Egerton University Department of Agricultural Economics and Agribusiness Management Policy options on contract farming in developing countries and

their implication on stakeholders. Khainga, D.N., Kibet, W.K., Robert, G.B. Abstract There is an emerging concern about the viability of contract farming in developing countries among the smallholder farmers and larger agribusiness firms particularly in the context of on-going process of globalization. It is contended that profitability of small farms can be improved through diversification of agriculture into higher-value crops like fruits and vegetables. This paper has assessed the benefits and constraints faced by contracted farmers and contracting firms as well as policy options available to the developing countries to promote contract farming for fruits and vegetables. Theres is empirical evidence that fruit and vegetable production is more profitable and labour-intensive; therefore it fits well in the small farm production systems (Joshi, et al, 2006). Fruits and vegetable production is the emerging sector in agricultural diversification that would augment income of smallholders and generate employment opportunities in rural areas. Promoting women participation in negotiation and management of contracts is critical to the sustainability of contract farming. The need to fully involve all the stakeholders in formulation and implementation of the contracts is essential to ensure that all their interests are taken into consideration for its success in the long run. However, prevailing constraints do not allow smallholders to fully expropriate the emerging opportunities in fruits and vegetable production. Fruits and vegetable prices are volatile, which severely affect the profitability in the event of marginal increase in their supply. Low volumes of marketable surplus also adversely affect the bargaining power of smallholders and thus results in realizing lower prices. The possible solution for overcoming this is through developing institutional arrangements that strengthen farm-firm linkages. Contract farming is one such arrangement that helps smallholders to overcome the constraints in production and marketing fruits and vegetables in developing countries. Thus, the need for developing policy framework that promotes and safeguards the interests of all the stakeholders in contract farming schemes

Table of Contents Abstract ................................................................................................................................................................. i Stakeholders ......................................................................................................................................................... 1 1. Participating farmers ................................................................................................................................... 1 2. Non-participating farmers........................................................................................................................... 2 3. Contracting firms ........................................................................................................................................ 2 4. The government........................................................................................................................................... 2 5. Farmer organizations .................................................................................................................................. 2 6. Non governmental organizations ............................................................................................................. 2 Benefits of contract farming ............................................................................................................................... 3 Constraints of contract farming in developing countries .................................................................................. 3 Policy options for developing countries............................................................................................................. 4 Summary .............................................................................................................................................................. 8 References ............................................................................................................................................................ 9

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Background Minot (2007) defines contract farming as agricultural production that is carried out according to prior agreement in which the farmer commits to produce a certain product in a given manner and the

buyer(contracting firm) commits to purchase it. Production and selling under contract has been a common arrangement in agricultural production and marketing in both developing and developed countries. This implies that contract farming has been in existence for a long period, particularly for perishable products such as vegetables, milk and fruits (Bijman, 2008). In most developing countries there are two types of contracts in contract farming, one is formal contract and the other is informal contract. Formal contracts are legal and can be enforced at the court of law whereas oral contracts are implicit and greatly rely on self enforcement. There are probably many types of contracts in contract farming but there are common distinguishing factors from other alternatives in that contract farming impacts on the marketing of the produce in three stages comprising of agricultural micro-system of input supply, production and processing (Abler David et al, 2011). Contract farming is usually attempts by agribusiness firms to expand their operations by increasing on their profitability and risk management by diversifying the sources of their agricultural products. As contract farming becomes more important for agric-food industries especially for vegetables and fruits, there is demand on better insight on the conditions under which contract farming works for it to be efficient and fair. This can be achieved by eliminating bounded rationality and opportunistic behaviour among the parties (Bijman, 2008). The majority of empirical studies suggest that contract farming schemes generally raise the income of farmers participating in contract farming but it is not clear to what extend are the contracting firms are willing to contract small holder farmers. The solution depends on the commodity, the market and mainly on the policy environment. Stakeholders 1. Participating farmers These are farmers who participate in contract farming. They face unequal power relations between them and the contracting firms. They usually participate in the contract for their own interests for instance access to inputs, guaranteed lucrative markets and stable prices. When prices are higher than the contract prices they are tempted to sell their produce in spot markets risking losing the contract if discovered.

