Report No. 44843-UA Ukraine Agricultural Competitiveness June 2008 Europe and Central Asia Region Sustainable Development Unit Document of the World Bank Currency Equivalents (Exchange Rate Effective June 18,2008) Currency Unit = Ukrainian hryvnia (UAH) UAHl = US$O.21 U S $ l = UAH4.70 FiscalYear January 1 - December31 Vice President: Shigeo Katsu Country Director: Paul Bermingham Sector Manager (Acting): Holger Kray Task Team Leader: Matthias Grueninger - 11*. - Table of Contents Abbreviationsand Accronyms ................................................................................................................... v Acknowledgement ....................................................................................................................................... vi ExecutiveSummary ................................................................................................................................... v11 .. IAgriculture'scurrentandpotentialroleintheUkrainianeconomy . ................................................... 1 Agriculture's role in the Ukrainianeconomy .................................................................................................. 1 Ukraine's agricultural potential ....................................................................................................................... 4 I1 Outlookonfuture agriculturalmarketsand the positioningofUkrainianagriculturalproducts 5 . . Recent and forecast.developments on international agricultural markets........................................................ 5 Ukrainian agricultural trade .recent and forecast developments ..................................................................... 7 Positioning Ukrainian agricultural products .................................................................................................... 9 I11 The currentstatusofUkrainian agriculturalcompetitiveness . ....................................................... 10 Indicators o f agricultural competitiveness ..................................................................................................... 10 The current status of Ukrainianagricultural competitiveness ........................................................................ 13 IV Factors constrainingagriculturalcompetitivenessinUkraine . ....................................................... 19 V Measuresto increaseUkraine'sagriculturalcompetitiveness . .......................................................... 28 Appendix 1: The DomesticResourceCosts method and the calculation of DRC distributions ........35 Appendix 2: StatisticalData ..................................................................................................................... 43 References ................................................................................................................................................... 49 Figures Figure 1: The sectoral composition of the economy in the European Union and Former Soviet Union countries (2002) ................................................................................................. 3 Figure 2: IMF agricultural commodity price indices and corresponding quadratic trends. 1980- 2007 (1995 = 100) ......................................................................................................... 6 Figure 3: Past and projectedprices for major agricultural commodities (US$/t, 2002-2017/18)....7 Figure 4: World export volumes for major agricultural commodities, 1992-2006 and projections through 2015 (1995-97 = 100) ...................................................................................... 8 Figure 5: The share of householdsintotal production of agricultural products, 2004 (%) ........... 13 Figure 6: Domestic resourcecost distributions for major crop products inUkraine, 2005 ........... 14 Figure 7: Domestic resource cost distributions for major crop products inUkraine, 2004 ........... 14 Figure 8: Domestic resource cost (DRC) distributions for major livestock products in Ukraine. 2005 ............................................................................................................................ 16 Figure 9: Domestic resource cost (DRC) distributions for major livestock products in Ukraine. 2004 ............................................................................................................................ 17 Figure 10: Gross agricultural output inUkraine by type of farm. 1990-2006 (1990 = 100).........20 Figure 11: The composition of producer support inUkrainianagriculture. 1992-2005 (million U S dollars) ........................................................................................................................ 22 Figure 12: Milling wheat prices in Ukraine and a comparable world market price for wheat, January 2000 -January 2008 (US$/ton) ..................................................................... 22 Figure 13: Nominal rates of assistance to agriculture inUkraine, 1992-2005 (YO)....................... 23 Figure 14: Grainmarketing costs inUkraine and Germany, 1999 and 2005 ................................ 24 TABLES Table 1: Distributionof farms inUkraine by size (2006) ................................................................ 2 Table 2: The Policy Analysis Matrix (PAM) ................................................................................. 