The PTI-led government is facing a decisive moment’ in its tenure thus far. If done right, the ongoing sugar shortfall presents an opportunity for the Prime Minister to not only take on the elite capture he referred to ad nauseum in his 22-year long political career; but can also serve as the basket case of how markets for goods should be reformed to create a level-playing field for players across the value chain.

Over the past two years, BR Research has on several occasions highlighted the structural challenges in the sugar sector, from the distortive role played by existence of minimum price guarantee, trade restrictions, geographical controls, and lack of transparency in cross-ownerships in the value-addition industry. The following list presents a summary of those issues, before making policy recommendations to address the same.

Support Price: Currently, provincial governments fix minimum price of sugarcane at the beginning of crushing season which serves as a floor price at which mills may procure raw material from growers. Support price is calculated by regulatory bodies based on an indicative cost of production that takes into account the opportunity cost of rental income from land use, but also assumes a built-in ROI of 25 percent.

Over the years, this has resulted in steep rise in sugarcane price, which has made it a highly remunerative crop for growers, compared to substitutes such as cotton or even oilseeds. While ordinarily beneficial for farm incomes, it has had the unintended consequence of creating surpluses of cane.

Mandatory crushing: The Sugar Factories Control Act, 1950 prescribes mandatory crushing, which means that mills must crush all harvested cane for so long as grower in the local area demands to sell at minimum support price. Because sugarcane is a very-high tonnage crop that is uneconomical to transport for long distances, the rules were designed to ensure that in case of surplus in home-region, growers do not have to face the prospect of letting their standing crop go to waste.

However, this leads to the obvious consequence – albeit only theoretically - that mills become hostage to producing sugar in excess of market demand leading to bloating carryover stock in consecutive seasons, which depresses domestic prices. Because no profit-motive can survive on operating loss indefinitely, mills respond by delaying payment to growers.

Subsidy on exportable surplus: Sugar export is a negative list item by law, whose export is only allowed under special quotas announced by Federal Ministry for Commerce. This means that if the international market conditions are favourable, mills are not free to take advantage of surplus stocks.

Successive governments have only allowed exports as last resort situations, often based on political considerations such as last seen in election year 2017-2018. At that time, sugar surplus in domestic market was at an all-time high – in excess by 33 percent of domestic demand – whereas price in the international market was also at a 15-year low.

In order to ensure that mills make payment for carryover inventory purchased in previous seasons to the growers – an important electoral constituency – government announced subsidy on export of 2 million tons of sugar. The program was continued under the incumbent government – with additional export quota of one million ton – that has in part resulted in the ongoing shortfall of sugar due to erroneous estimates of carryover stock in the domestic market.

Ratoon crop: Sugarcane is a unique crop in that it has an up to three-year cycle; meaning that it is cultivated in one season and ratoon is harvested for next three seasons without fresh sowing. This means that once the grower plants sugarcane, it does not make economic sense to plant a substitute crop unless the returns on alternate crops are dramatically high.

This means that grower’s land is tied up for up to 36-months; while the mill must continue to purchase and crush the raw material irrespective of demand and supply situation due to mandatory crushing laws. Once the final ratoon crop is harvested, delay in payment discourages grower from re-planting the crop, who instead shifts to substitutes. A major decline in crop cultivation from one season to next results in sudden shortage of cane, which attracts speculation and higher retail price of sugar.

Prohibitive duties on import of sugar: As crop estimates are usually available well in advance of crushing/harvest season, shortfall in domestic sugar production can easily be predicted and managed through import in open market.

However, because import of white sugar is discouraged to protect domestic producers, import faces prohibitive tariffs through 40 percent customs levy. Importing sugar at a time of impending shortage thus become economically unfeasible for market players, even though sugar has historically traded at a discount in international market due to lower competitiveness of domestic crop. Instead, import takes place through TCP often in reaction to a sharp upwards spiral in retail price, as witnessed over the last one month.

Substitution in cotton areas: Sugarcane cultivation has historically been encouraged for domestic security needs only. The crop is perceived to have a very high-water footprint when compared to alternates such as rice and cotton. However, the comparison is flawed, as sugarcane consumes same amount of water over a 12-month period as rice does in 6-months.

Cane cultivation in fertile lands is thus frowned upon, especially as it has made in-roads in South Punjab, that has historically been devoted to cotton cultivation. Growth in cane acreage over the past decade has coincided with decline in domestic cotton production and increase in cotton import bill, leading to a backlash at policy level.