2. Non-participating farmers These are farmers who are undecided about joining the contracts or not. Some were in the contracts but they decided to quit or they breached the contracts or the contracts ended. The motivating factor that can make them participate or join contracts is access to inputs and stable prices. Most of non-participating farmers are those who sell their produce on spot markets and they bear high risks because they are not guaranteed stable prices and access to inputs. They may be unable to participate in the contracts due to barriers of entry such as criteria established by the firm regarding the contracts. 3. Contracting firms These are Agribusiness companies that engage in production of a given product at a guaranteed future price. Their aim is to ensure steady flow of high quality agricultural products at the lowest cost. These firms face difficult decisions between working with the lowest number of large scale farmers who are difficult to bargain with and the pressure from the government to work with small farmers and help promote rural development. 4. The government The government provides infrastructure that leads to improvement in the modern agricultural sector, extension services and policy guidelines that encourage the contractors extend the contract periods. The government benefits from contract farming through tax revenues, increase in the exports resulting in high foreign exchange rates and balance in trade. Contract farming leads to creation of employment addressing the problems of rural area development through increase in earnings and overall rural development. 5. Farmer organizations These are groups and organizations formed by the farmers, mostly by farmers with common interest, at times referred to as common interest groups. They facilitate trainings and help in negotiating better prices for the farmers and rules on grading and standards. They also do bulk building thus benefiting from the economies of scale. 6. Non governmental organizations They act intermediary between the contracting firms and participating farmers. They offer training to farmers and link them to input suppliers. They disseminate experiences and develop best agricultural practice guidelines for the farmers. NGOs assist in forming farmer groups

and can increase business and technical skills of groups, developing good working relationship among the groups and agribusiness firms. Benefits of contract farming Contract farming in developing countries has numerous benefits to the stakeholders. These benefits differ from large to small scale farmers. First, farmers have access to markets for their produce. This guarantees farmers access to ready lucrative markets that fetch high prices for their output which has an impact on their household income. Secondly, the farmers will have input access, technical assistance and credit facilities. The farmers are provided with the right and quality inputs for planting and technical assistance on how to manage the crop till maturation. The farmers are also assisted in harvesting and post-harvest handling through provision of agro-chemicals such as pesticides, herbicides and fungicides. Thirdly, contract farming leads to reduced production and marketing risks. The participating farmers are guaranteed price for their produce by the contract which is a motivation for them to produce. The contract reduces the number of brokers in the agricultural industry. Fourthly, contract farming results to higher and stable incomes to the small holder farmer in developing countries contributing to reduction in rural poverty. Fifthly, contract farming has the potential to create employment opportunities to the rural people through new technologies. This makes use of family labour which has ripple effect on family income. Sixth, contract farming reduces contractors transaction costs, coordination costs and input cost. By providing inputs the contractor reduces cost per unit of input thus leading to lower output prices. Buying from contracted farmers reduces the coordination cost such that it links transaction activities upstream and downstream. Spot market buying needs a lot of screening and selection unlike purchasing from contracted farmers where there exists a relationship between the buyer and the seller. Finally, by providing technical assistance to farmers, contractors are able to obtain a more uniform product, raise the product quality and improve safety standard requirements though frequent visits to the production farms. This enables the contractor to obtain sufficient produce at the right time and quality for the market. Constraints of contract farming in developing countries Despite the glaring benefits derived from contract farming in developing countries, farmers face a number of challenges. They include: 1. Lack of information about production methods and market opportunities, particularly on export crops. 2. Farmers lack sufficient information about profitable investments. Wrong enterprise choice leads to low productivity among participating farmers.

3.

Small scale farmers often lack the necessary financial reserves to cushion themselves against unfavourable weather conditions in the developing countries.

4.

The farmer lack awareness about available arbitration services in case of breach of contract or those that are available are expensive to them. This leads to long legal process in court making contracts undesirable to small scale farmers.