12 Table 3: Summary of DRC results for major crop products .......................................................... 15 Table 4: Summary of DRC results for major livestock products................................................... 18 .iv. ABBREVIATIONSAND ACCRONYMS BCI Business Competitiveness Indicator DDGS Distillers' DriedGrain and Soluble DEA Data Envelopment Analysis DRC Domestic Resource Cost EU EuropeanUnion FA0 Food andAgriculture Organization FAPRI FoodandAgricultural Policy ResearchInstitute FSU Former Soviet Union GAO Gross Agricultural Output GAP Good Agricultural Practices GCI Growth Competitiveness Indicator GDP Gross Domestic Product HACCP HazardAnalysis and Critical Control Point IAAE International Association of Agricultural Economists IER Institutefor Economic Research IMF International Monetary Fund OECD Organization for Economic Cooperation and Development PAM Policy Analysis Matrix RCA RevealedComparative Advantage SFA Stochastic Frontier Analysis SPS Sanitary and Phytosanitary Standards us UnitedStates USA UnitedStates ofAmerica VAT Value-added-Tax WEF World Economic Forum WTO World Trade Organization - v - ACKNOWLEDGEMENT This Policy Note is a product of the Sustainable Development Unit of the Europe and Central Asia Region of the World Bank. It was prepared by Stephan von Cramon-Taubadel and Oleg Nivyevskiy (Consultants, University of Gottingen, Germany) and Matthias Grueninger (Senior Agricultural Economist, ECSSD, and task team leader), with guidance from and final review by Will Martin (Lead Economist, DECRG) and John Nash (Lead Economist, LCSSD). Further guidance was received from the peer reviewers Martin Raiser, Sergiy Zorya, and Alex Kramer, which was greatly appreciated. The team is grateful to the many staff at the World Bank and partner institutions who made substantive contributions to this Note. Inparticular, the team would like to thank Antje Wagener inGottingen for her organizational support, Veronika Movchan(Institutefor Economic Research and Policy Consulting) and Heinz Strubenhoff (German-Ukrainian Agricultural Policy Dialog) in Kyiv for providing data and useful comments, and Olena Tranina and Irene Bomani of the World Bankfor their support inpublishing the final draft. This policy note is part of a programmatic effort to support agricultural policy reform and investments in Ukraine. Several topics covered in this Note are the subject of more detailed analyses in separate products currently under preparation, including issues related to bio-energy production and agricultural trade. The results and conclusions presented in this Note should be understood as work in progress, disseminated to encourage further professional exchange. Feedback and suggestions are welcome and invited and should be sent to the task team leader, Matthias Grueninger (mrzrueninaer@,worldbank.org). - vi - EXECUTIVE SUMMARY i. Theagri-foodsectorisanimportantpartoftheUkrainianeconomy.Agriculturecouldmake an even larger contribution to economic growth and the vitality of rural areas in Ukraine than is currently the case. Ukraine has the agro-climatic potential to be a major player on world agricultural markets. ii. However,asagriculturalcompetitivenessisincreasinglydeterminedbytransformationsthat take place post-harvest in complex food chains, the importance of natural conditions is declining. Ukraine's most important agricultural handicap and the essential constraint to its competitiveness in agriculture is that its endowment of high agro-climatic potential and strategic geographic location is currently not combined with sufficient quantities and qualities of complementary inputs such as a supportive policy framework, human capital, and information and marketing systems. iii. International agricultural trade has expandedconsiderably and prices are strong. While current price peaks may not last, high prices and growing international agricultural trade are expected to persist in the medium term. Hence there is significant potential for expansion of Ukrainian agricultural exports, if competitiveness constraints are addressed successfully. O f course, forecasts of developments on world agricultural markets are notoriously difficult. However, Ukraine is not taking full advantage of the window of opportunity offered by current favorable conditions, and this - along with the immediate costs it implies - will certainly not makethings any easier ifand when world market conditions become less favorable. iv. Ukraine's recent WTO accession and the start of negotiations of a free trade agreement with the European Union (EU) offer attractive opportunities but also put additional pressure on Ukraine's agricultural sector to compete indomestic and international markets. Private and public players in Ukraine's agriculture sector have recognized these challenges and are seeking ways to enhance the sector's competitiveness. The World Bank, through its analytical work, i s supporting this process of identifying and choosing between options that are available to Ukraine. This Policy Note is the first in a series of analytical pieces that provide insights into the issues and options of Ukraine's agricultural sector development. v. In this first Policy Note, Domestic Resource Cost (DRC) analysis using a Ukraine-wide farm accounting dataset is used to