China's Cotton Mountain Grows

China is creating a huge stockpile of cotton similar to the infamous "butter mountain" accumulated in the European Union during 1980s and earlier decades. Like the EU and U.S. during the 1980s and earlier, China has a minimum price for cotton that exceeds the market price. That means the government has to buy cotton to maintain the minimum price because private sector businesses can't make a profit buying cotton above the market price.

Unlike the E.U. and U.S. price support regimes of earlier decades, China has committed to relatively low tariffs and China is a net importer of cotton. The E.U. and U.S. subsidized exports of their commodity mountains, distorting world markets and leading to the adoption of disciplines on domestic support in the Uruguay Round of GATT. China, however, is accumulating a mountain of domestic cotton AND importing huge quantities of cotton. This is the perverse three-tier market described on this blog in October.

As of December 5, China's national cotton reserve corporation had purchased a cumulative 3.6 million metric tons of cotton from the 2012 harvest. This is the second year of massive stockpiling after the price support policy was introduced in 2011. The addition to the stockpile from this harvest so far exceeds the addition to last year's stockpile of about 3.1 mmt. Total reserves are now near 7.5 million metric tons. This exceeds China's annual production--estimated at 6.6 mmt this year--and is about 75 percent of USDA's estimate of China's annual consumption of cotton.

The cotton mountain phenomenon is exacerbated by weak demand for cotton from the Chinese textile industry. The textile business in China is still relatively slow. There are signs of recovery in domestic apparel sales but the export business is not good. Many companies report very slow orders.

For the most part, the only buyers of cotton in the China market now are companies that are authorized to buy at the minimum price. Private-sector operators are only buying cotton as they need it. Many companies in the textile business have either idled their factories or are running at a fraction of capacity. Those still operating are losing money and continue operating either to keep workers busy or to fulfill orders for high-end products. Inventories of unsold textiles are up. Companies are reportedly facing cash flow pressure. They have to repay outstanding loans before getting new ones. Many are having trouble paying their employees. Reportedly, more textile operators will have to shut down around the new year.

Imported cotton is cheaper than domestic cotton at the support price, so companies looking for cotton try to get imports. Cotton imports are controlled by a tariff rate quota system installed after WTO accession.  According to a cotton industry report, quotas to import have become a valuable right. Some trading companies holding quotas import cheap cotton and resell it to Chinese companies at a price near the support price. Some textile industry people say the availability of  cotton imported at the 40 percent sliding scale tariff has recently been restricted by some unspecified policies.

China's imports of cotton soared to 5.4 mmt during 2011/12, more than double imports of about 2.5 mmt during the previous two years. According to Chinese customs statistics, imports during the first two months of the 2012/13 market year are at about the same pace as last year.

Why did China pursue this policy? According to Ministry of Agriculture surveys, farmers wanted a price support policy. Ministry economists explained in a 2011 report that the policy was meant to address "cobweb"-type oscillations in the cotton market--a low price induces a decline in production which leads to high prices the following year, which leads to expanding production, which leads to low prices... Previously, the government tried to manage reserves to stabilize the cotton market, but it didn't have much impact and farmers didn't perceive any benefit from the policy.

An unspoken strategy behind the cotton policy is to buy regional stability in China's restive northwest Xinjiang "autonomous" region. Chinese authorities built up a cotton industry in Xinjiang during the 1990s to maintain self-sufficiency as cotton use swelled and eastern production areas faced pest problems. Xinjiang now accounts for nearly half of China's cotton production and would be one of the top producers in the world if it were a country. About two-thirds of the reserve purchases under the price support program are made in Xinjiang.

Xinjiang borders several central Asian countries and was the site of violent protests by the native Uighur population in 2009 and 2011. China's President Hu Jintao recently noted that policies are tilted toward border regions (check) and ethnic minority regions (check). A Ministry of Agriculture article offering recommendations for the design of the policy noted the importance of supporting poor farmers in Xinjiang who, unlike farmers in eastern China, had no good alternatives to growing cotton.

The problem with creating a cotton industry in Xinjiang is that it's thousands of miles from the textile industry and there has been very little progress in developing a local industry beyond basic cotton-ginning and trading. On December 7, a team of officials from the National Development and Reform Commission, Railway Ministry, Supply and Market Cooperative and National Cotton Reserve Corporation went to Xinjiang to inspect the situation regarding purchase, reserves and transportation of cotton. This presumably was prompted by the overflow of reserve capacity reported in this blog's October post. The team's recommendations included getting accurate statistics to find out how much cotton production is actually produced; adjusting the structure of products transported, "improving rail work"; and exploring ways of storing cotton in courtyards, finding more space in warehouses and using them more efficiently.

Agricultural officials worry that Chinese farmers will abandon cotton production in droves if the cotton price declines. A team of Ministry of Agriculture analysts visited several cotton-producing counties in eastern China during October. They found that cotton yields were good this year and net returns from planting cotton  were up 30 percent from 2011. However, farmers in this region can make more from planting winter wheat followed by a summer corn crop. Also, cotton takes a lot more labor, a problem for farmers who can earn a lot more working off-farm. Officials in the regions they visited expected more declines in cotton production next year.

The team of agriculture analysts recommended extending the "general input subsidy" to cotton farmers--this subsidy is now given only to grain producers. They called for beginning the general input subsidy for cotton in Xinjiang next year and later spreading it to other provinces. (The only direct subsidy for cotton producers now is 15 yuan per mu for improved seed varieties.) In Xinjiang (and Shandong) the general input subsidy for grain is distributed based on the area planted in wheat, so adding a subsidy for cotton would be seemingly straightforward. However, in Hebei and Henan Provinces (also big cotton-producing areas) the general input subsidy is now a decoupled payment based on a farmer's historical land parcel designated for producing grain, but there is no formal requirement that they plant grain. In these provinces, farmers may already be planting cotton on part of this land, so it would be problematic to implement a general input subsidy for cotton.

The agricultural analysts also called for announcing the support price as early as possible--before they plant the crop in the spring--to give farmers "confidence" and incentives to produce.

There is no discussion of how China will dispose of its massive cotton stockpile. The Ministry of Agriculture analysts make some vague recommendations in this direction. They call for adjusting the annual import quota based on international and domestic market conditions and using other inducements to encourage companies to use Chinese cotton. These proposals sound like WTO violations, however, and Ministry of Agriculture officials regularly insist that they adhere to their WTO commitments.

For now, Chinese authorities are subsidizing domestic producers by stockpiling their cotton at artificially-high prices, and they are subsidizing cotton producers in the United States, Australia, India and elsewhere overseas by creating an artificially-high demand for cotton as they lock up half the Chinese crop in warehouses. Chinese officials may be hoping there will be a rebound in textile demand that will allow them to sell off the reserves at a price higher than they paid.  Some reserves from last year are being sold to textile companies at last year's price now. It would take a lot of demand to use up the volume they have accumulated.

Finally, as with most buffer stock policies, the result is the opposite of what was intended. The idea of the price support was to stabilize the cotton market, but instead it has created even more confusion and potential instability. Chinese cotton production continues to fall; the subsidy cost soars. In the same way Chinese businesses copy factories and products overseas, Chinese officials adopt policies discovered in textbooks or  overseas study tours without carefully thinking through the potential outcomes.