in place.
Conclusions
Subsidies are necessary. They are very crucial to get things
started. However, subsidies cant continue forever. Farmer needs
to make decisions, they need to take responsibility in investing
and the private sector needs to develop so subsides do not
become a necessity.
Any subsidy program must have a transition program. It is not
easy to give a subsidy and take it back, especially in a developing
country context. Subsides can easily transform from being an
economic instrument to a political instrument. Subsidies should
be stand-alone programs, otherwise it will bring burden to other
program as well. Capacity to implement and the management
process is essential in a successful subsidy program
implementation.
Finally, the subsidy must take the whole value chain into
consideration. If these things are not assessed, then the subsidy
can easily become a curse.
(Dr. Chatura Rodrigo is an agriculture and environment economist.
He can be reached at chatura_rodrigo@yhoo.com and 94 77 332
6834)

Posted by Thavam