generate DRC distributions that cast light on the competitiveness of Ukrainianagriculture. The results demonstrate that many Ukrainian farms are able to produce wheat, sunflower seed, barley, eggs, beef and milk competitively. In 2005, for example, 44% of all Ukrainian farms that produced wheat did so competitively. Corresponding shares for sunflower seed (41%), barley (25%), eggs (40%)' beef (22%) and milk (20%) are rapeseed(lo%), soybeans (8%), pork (8%), potatoes (6%), poultry (4%) and sugarbeet (2%). For lower but point to a sizeable competitive core. The lowest shares are found for maize (13%), all products, the majority of the farms in Ukraine are not able to produce sufficient surplus to cover the costs of domestic and tradable inputs. For many farms and products, the value of production does not even suffice to cover the cost of tradable inputs, indicating that production is subtracting, not adding value. Competitive farms account for a disproportionate share of Ukraine's total output of agricultural products; the 44% o f the wheat producing farms that were competitive in 2005, for example, accounted for almost 56% of Ukraine's wheat production in that year. - vii - vi. The fact that some farms are able to produce competitively bodes well for Ukraine's future international competitiveness in major temperate agricultural products and processed foods. Realizing Ukraine's competitive potential i s a matter of: i)shifting the competitiveness distributions presented here so that the great majority o f farms in Ukraine can produce as efficiently tomorrow as the best farms do today; and ii)developing marketing and processing systems so that Ukraine's ability to produce competitive raw products on the farm i s translated into competitiveness on world markets and for high-value added agri-food products. vii. Agricultural competitiveness in Ukraine is constrained first and foremost by an insufficiently transparent, predictable and market-oriented policy framework. Ad-hoc government interference in agricultural markets reduces the transparency and efficiency o f price formulation on agricultural markets, increases uncertainty and risk, and provides opportunities for rent seeking. These factors discourage private investments and lead to inefficient public and private resource allocations. In addition, and although some improvements have been made recently, domestic support to the sector i s still largely inefficient and often counterproductive. At the macroeconomic level, relative stability and growth since 2000 have benefited agriculture. However, persistent problems with export VAT refunds and over-regulation o f the economy continue to hobble agriculture. At an intermediate level, the lack o f a coherent rural development strategy that provides employment alternatives in rural areas and unburdens farms o f `social sphere' responsibilities is a barrier to competitiveness. At the level o f agricultural policy, agricultural spending i s high and growing, but often ineffective. Especially competitive products such as grains and oilseeds are taxed, while the least competitive o f all, sugarbeet, i s heavily subsidized. Subsidies are erratic over time and not distributed across farms according to any identifiable efficiency or equity criteria. viii. Marketing chains in Ukraine are characterized by physical losses (due to poor harvesting and storage technology on the farm), inefficient and expensive infrastructure and processing between the farm gate and export positions, and inflated margins due to policy-induced risk. Policy has actively contributed to perpetuating these problems. The result i s costly: if farmers in Ukraine had received roughly the same share o f fob grain prices as their counterparts in Germany, the 2006 harvest o f roughly 35 million tons would have resulted inan additional US$1 billion o f farm revenue, equivalent to about one-half o f total government spending in support of agriculture inthat year. ix. Agricultural competitiveness in Ukraine also suffers from inadequate systems to test and document food product quality and food safety. Ukraine's food safety control system is complicated and characterized by fragmented and often overlapping jurisdictions. Many standards applied inUkraine are inconsistent with WTO provisions, with standards established by the responsible international bodies, and with accepted practices in international trade. Without improvements towards an efficient and internationally recognized food quality and safety control system, Ukrainian agriculture will find it increasingly difficult to sell into international markets and its products will not be able to command top prices. The ban on Ukrainian meat, eggs, fish, cheese, milk and butter imposed by Russia in mid-January 2006 provides an example o f the disruptions that can result. This negative impact on competitiveness will be increasingly acute for more perishable products, higher-processed products and products that combine different agricultural raw materials-inother words many high-value added products. - V...l - l l x. Ukraine lacks a complete set of land markets and conditions for the enforcement of bankruptcyproceedings inagriculture. Landleaseis possible, but a market for land sale, which is an integral element o f the development of rural finance markets, has not been established. The