CHAPTER 2 Current State of Sugar Sector of Pakistan-2007-2008 PICTURE OF COMPETITION COMMISSION PAKISTAN

CHAPTER 2 Current State of Sugar Sector of Pakistan 2.1 Political Economy of the Sector Sector As mentioned in the preceding chapter (Table 2A), growth in the sugar industry in Pakistan started in the late 1960s. Before that only a handful of sugar mills were operating in the country. Largely ignoring the economic aspect, the use of political patronage for acquiring sugar mill licenses has been prevalent since the 1960?s. As a result, for many individuals who were granted licenses to establish sugar mills, the licenses effectively became a tradable commodity for them. The role of politics is still central - from the sanctioning of a sugar mill to its day-today financing and operations. Of the 80 mills, more than half are owned by members of parliament and/or their extended families. They represent a wide political spectrum, ranging from the treasury as well the opposition benches potentially creating serious conflicts of interest in policy decisions. The organization of the sugar industry in Pakistan serves as a stark example depicting the extent to which markets and public policy are routinely captured by inter-connected interests6 . In this process PSMA has provided a useful platform for facilitating collective decision-making in the sector. The political leverage has many undesirable side-effects. It clearly inhibits competition and hence restricts the emergence of the required entrepreneurial drive that is essential for the development of any sector. As a consequence, the industry continues to employ relatively old technologies, adopts extremely low levels of value addition, especially through the vigorous manufacture of by-products – a standard practice in sugar-making the world over - and appears to have all the traits of a quasirent seeking industry. There is strong evidence that the industry as a whole primarily works on the basis of standardized recurrent costs and incomes which exclusively focus on producing refined sugar by crushing local cane production and processing imported raw sugar. During the past 60 years, the industry has consistently followed a path that has avoided the costs of technological innovation and value addition. As a result, capital investments have tended to become irretrievable sunk costs and over the long run the industry may be categorized as driven not by competition but by economic rent-seeking. Unless the right incentives can be put in place to encourage modernization and diversification the industry is likely to remain stuck in this perverse status quo. The structure and contents of official sugar policies announced as part of annual trade policies primarily focus on fixing prices (on an indicative basis) of cane as well as of refined sugar from time to time, largely ignoring the potential gains of a competitive environment. A variety of provincial and national laws exist in the country that affect the sugar industry, with varying levels of operational effectiveness. All of them serve, however, to perpetuate anti-competition practices on the part of mill-owners. There is a widely held view that operating under a competitive environment, mills would be 6 “Sugar and Political Power” – a note by Dr. Adeel Malik, University of Oxford (September 2009). 12 forced to compete with each other on the basis of their individual technical and productive efficiency as is the case in other developing countries. In addition to the production of sugar, value addition would be brought about by innovation and an optimal use of by-products leading to the eventual development of downstream industries. The fact that neither individual mill-owners nor PSMA have felt it necessary to look at by-products as a means of improving the economics of sugar refining suggests that the latter has been sufficiently profitable for them. 2.2 Current Levels of Production This section provides information on levels of productivity of the sugar industry during 2008/09. It primarily focuses on variations in the recovery rates of sugar and molasses, length of the crushing season and size of sugar mills and their correlation. Out of the 80-odd sugar mills operating during 2008/09, eight sugar mills were sampled for analysis. Four mills each, with the highest and lowest sucrose contents were selected. The purpose of this categorization was to observe other attributes of these extreme level cases i.e., recovery rate of molasses, length of the crushing season as well as the actual time of its occurrence. The rationale behind this analysis is to highlight the fact that production of molasses is as important for the economy as the level of refined sugar production. Furthermore, it reveals whether sugar and molasses are substitutes or compliments. The production level of molasses is being emphasized in the context of two major aspects related to the development of Pakistan?s sugar industry. First, to ascertain the degree to which the current levels of molasses production depend upon the technical effectiveness of the management of the mills; and second, to analyze the opportunities that direct and indirect products of the sugar mills proffer. This becomes important in the context of the extensive use of by-products, especially molasses by rival sugar producing countries. Data on the levels of cane crushed and production of sugar and molasses across all sugar mills in Pakistan during 2007/08 and 2008/09 published by PSMA reveal the following: i) Sugar Recovery The recovery rates (i.e., sugar as a percentage of cane crushed) show significant variations across mills in each province, as explained below: Punjab : from 7.50 percent to 11.25 percent Sindh : from 7.88 percent to 11.30 percent KP (NWFP): from 7.88 percent to 9.71 percent It follows from the above that the level of sucrose contents vary equally across the provinces, particularly in Punjab and Sindh, implying potential efficiency gains. The data also shows an overall recovery of 9.45 percent in 2008/09 as compared to 8.98 percent in 2007/08 i.e., an overall growth of 5.2 percent during the period. 