As China faces food safety and disease problems, companies are moving away from the traditional small-farmer "production base" model to a mechanized, industrialized mode imported from developed countries. This trend may signal China's transition to a "middle income trap" as capital-intensive production with imported technologies are employed in a country that is still pretty much a developing country.
The YUM! executive explains that they are moving toward a more tightly-controlled integrated production model because the traditional "company + farmer" model has too many vulnerabilities that the company can't control. For example, he explains that there are two kinds of chicken pharmaceuticals on the market--an imported brand that leaves no residue in the meat but is expensive and a domestic brand that is cheaper. Of course, small farmers are inclined to use the cheaper drugs and the company has little control over them. The company is adopting a fully integrated model which controls each aspect of the chain from feed and chicks to production, processing, and sales.
Inside a mechanized poultry slaughter plant in China.
One analyst noted that the dairy industry sped up development of its own farms after the melamine incident and the poultry industry should follow the same road.
A related article describing the company that supplies much of KFC's chicken says the broiler industry is in an "upgrade" period. Vertical integration (a "long dragon" resembling the dragon in a dragon dance) is now one of the leading industry models.
The reporter visited a chicken farm with 16 chicken houses, each holding 30,000 birds that take 45 days to reach slaughter weight. He had to wear protective clothing, hat, gloves, and rain boots. The chicken houses were warm, temperature controlled, with feed and water piped in, all part of an automated system overseen by a single worker. Workers are not permitted to leave the farm during the 45-day growing cycle. The slaughterhouse looks like just another factory from the outside. Inside, the large factory floor is completely mechanized with a dozen or so workers in pink protective clothing busy on the production line.
This company pioneered the vertically integrated model that links up the whole process, from breeding and multiplier farms to grow-out, slaughter, processing, packaging, and sales. They plan to invest 5 billion yuan (over $800 million) in an integrated complex that will produce 250 million birds annually. He claims the integrated model can reduce unit cost and better manage price risk.
A Daily Business News article highlights the breakdown of the small farmer-plus-company contracting model that vertical integration is displacing. Chengde county, a mountainous area north of Beijing, has 3500 farmers raising 67 million chickens annually, scattered over 178 villages. Most of them raise chickens under contract for one company that is dominant in the county, but several other large companies are also active in Chengde. The reporter suggests that farmers have grown disenchanted with chicken-farming due to the inflexibility of company contracts.
According to county officials, farmers earn 20,000 yuan ($3,225) on average from chicken-farming, but local farmers are skeptical of this number. One leader of a chicken farm cooperative told the reporter: “About 50-60 percent are losing money and just about everyone is in debt.” One farmer said he lost 20,000 yuan on his last batch of chickens.
Company contracts specify that farmers use chicks, feed, and medicines specified by the company. They set a purchase price that is supposed to cover costs plus a profit. However, farmers say their margins have been shrinking due to rising costs of feed, labor coal (for heating) and electricity. They complain that they have no negotiating power and have less information than the company.
Six years ago, Mr. Song decided to quit truck-driving and return to his village to raise chickens. He was enticed by government and company advertising that said he could earn 10,000 yuan from each batch of chickens. Other farmers say the local government gave out subsidies and townships and villages had targets for recruiting chicken farmers. At its peak around 2008, one farmer said chicken houses "fell like rain."
Many farmers now say they lose money raising the birds, but they are tied to the company by a five-year contract. Many others have quit and empty chicken houses are evident. The director of one town's rural credit cooperative said 60-to-70 percent of farmers had quit raising chickens in his area. One company that had previously signed up 800 farmers now has 400-to-500 left.
Mr. Meng, a village party secretary and chicken farmer, said each 5000-bird cycle of chickens eats up 24-to-25 metric tons of feed at a cost of 120,000 yuan. After deducting his advance payment, he earns nothing from selling the chickens.
Companies require that farmers use the inputs supplied by the company to maintain uniform products and prevent problems from low-grade feed or toxic pharmaceuticals. The intent was to gain the type of control over the product that KFC is looking for in its vertical-integration model. However, now the Chengde company is facing hard times and farmer-suppliers say the company is shifting losses on to them. A farmer complains that he is required to use the feed supplied by the company. If he uses too little company feed (which implies he uses an unapproved type), he is penalized. Last year, the company was substituting wheat for corn in the feed which slows down the growth of the chickens. A farmer complains that the quality of chicks has declined.
Feed prices went up from 3200 yuan per metric ton in 2010 to 4200 yuan now, but chicken prices didn't go up much.
These developments seem to signal the end of the small-farm backyard-livestock era in Chinese agriculture. The "backyard" mode was appropriate for a labor-abundant countryside and farmers were eager to sign up. Now that wages are rising this activity is no longer attractive. Consumers are "fed up" with the uncertainty over food safety and companies are taking more control over production to assure consumers that products are safe.
"Modern agriculture" is an inherently capital-intensive activity. Does it make sense to adopt capital-intensive production methods in a labor-abundant country? Companies will have to offer high wages to workers who can't leave the chicken farm for 45 days at a time. Will the company have any more control over its wage employees than it does over farmer-suppliers? Processing plants will have to use huge amounts of water and spend a lot treating it or create even worse pollution problems. While it may be possible to have low unit costs with an integrated high-input production system, other companies are also building massive-scale production capacity. Competition will keep downward pressure on prices, prevent production capacity from being fully utilized, keep unit costs high, and lead to losses. Instead of importing a high-cost production system that employs a dozen workers, why not import cheap poultry from the U.S. or Brazil?
By pretending to be a developed country, China may be pushing its costs upward and inadvertently falling into the much-dreaded "middle income trap." There is also an absence of innovation--the "white feather" broiler breeding stock (twice as efficient as native "yellow feather" chickens) must be constantly replenished by imports.