Geographical barriers to entry: Substitution of cotton acreage is thus used as a pretence to discourage entry of competition, when in fact it allows existing players to monopolize supply. The distortion is created by Control on Establishment of Industries Ordinance, 1963 which prohibits establishment and expansion of new sugar mills in cotton growing regions.

However, the reality is that the law has been selectively relaxed to allow establishment of new units over time based on political considerations. While minimum support price exists theoretically, abundance of anecdotal evidence suggests that it is rarely implemented – especially in periods of surplus.

Mills use carryover stock, mandatory crushing, and export prohibition as an excuse to short-change growers, as evidenced in the April 2018 hearing at the Supreme Court where industry members admitted having paid less than the government-fixed rate due to operating losses.

Sucrose recovery and role of competition: Inability to transport cane at long distances to regions facing raw material shortage - coupled with prospect of ratoon crop – means that growers become hostage to mill’s bid price.

This is further compounded by the fact that sugar output is crucially dependent on sucrose recovery, which varies substantially between regions. For example, mills in Faisalabad have an average sucrose recovery rate of 8.5 - 9 percent, whereas sugarcane grown in Rahim Yar Khan yields recovery rate as high as 11.5 – 12 percent. This means that the profitability of sugar milling business is primarily determined by its geography.

But regulatory barriers to entry mean that firms enjoy a first-movers advantage, and competitors’ access to high quality raw material is restricted. Farmers lose out by not being able to sell their commodity to the highest bidder.

Buyer’s informal monopoly also means that support price sometimes functions as a ceiling rate – especially in times of surpluses – as growers with high quality cane are offered no more than the government-set rate whereas those with poor quality crop are paid even less.

Political influence:

The regulatory framework currently governing sugar sector was designed at a time when white sugar was a rationed commodity, with sugar mills allocated production quotas by the government. The office of the Cane Commissioner – a relic of colonial past – determined the acreage under sugarcane, whereas inputs such as seeds and fertilizer were supplied by the government to ensure controlled production and growth based on domestic demand.

Today, sugar industry faces systemic distortions due to partial liberalization that only deregulated price of output, along with periods of unabated licensing of new units during 90s and mid 2000s that led to industry’s mushroom growth with little attention paid to economic feasibility.

However, restrictions on trade have continued to persist, which initially turned milling into a highly lucrative business – leading to issuance of licences based on political influence.

Recommendations:

The PTI-government has an opportunity to set the mess straight – without resorting to crucifixion of allies for populist gains or risk appearing sided. While charting a policy framework for the sector requires deliberation involving all stakeholders, a baseline can be established based on principles of free enterprise while keeping in mind consumer welfare.

• Remove minimum price guarantee: Growers’ remuneration should be based on sugar yield of the raw material, and not on absolute tonnage of the crop. Minimum price guarantee serves as a perverse incentive that encourages cane plantation irrespective of its quality. Mills located in geographical area that yields low sucrose cane are thus at an inherent disadvantage, which makes the marketplace uncompetitive.
• Remove mandatory crushing & barriers to entry: Mandatory crushing is only essential in absence of competition; in absence of support price, cane will no longer be excessively attractive compared to substitute crops and will trade at price mutually agreed between buyer and seller. However, in order to ensure that growers are not beholden to mill offered price, allow entry of competition in restricted areas, which shall ensure that buyers compete for crop, maximizing farmer income.
• Remove restrictions on trade: Because of crop’s unique dynamics, surpluses and shortages in raw material production may result from natural crop cycle. However, in order to ensure that mills do not refuse procurement from growers at the time of unfavourable conditions in domestic market, mills may be allowed to export freely. Similarly, shortages may be dealt with by allowing import at low tariffs, in order to stabilize price in the domestic market on forward-looking basis; rather than waiting for a shortfall to turn into a full-blown crisis that demands government intervention.

Long term solutions such as investment in R&D and development of drought-resistant varieties, establishment of breeding facilities at national level, and mechanization of plantation and harvest to reduce labour cost, are self-evident as in the case of any other crop.

Sugar industry’s current predicament is a result of politically influenced decisions of partial liberalization, but no industry can sustainably achieve its potential if it is deregulated incompletely to the benefit of the few. Imran Khan has an opportunity to correct this mess or choose going down the reactionary route of firefighting the crisis using Utility Store subsidies.