13 ii) Molasses Recovery There seems to be an inverse relationship between sugar and molasses production levels (based on 2007/08 and 2008/09 PSMA data). It implies that the benefits attributable to molasses need to be measured in detail to ascertain the relative share in costs and benefits of individual mills. The inverse relationship needs to be studied further in order to investigate the presence of cartel-like behaviour by sugar mills to reduce volumes and create shortages. Such shortages can be used to justify a higher sugar price and simultaneous benefit through increased molasses production can be realized. Sugar production levels may be used as instruments by the mills to affect the domestic sugar price in the wake of hikes in international sugar prices. On the contrary, the differences may, in fact, be attributable primarily to the limited technical management capacity of individual mills. iii) Length of Crushing Season The length of the crushing season (including stoppages due to various reasons) also varies significantly across mills. PSMA data reveal the following length of crushing season across provinces: Punjab : from 50 to 122 days Sindh : from 60 to 139 days KP (NWFP): from 59 to 106 days These variations depict both scenarios. Some mills may be operating at low levels due to their inability to procure cane in the required quantity. On the other hand, some mills may be crushing for excessively long periods, which appear to be economically unfeasible for the sector (though it might be feasible for the mills in the context of their financial return). Under both scenarios, these variations depict economic inefficiencies which need to be checked. A shorter crushing season may also be related to poor mills-farmers relationship. The crushing season of each mill also depends on its policy with regard to expected cane supplies and/or pre-determined sugar production levels. A delayed crushing season may also affect farmers? cropping patterns, particularly cotton growers who need to sow cotton in the month of March. iv) Size of the Sugar Mills Bigger sized sugar mills may also enjoy complimentary benefits of economies of scale. It appears from the data that the rate of sugar recovery is proportional to the amount of cane crushed. However, further analysis based on the amount of cane crushed per day by individual mills during the season shows that a higher sugar recovery is associated with the size of the mill. In light of (i) to (iv) above it appears that all the four factors namely sugar recovery, molasses recovery, length of the crushing season and the size of the mill crushing capacity play important roles in determining the performance of the mills. For the year 2008/09, the PSMA data show how extreme variations in sugar recovery rates are associated with other factors as explained in Table 1. 14 The comparative statistics, based on sugar recovery rates of the four highest and the four lowest performing sugar mills show that: i) The four high performing mills, on average managed to achieve 43 percent higher recovery rates than the average for the four low performing mills. ii) In contrast, the four mills with the highest sugar recovery rates, on average, achieved only 84 percent of the average recovery rate of molasses achieved by the lowest sugar recovery mills. It implies an inverse relationship between the recovery rates of sugar and molasses. Table 1 Extreme Cases of Sugar Recovery and Associated Factors Extreme Sugar Recovery Rates Associated Factors Molasses Recovery Rate (%) Length of the Crushing Season (# years) Total Level of Cane Crushed (“000” tons) Level of Crushing Per Day Per Mill (“000” tons) i) Highest Recovery Cases: 11.30% (Ghotki, Sindh) 11.25% (United, Punjab) 11.15% (JDW, Punjab) 10.70% (Dewan, Sindh) 4.02 4.02 4.16 4.80 94 (1 Dec?4 Mar) 103 (23 Nov?5 Mar) 107 (24 Nov?9 Mar) 72 (19 Dec?5 Mar) 553 596 1,488 141 5.88 5.78 13.91 1.96 Weighted Av. of Higher Recovery Cases 11.2% 4.13 94 695 6.88 i) Lowest Recovery Cases: 7.88% (Ansari, Sindh) 7.88% (Chashma, NWFP) 7.81% (Baba Farid, Punjab) 7.50% (G. Summandri, Punjab) 4.93 4.65 4.98 5.50 112 (28 Nov?19 Mar) 101 (7 Dec?2 Mar) 93 (27 Nov?27 Mar) 93 (26 Nov?28 Feb) 491 370 219 124 4.39 3.66 2.36 1.33 Weighted Av. of Lowest Recovery Cases 7.83% 4.91 100 301 2.93 Source: Derived from PSMA Data: 2008/09. iii) The sugar mills with the highest sugar recovery rates had, on average, crushed 695,000 tons of sugarcane during the season which is 131 percent higher than the crushing done by sugar mills with the lowest sugar recovery rates. 