What is Wrong With Buffer Stocks?

Why shouldn’t countries build buffer stocks?

 In mid-March 2015, the Ministry of Textiles of the Government of India floated a proposal to guard against year-to-year fluctuations in cotton production by limiting exports in order to build a “reservoir” for use by the domestic textile industry (Business Standard, March 18, 2015).  What’s wrong with this proposal?The concept of buffer stocks is an old one. The proposal by the Ministry of Textiles is a variant on the old theme of buffer stocks, no matter what name, “reservoir” or any other, they may choose to employ.

Member governments of the International Cotton Advisory Committee considered establishing international buffer stocks in 1939, 1952-54, 1967, and 1978-81. None of the attempts to achieve an international consensus were successful, not because of philosophical opposition, but because the logistics of operating an international buffer stock could not be agreed. Issues such as deciding which country’s cotton should be purchased and held, how to account for quality differences, where stocks should be held and at whose expense, prevented agreement.

In the absence of an international consensus, there have been national efforts over the years. The United States inadvertently established a de facto buffer stock between 1983 and 1986 when market prices remained consistently below the loan rate. The Soviet Union maintained a strategic reserve, although the size was never acknowledged. During the Mao era, China maintained strategic reserves of cotton in each province, and smaller cotton countries, like South Africa during the apartheid era, have also maintained strategic reserves. More recently, China built a state reserve of more than ten million tons of cotton between 2011 and 2013. And other countries with other commodities also practice resource nationalism; for example the United States blocks exports of crude oil to benefit domestic refiners and consumers.

So, why shouldn’t India, or any other country, do the same with cotton?

Carrying Costs: many government employees, perhaps including those in the Ministry of Textiles who are making this proposal, have little or no experience in private industry, and the concept of carrying costs may seem trivial. But, in a commodity industry characterized by large volumes and low margins, carrying costs can be crucial.

In round numbers, the cost of storing cotton in India at current prices is around U.S. 1.5¢ per kilogram per month (nearly one Rupee per kilogram per month), which is mostly interest on the value of cotton at 12% per year with prices currently near 70¢ per pound. Warehousing costs of about 50¢ per bale per month (30 Rupees/bale/month) and storage insurance of 0.05% per year, add marginally to the monthly cost of carrying inventories. While 1.5¢ per month per kilogram may not seem like much, in a year these costs amount to 18¢ per kilogram or $31 per 170-kilogram bale (Rupees 1,900/bale). If the Ministry of Textiles wishes to establish a “reservoir” of one month’s worth of Indian mill use, or 440,000 tons, the cost of carry for one year would be US$6.6 million (Rupees 410 million). Someone will have to pay this cost. If the Ministry of Textiles absorbs the cost of carry for a national reservoir, Indian taxpayers will be subsidizing the supply of cotton for textile mills. If the private sector is forced to cover these costs, ginners and merchants will pay lower prices to farmers or charge higher prices to textile mills, rendering the Indian cotton value chain less competitive in the world economy.

Uncertainty: Any analyst can look at past statistics on cotton supply and use, and with the benefit of hindsight, say with certainty that the government or industry should have purchased cotton here when prices were low and sold them there when prices were high. It all looks neat and obvious on paper. However, in reality, forecasting cotton production is very difficult, and no one can consistently anticipate crop yields from one season to the next.

8. CAI NewsletterAs the Ministry of Textiles notes, cotton production fluctuates from year to year, but no one knows this year if there won’t be another good/poor harvest next year. If production is large several years in a row, the “reservoir” will build, resulting in even more carrying costs. If production is low several years in a row, the “reservoir” will be exhausted, leaving textile mills unprotected.

Anticipating when to build a “reservoir” and when to liquidate the “reservoir” is very difficult. As China’s recent experience illustrates, it is a near certainty that government officials will get it wrong. This is why decisions related to inventory management are best left to the private sector. Indian textile mills, like their counterparts around the world, are free to build their own physical inventories if they wish, or to contract in advance for future deliveries or to hedge in futures markets. Fiber inventory management is a crucial component of textile mill success, and those mills that manage inventories wisely will prosper, those that do not will fail, and over time industry becomes more efficient and productive.

