Cotton indicative price: don’t go down that road

It appears that the farmer representatives - under the umbrella of Pakistan Kissan Ittehad - have the federal cabinet convinced that introducing guaranteed returns are a sure shot way to expand acreage under cotton for the upcoming season. They are correct. But it may also deliver the final blow to the crop in the long term.

The case for an indicative price is built on parallels drawn with competing crops such as sugarcane, where remunerative rates have helped grown output by two-thirds in less than a decade. Because profitability is linked with volume (quantity produced), growers are more likely to invest in yield maximizing inputs, given land is the limiting factor (corroborated by the fact that between two peak production seasons of MY08 and MY18, acreage increased by only 8 percent, compared to a surge in average yield of 20 percent).

Except, that the parallel drawn is not only faulty, but it is also incomplete. First, unlike sugarcane, cotton market is highly quality driven. According to Arif Nadeem, CEO Pakistan Agriculture Coalition, globally cotton prices are determined based on a highly specific quality classification system, based on standardized grading. Pricing of the US upland cotton for example – the universal standard – is based on several physical characteristics such as fibre length, length uniformity, fibre strength, micronaire, color grade, trash, contamination level, and leaf grade.

Even in domestic market, daily price notified by Karachi Cotton Exchange is based on defined grades – spot price of the optimal grade-3, staple length 1-1/16, micronaire between 3.8 to 4.9NCL is quoted. Appropriate discounts and premiums are then applied over base price for lint of other grades.

And there in lies the problem. In order to incentive growers to invest in yield maximizing inputs for the crop, the government is most likely to set a floor price not for lint, but for seed cotton - commonly known as phutti. That would also be in line with demands of the farming community, which readers would recall had advocated support price of Rs 4,000 per maund for seed cotton during the last season.

Incentivize, it would. Indicative prices are usually recommended by the Agriculture Policy Institute and are based on a 25 percent investment incentive over average per acre cost of production (at mandi-gate). Consider that in 2019, gross investment required per acre to achieved average yield of cotton was under Rs 60,000 compared to over Rs 122,000 for sugarcane. Thus, for so long as the ROI is guaranteed at competitive levels, diseconomies of scale should tilt in cotton’s favour, considering the high incidence of low-income, subsistence growers with limited access to capital.

Guaranteed remunerative returns for growers, higher investment in yield maximizing inputs, increased acreage – all leading to higher local production and lower reliance on imports; sounds nothing short of a win-win for the cotton-based textile value chain. What is the problem then?

To understand the distortions involved, first a refresher in cotton value chain. Pakistan’s annual cotton output of 10 million bales is grown on two million odd farms. Sowing begins in April-May, with harvest starting by end August and closing by December. Hand picking of seed cotton during harvest increases incidence of contamination. Collected stock then makes it way to ginning factories, where the seed is separated from phutti, and the cotton boll is processed into lint by removing moisture, before finally pressing it into bales.

It is these bales of lint that are synonymous with the tradable commodity familiar to most; prices quoted for cotton indices both in domestic and global markets are also for lint cotton whose classification is based on stringent criteria as explained. Except the ground reality in domestic market shows it is anything but.

Because cotton farming is a seasonal, so is its ginning. Ginning business is no more than 120 days affair, from the beginning of harvest. In addition, high cost of transportation means that the operation is only profitable if gin is set up near farmgate. Because cotton is cultivated in over 70 districts across the country, ginning operations are highly fragmented by geography. The fragmentation is further exacerbated by the fact that very little capex is required to set up a ginning unit (plant and equipment required may cost as low as Rs 2 to 3 million).

As a result, quality of ginning output in Pakistan is noticeably varied, especially when it comes to highly specific classification standards such as contamination percentage, strength and uniformity. But even when it comes to specification as basic as bale weight, Pakistani ginning follows few standards if any. Globally, one unit of bale is equivalent to 217kg; Pakistan Economic Survey and Central Cotton Committee defines it at 170kg, whereas, according to sources in Karachi Cotton Association, bales available in market weigh as low as 155kg.

And that is symptomatic of the problem at hand. While the government may very well achieve near-term production targets by setting indicative prices for seed cotton or phutti, that will do precious little to improve the quality of cotton bales. In fact, it may end up achieving the exact opposite.

Setting a floor price or guaranteed returns for phutti means growers may face the perverse incentive of increasing profitability by limiting investment to the extent that target yield is maintained. Because ginners will be expected to pay the notified rate irrespective of quality, incidence of adulteration/contamination practices that increase bale weight for onwards sale to spinning units may increase. Even in present circumstances, cases of moisture application to raise bale volume are not entirely unheard of.

Which means spinners will be faced with the prospect of procuring raw material of questionable quality. While standalone units may be willing to accept the trade-off by applying a discount; the government may be fooling itself to believe that textile exporting groups, especially ones integrated downstream, may accept the fresh turn of events.

In fact, if the ongoing season is any guide, reliance of textile groups on imported cotton is only increasing, given buyers’ insistence on using high quality imported cotton with reliable characteristics. And considering that support price is almost certain to result in higher price for domestic lint compared to imported, the trade-off will make little difference to these exporters.

Eventually, the chain of causation will lead to one of two possibilities: increased cotton import during the duty-free season of Jan to June that will depress demand for domestic cotton and in turn push growers away. Or, force government’s hand into banning cotton import altogether to incentivize consumption of domestic output – in turn making textile exports uncompetitive.

Solving years of shortfall in domestic cotton production with a stroke of pen is nothing but a teaser. If the cotton production in fact increases in the upcoming season, the government may even declare victory. Only, it would be premature. The federal cabinet would be wise to avoid easy too-good-to-true fixes.