2.3 Causes of Recent Sugar Crises in Pakistan The process of sugar production in Pakistan has historically followed a cycle of three or four years, i.e. a ?bad? year followed by two or three good years. Production levels generally show a decline after which they mostly rebound, either as a result of favourable weather conditions alone or a combination of favourable weather and higher sugarcane prices offered to growers, if only on an indicative basis. During years when the domestic production exceeds demand, surplus stock is carried forward. In the event of the international market price of sugar exceeding the domestic price, some surplus is also exported. At times, small quantities of sugar are exported despite a low international price because stocks to be carried forward are 15 large enough to create liquidity constraints for the mills as well as a shortage of space for stocks. However, due to a weak policy framework, sugar has sometimes been imported as well as exported during the same year. This reflects unwise decisions taken to export notional surpluses. Similarly, sugar is imported expecting a shortage at home either due to reduced supplies of cane and/or late start of the crushing season. In this regard, the likelihood of misjudgments is substantial but there is an economic cost involved in terms of skewed incentives for mill-owners for the next crushing season. A resort to collective action to pre-empt such dangers on a collective basis is therefore understandable. A closer view of the levels of domestic production and consumption and international trade of sugar in Pakistan during the last 16 years shows that in most years, level of stocks carried forward were rather low i.e., less than 20 percent of the consumption level (with the exception of one or two years when they exceeded 30 percent). In contrast, globally, stock levels of 40 to 50 percent of consumption are maintained. Since a strategic food management system is currently not in place in Pakistan, inappropriate decisions have been taken with regard to the sugar trade (both in terms of quantities to be exported/imported and their timings) and the management of stocks at home. Shortage of sugar and its higher price for consumers is not related to low levels of production. Rather, untimely and inadequate quantity of sugar reserves through imports and carried forward stocks seem to be the real cause of apparent shortages. Inter-temporal shortages in a given year which cause upward shifts in consumer prices are in fact a reflection of untimely decisions on the import (or export) of sugar and the lack of a well-organized distribution system. According to the Annual Report of the Pakistan Sugar Mills Association (PSMA) of 2008, the total availability of sugar remained above the domestic consumption requirements in the country during the period 1992/93 to 2007/09. Total availability, however, does not provide evidence that each year the stocks were managed on a timely basis to prevent a price hike of sugar. From 1991/92 to 2007/08, the retail price of sugar showed a range of Rs 11.26 to Rs 32.40 per kilogram. However, in the year 2009, the country witnessed a major sugar crisis. In late 2009 and early 2010 sugar virtually disappeared from the market and caused significant social unrest. Given the severity of the situation, the Government of Pakistan and the Supreme Court of Pakistan took a serious view of the issue. The Government of Punjab took administrative measures through raids on hidden sugar stocks at sugar mills as well as warehouses. These raids were probably counterproductive in their effectiveness. Through a High Court order, the retail price of sugar was fixed at Rs 40 per kilogram. Sugar is a homogeneous commodity with a low elasticity of demand. It is impossible for a government, especially in a developing country setting, to ensure that subsidies, targeted through price-fixing, actually reach the poorest sections of society. A black market inevitably develops and thrives in such a situation. Apart from the scarce quantity sold through state-owned utility stores, sugar prices remained stubbornly unchanged. In fact, such subsidies end up creating windfall profits for middlemen, rather than achieving their intended purpose of providing relief to the poor. 16 Reasons for Shortages of Sugar A number of factors are attributed by different stakeholders towards the recent sugar shortages and the sharp hike in its price. These include the following: i) Absence of a strategic food management system The independent views based on the information about: i) the level of sugar stocks carried over from the surpluses of 2007/08; ii) reduced output of 3.2 million tones of sugar during 2008/09; and iii) the extra- ordinary hike in the price level to $ 638 per ton of refined sugar in the international market, suggest that had sufficient stocks through import been made on a timely basis by the government (through the Trading Corporation of Pakistan) substantial savings of foreign exchange would have been realized while ensuring a smooth supply of the commodity. In the earlier period, the international market price of refined sugar was much lower than the price of $ 638 per ton which the government paid eventually. A timely decision by the government in this regard would also have averted the sugar crises witnessed recently. Another major decision that did not prove to be correct, was the export of 260,680 tons of sugar from the surplus stock of 2007/08 at Rs 22 per kilogram. In comparison, the landed cost of sugar imported in 2008/09 was over Rs 60 kilogram. Such blunders are natural outcomes of a failure to establish a strategic food management system in the country. In the absence of such a system, a recurrence of such mistakes in future is quite likely. ii) Role of Sugar Mills and Traders In addition to (i) above, a close assessment of the cost of sugar production at present demonstrates that sugar could be provided to consumers at Rs 40 per kilogram (see Table 2). For the year 2008/09, the government fixed a price of Rs 82 per 40 kilograms of sugarcane. However, the shortage of sugarcane during the year led to excessive prices charged by the growers. If we assume, for the sake of analysis, an average price of Rs 100 instead of Rs 82 per 40 kilograms of sugarcane paid by the mills to the growers (suppliers) and add all other costs including excise duty, sales tax and appropriate marketing margins, the consumer price should not exceed Rs 40 per kilogram. Given this scenario and the fact that sufficient surplus