Stocks Depress Prices and Discouraging Production: The existence of a “reservoir” will in and of itself depress prices paid to farmers. Demand for cotton, or any other commodity, at any moment is composed of several components, including demand for immediate consumption and demand for stocks to hedge against future consumption. Knowing that a “reservoir” exists, the private sector will reduce purchases to cover only needs for immediate consumption. This is the fundamental reason why prices fall whenever stocks are high.

Poor Quality, Quality Deterioration & Fraud: Cotton is a storable, durable commodity that can maintain its value for months and even years if properly stored. However, proper storage is expensive, requiring controlled environments with proper humidity, and conditions are rarely optimal. As a consequence, most cotton deteriorates in color over time.

A related problem is that, other things equal, both domestic and international buyers desire higher qualities of cotton. Therefore, almost by definition any cotton left over at the end of a season to be placed in a “reservoir” will tend to be below average in quality. As a consequence, when cotton from the “reservoir” is needed a year later, it will almost certainly not match the qualities that textile mills desire.

Finally, in any government program of managed inventories in which billions of Rupees are at stake, fraud will occur. Fraud occurred in the United States in the 1980s, in the Soviet Union in the 1980s, and it is evidently occurring in China now. If the government of India mandates the formation of a “reservoir” of cotton, it is inevitable that qualities and quantities destined for the “reservoir” will be falsified, inventories will be stolen, and warehouse charges will be padded. When it comes time to use the cotton from the “reservoir,” cotton that existed on paper won’t be there in reality.

Rent Seeking Behavior Expands: A major beneficiary of any government proposal to intervene in markets is the domestic airline industry as association executives fly to the national capitol to plead for or against the proposal. In economics, benefits conferred by government policies are described as “rents,” and when governments propose market interventions, executives in the industries to be affected by the proposal are quick to board planes to lobby on behalf of their interests. Instead of staying at home and working to make better products at lower costs so as to be increasingly productive, industry representatives feel compelled to “communicate their concerns” to government officials to ensure that decisions do not adversely affect their interests.

However, rent-seeking behavior is inherently a zero-sum game, meaning that the benefits that might accrue to any one segment will necessarily represent losses to other segments of the value chain. Rent seeking behavior is in and of itself a deadweight loss on social welfare, and government proposals to intervene in commodity markets always engender more rent seeking behavior.

Trade Retaliation: India is a member of the World Trade Organization (WTO) and also participates in numerous regional trade bodies and bi-lateral free trade agreements. India is now the largest cotton producer and second largest exporter and benefits from trade access to the markets of countries around the world. Efforts by India to protect the interests of its domestic textile industry by limiting cotton exports, either through regulation or taxation, will harm the interests of trade partners, especially Bangladesh and Pakistan. Inevitably, there will be repercussions in the form of international ill will, reduced cooperation and possibly even future retaliation.

Freedom: As reported in the same story carried in the Business Standard, the Indian Ministry of Commerce has replied to the proposal by the Ministry of Textiles by noting that in a free market, producers should be free to sell to whomever wishes to buy, including domestic or international customers. It is self evident that the Ministry of Commerce is correct. Otherwise, why have free markets at all?

Precedent: If the Ministry of Textiles proposes to limit exports of cotton to ensure a “reservoir” for domestic use, why not also limit exports of yarn to ensure that weavers and knitters are protected, or limit the exports of fabric to ensure supplies for domestic tailors, or limit the exports of clothing to ensure enough for domestic consumers? Interventions in markets always engender more interventions in markets as industry segments compete for government favors through ever more vigorous rent seeking activities.

Conclusion

Buffer stocks to cushion variations in commodity supply and prices have been tried many times in many industries by many countries, and they have all failed. There are reasons why governments eschew such policies. Government interventions in markets through the creation of buffer stocks result in higher inventory expenses, lower prices paid to farmers, a mismatch between qualities available and qualities desired, fraud, rent seeking behavior, trade retaliation, a curtailment of freedom and yet more interventions as government officials try to offset the distortions caused by the first intervention.

All segments of the cotton value chain in India would be well advised to oppose the proposal by the Ministry of Textiles to create a “reservoir” of cotton by curtailing exports, and the Ministry of Textiles would be well advised to allow this proposal to quietly slip under the table and die a merciful death.

End.