5. Farmers have limited access to credit due to lack of collateral and/or by the high interest rates demanded. 6. Small scale farmers operating near subsistence are more risk averse than large scale farmers. This makes contractors especially of foreign origin to prefer dealing with large scale farmers. 7. Contract farming shifts farm production to cash crops, which may adversely affect the production of basic food crops. It may also lead to more narrow local farm markets resulting from agricultural resources being diverted to contract farming. This creates problems for non-contract producers who then face thin markets and lower prices. 8. Contract farming in developing countries leads to a dependency relationship between producers and contractors, which make the producers vulnerable to sudden changes in the strategy of the (foreign) contractors and result in exploitative behaviour by the contractors. 9. Contract farming leads to gender inequalities both in quantity and quality of work for women and children. In developing countries, most work is done by women especially farming. 10. Contract farming leads to overexploitation of natural resources. In pursuit of high yields from small farm, farmers try to overuse agro-chemicals which compromise the environment and natural resources conservation through leaching, soil mining and pollution. Policy options for developing countries 1. Facilitate conducive investment environment in agricultural sector The developing country governments should create a favorable investment climate for both the contractors and the small scale farmers to stimulate the level of agricultural production for both fruits and vegetables. Conducive investment climate will create an incentive for more contractors to participate in the industry. This can be achieved by provision of adequate infrastructure to lower transaction costs and reduce administrative bureaucracies involved when contracting. The government through line ministries and private sector partnerships can put in place good roads, cooling facilities and communication channels to allow free flow of information among the stakeholders since fruits and vegetables are perishable. Contract farming helps small scale farmers to reduce transaction costs of accessing new markets, borrowing, managing risks, acquiring information and increased employment opportunities to 4

the society. The success of contracts reflects both the contracting environment and management policies (Simmons, 2002). 2. Promote competition through provision of relevant information to both the contractors and the participating farmers This policy is meant to reduce the impacts of information asymmetry and opportunistic behaviours by dishonest contracting parties. The government should create a pool of information that should be available to farmers about viable and profitable contracts and contractors to transact with. This is likely to expose those contractors who misuse farmers and to achieve profits at the expense of farmers efforts. Its imperative that contractors also be informed of the attributes of the farmers they are dealing with so as to shield their interests to make contract farming appealing. Recent expansion of contract farming is often viewed as part of the broader globalization phenomenon whereby removal of trade restrictions will lead to increased flows of agricultural products especially from developing to developed countries. Prices paid for contracted crops are usually lower than market prices. Singh, (2004) revealed that most farmers try to sell their produce to spot markets for better prices instead of factories where they had contracted. However, Baumann, (2000) stated that it is easy for a company to manipulate prices when the market is competitive and prices are volatile. This policy will help the farmers and contractors to offer the right quality and price for the produce since price stability is essential if firms are to continue contracting with their growers and growers are to obtain income stability (Sriboonchitta and Wiboonpoongse, 2008).

3. Promote cooperation among all stakeholders in the agricultural sector There is need for developing country governments to promote cooperation among private farms, nongovernmental organizations, and contractors in the provision of extension services so as to enable small holder farmers to meet market requirements. These requirements include the right product standards needed by the buyer, for instance product quality, grades, size and inspection for safety. This can be achieved when the stakeholders including the government work as partners. There is need to incorporate all the stakeholders so as to achieve success in contract farming otherwise, pull out by the contractors would simply mean collapse of the contract farming. Porter and Philips-Howard (1997) describe contract management failure in Africa resulting from use of expatriate staff with inappropriate cultural values in management roles. They argue that lack of knowledge of cultural values contribute to underperformance and failure of contracts through misunderstanding of issues, inappropriate conflict resolution processes and miscommunication. Thus need for a policy framework for developing countries to provide for inclusion of all the stakeholders in contract farming. 5