stock of sugar was carried forward from 2007/08 and was available with sugar mills and traders, it is surprising that these stocks of sugar were not brought to the market. Whereas the domestic cost of production of sugar was well under Rs 40 per kilogram, the landed cost of imported refined sugar was over Rs 60 per kilogram. Although this difference may be attributed to a hike in sugar prices in the international market, massive sugar shortages witnessed across the country hint at some degree of manipulation and distortion of market forces. Whether the manipulation can be described as defensive (in the guise of collective decision-making), or a more blatant resort to cartelization remains to be seen. 17 As part of CCP?s investigation report, information collected from the inspection of PSMA premises seems to suggest that this body, rather than solely being a representative forum of sugar producers, prima facie appeared to be acting as an institution for collective business decision-making. Evidence suggests the presence of collective stances in the purchase of sugarcane (mostly done by geographically defining boundaries), as well as in the production and sale of refined sugar. The information obtained from PSMA depicts collective efforts to control output and prices, as well as lobbying with the Trade Corporation of Pakistan in the matter of the quantity of sugar to be imported. Such practices clearly distort the market. The victim of such market distortions are the ordinary consumers, who end up either paying exorbitant prices for sugar or, on certain occasions, are not able even to purchase the commodity at all. The need to check collective decision-making by producers to manipulate or rig the market, is therefore self-evident. Table 2 Cost Structure of Sugar Production in Pakistan (2008-09) 1. Cane Price (Rs.40/Kg.) Rs.100 2. Cane Price (Rs.100/Kg.) Rs.250 3. Recovery Rate 9 Percent 4. Sugar Produced from 100 Kg. of Cane 9 Kg. 5. Cost of sugar / Kg. i) Sugarcane Cost Rs.27.8 ii) Conversion Cost Rs.5.0 iii) Excise Duty & Sales Tax Rs.2.6 6. Ex-Mill Price Rs./Kg. 35.4 7. Marketing Margin including marketing, storage, wholesale profit, etc. Rs./Kg. 4.0 8. Consumer Price Rs./Kg. 39.4 Source : PSMA Annual Report 2008 Note: Results of sensitivity analysis on the above cost structure have been discussed in detail in the following chapter. An associated adverse effect of such practices has traversed down to sugarcane growers and the traders. Growers, on numerous occasions refuse to supply sugarcane to mills at the prices indicated by the government. Their plea is simple: if sugar mills can make extraordinary profits, the growers should also be given a fair share. Such a tendency is bound to increase the 18 cost of sugarcane in the total cost of sugar which is already close of 80 percent. If not controlled, this is likely to create a perpetual adverse impact on the efficiency of sugar production in Pakistan. The current crushing season has already started experiencing this effect. Based on reports in newspapers, growers are currently selling sugarcane to mills at Rs 130 to 140 per 40 kilograms compared to a price of Rs 102 per 40 kilogram set by the government. The impact of this on the price of sugar for 2009/10 would thus be adverse. iii) Wholesalers and Retailers Views As mentioned earlier, sugar was not available at Rs 40 per kilogram despite rulings from the High and Supreme courts. Rather, sugar was sold at Rs 60 per kilogram or more in retail shops and at a somewhat lower rate in the government utility stores. The issue was raised with wholesalers and retailers to find out the causes of non-adherence to a mutually agreed price fixation closer to the Rs 40 per kilogram level. It was revealed that the decision of the Supreme Court dated October 30, 2009 to fix the sugar price at Rs.40 per kilogram was relevant to the level of sugar stocks which were sufficient only for one month. As a result, the decision could only be enforced till November 30, 2009. According to some news reports, the trading community had to face additional hardships in the shape of different kinds of checks and raids in carrying sugar stocks released under the court?s ruling. This increased the transaction costs of the wholesalers and retailers and by the same token gave them the liberty to charge a higher price from consumers. In the process, the average sugar price went much above Rs 40 and reached Rs 60 per kilogram. This situation continued till November 30 after which all restrictions on price and mobility were relaxed. As a result, the retail price of sugar actually came down somewhat and tended to stabilize at around Rs 52 per kilogram in most cities and towns.7 The lessons of recent events and the manner in which they were sought to be dealt with indicate that undue physical restrictions, fixation of prices and restricted mobility are contrary to free and fair competition and increase transaction costs, which are ultimately passed on to the consumers. Therefore, the use of force, raids and other drastic administrative measures only aggravate the problem rather than providing a solution. In implementing the court?s ruling, the process followed witnessed an excessive use of threats and harassment for sugar producers and middlemen. 7 Newspaper reports point out that after mid-November 2009 the open market price of sugar started rising again. This rise in sugar price is largely due to higher prices at which growers are selling sugarcane to mills. In the event the world price of refined (or raw) sugar drops below the domestic price, the government may decide to import sugar for building buffer stocks. This would hurt the interests of sugar mills who may not be in a position to pay growers for their supplie