4. Provide mediation services and affordable arbitration options The government should provide mediation services between the buyers and farmers and explore innovative ways to enforce contracts. This can be achieved by setting up a legal system under the ministry of agriculture to enforce contracts and limit opportunistic behaviours. The state can also introduce special contract law and provide affordable arbitration options for disputes between farmers and contractors. The policy intends to create awareness among stakeholders of the available options to them to achieve healthy contract farming. Contract farming offers a huge opportunity for commercializing smallholder agriculture, smallholder farmers have reportedly experienced some contractual problems in dealing with large agribusiness firms, resulting in smallholder farmers giving up contract farming. Similarly, agribusinesses have also reportedly encountered some contractual problems when dealing with some smallholder farmers that could have led to the exclusion of the latter from contract farming. In general, these contractual problems have been largely attributed to the failure of one of the parties to the contract, either agribusiness firm or smallholder farmer, to honour agreed-upon contracts (Wiegratz et al., 2007) Thus the need to learn from success story of Malawi, where the government has established guidelines for dispute resolution in agricultural contracts and offers the services of an officer of ministry of labour for mediation (Eaton & Shephard 2001). 5. Encourage formation of farmer organizations and trade association The country governments should encourage formation of farmer organizations to link the farmers to the trading firms/markets and give them a strong bargaining power in contract formation. Trade associations and better agribusiness bureaus under the ministry of agriculture will help discourage dishonesty by establishing code of conduct among the players in contract farming and expose firms that use unscrupulous practices. Such firms can be blacklisted such that they should not be allowed to contract with farmers in the country. Farmer groups also play an important role in the success of a contract by encouraging new technology and adjustments to changing market conditions; they facilitate contract management by dealing with disagreements between growers and contractors. Experienced farmers in the group may be a source of extension services for less experienced farmers (Simmons, 2002). Farmer groups can benefit from economies of scale that can be important in bargaining for better prices, access to inputs, credit facilities and other important services that encourage agribusiness. The formation of farmer groups can be achieved through the partnership of ministry of agriculture with other stakeholders in encouraging famers to form groups and educating them on the importance of the groups and how they can be run.

6. Establish and enforce standards acceptable in the international market Governments through research institutions and standardization bodies can develop grades and standards for the quality requirements of fruits and vegetables in the international market. They include food safety and quality requirements. Supply reliability demanded by supermarkets raise challenges to small producers (Boselie, D., Henson and D. Weatherspoon, 2003). Contracting firms and government extension officers can help small holders through the provision of technical assistance to comply with the (private) food safety standards and regulations (Bijman, 2008). Safety in the food chain is a major concern in all countries, and increasing resources are being directed in many countries to safeguard domestic consumers. Vigilance starts with setting up an appropriate structure at governmental level with the application of correct on-farm practices, and is particularly important during harvesting, storage, processing and marketing. This aims at regulating the market by ensuring that contractors do not abuse their market power. 7. Provide incentives to contractors to set up processing firms in rural areas The governments should provide incentives to fruit and vegetable processing firms to set up processing plants in rural areas. This policy strives to reduce high transaction costs resulting from uncertain quality; supply and price risk ensuring stable incomes to the participating farmers and also serves to encourage rural development. This can be achieved through promotion of activities such as preserving, packaging, freezing and transporting that meet consumer requirements (Simmons, 2002). This can also be realized through tax reliefs and good infrastructural development that can act as an incentive to contracting firms to set up those facilities. The government should encourage contractors to initiate new contracts and support farmers in making suitable contract selection. Farmers should be helped through direct subsidies to expand production of vegetables and fruits and provide affordable crop insurance options. Setting up of processing plants such as cooling plants by contractors in the rural areas ensures that the contract farming will last for a longer period. 8. Promote and women participation and empowerment in agricultural production Contract farming leads to gender inequalities both in quality and quantity of work for women and children (Bijman, 2008). Therefore the developing country governments should empower women because women do most of the production work (at least in Africa). This is aimed at reducing skewed power relations as this may lead to overexploitation of the powerless by the powerful (Little and Watts, 1994). Women empowerment can be achieved by making contracts more sustainable by involving women during negotiations, signing of the contract and payments made directly to women. 7

Summary Contract farming in fruit and vegetable production is an emerging sector in agricultural diversification and is growing fast given the returns from these high value crops. Smallholder farmer participation in contract farming is crucial in developing countries as a way of reducing rural poverty through employment opportunities, rural development and generation of household incomes. Through the stated policy options, the stakeholders can come together and help promote contract farming given the high returns accrued. Non-participating farmers should be encouraged to join the contracts to access inputs and stable market prices. Provision of technical assistance, input access and credit facilities to participating farmers especially smallholder farmers will be an incentive to higher production levels. Developing country governments should encourage the contracting firms to involve more smallholder farmers as a way of rural development. These governments should also emphasize on ways of protecting farmers from opportunistic contractors and brokers through the encouragement of the farmers to form farmer organisations. Promotion and empowerment of women in contract farming will help promote production. Fruits and vegetables being highly perishable, through arrangements like contract farming they can be marketed soon after harvest. The developing countries can also try to alleviate the constraints of contract farming to make the system favourable to all the stakeholders through promotion of cooperation among all the stakeholders. Hence the need for a policy framework that is inclusive of all stakeholders interests.

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