ongoing moratorium on the enforcement of bankruptcy proceedings in agriculture has a similar negative impact on the development of agricultural finance. It also hinders the movement of scarce agricultural assets from less to more efficient farm managers by allowing the former to continue operations longer than would otherwise be the case. xi. By limiting the development of agricultural credit markets, missing markets for land sale and the lack of bankruptcy enforcement have reduced especially medium- and long-term investments in farm machinery, on-farm storage, equipment for milking cows, cooling milk and drying grain, as well as manure treatment facilities, etc. Missing or outdated machinery and equipment incrop production results insub-optimal input application, higher costs of production and lower yields, and greater harvest and post-harvest losses. Inlivestock production it results in sub-optimal feed preparation and storage, animal health problems, and an inability to invest in superior genetic material. xii. Underlying and accentuating all of the barriers to agricultural competitiveness in Ukraine is a shortage of human capital. Farm managers often claim that a lack of capital for investments in modern technology is their biggest constraint. However, these same managers rarely make the best possible use of the - admittedly scarce - capital that i s at their disposal. Producers and agri- food businesses often lack skills in.business administration and farm organization and knowledge of markets and marketing, including quality requirements in target markets and how to work towards fulfilling these requirements on the farm and in the food chain. Public institutions, such as the ministries responsible for identifying policy needs and formulating and implementing appropriate responses, often suffer from a lack of analytical capacity and an inability to distinguish betweenprivate and social costs andbenefits. xiii. The agricultural research and education establishment in Ukraine i s not delivering the trained young professionals Ukrainian agriculture needs, and it fails to serve as an independent voice that informs policy makers and other stakeholders by subjecting policy proposals and developments inthe sector to objective and public scrutiny. Inthe years since independence,the agricultural research and education establishment has largely failed to serve as a conduit for new concepts and methods o f policy analysis into Ukraine. There are no provisions for the reintegration of young, foreign trained Ukrainian professionals who could reinvigorate the researchand education. xiv. Policy reforms and investments could greatly increase the competitiveness of Ukrainian agriculture. Inthe policy sphere, greater restraint should be exercised inthe area of trade, market and price policy. Ad hoc intervention on agricultural markets should be reduced.Accession to the WTO is an important and encouraging signal that policy makersare willing to adopt less intrusive and more stable trade, market and price policies. Inthe investment sphere, priorities include food safety monitoring and certification systems, trade infrastructure and logistic capacity, food chain management, technical advisory and market information systems, streamlined and transparent customsprocedures, land markets, and researchand education institutions. - ix - - x - I.Agriculture'scurrentandpotentialroleintheUkrainianeconomy Agriculture's role inthe Ukrainian economy 1. The agri-food sector is an important part of the Ukrainianeconomy. Agricultural production accounted for roughly 7% of Ukrainian GDP in 2007, and food processing for roughly 8% (Appendix 2, Table 1). If the industries upstream from agriculture (farm machinery, fertilizer, agricultural chemicals) are added, the agri-food sector's share of GDP in Ukraine approaches 20%. In 2007, 10% of the country's employed worked in agriculture and food processing, and 32% of the country's population lived inrural areas (Appendix 2, Tables 1and 2). 2. Some Oblasts contribute considerably more than others to agricultural production in Ukraine. Appendix 2 Table 3 presents data on the shares of Ukraine's 25 Oblasts in national production of major crop and livestock products. A group of `core' Oblasts in Central to Eastern Ukraine (Vinnitsa, Dnipropetrovsk, Donetsk, Kiev, Odessa, Poltava, Kharkiv and Cherkassy) have shares of over 5% in national gross agricultural production, (compared with an average share of 4% for 25 Oblasts). These arejoined by Kirovograd(also inCentral Ukraine) when only crop production is considered, and Lviv (in Western Ukraine) when only livestock production is considered. With few specific exceptions (e.g. poultry production in Crimea), Southern Oblasts (low precipitation) and the most Northern and Western Oblasts (less suited soils) make below- average contributions to Ukraine's agricultural production. 3. There are two broad types of farm in Ukraine; individual and corporate (Lerman et al., 2006). Corporate farms, of which there were roughly 17700 in 2004, are the large successors of the former collective and state farms. They account for roughly 59% of the 41.7 million hectares of agricultural land in Ukraine, and 30% of the country's gross agricultural output (GAO). Individual farms include the roughly 5.3 million household plots (33% of the agricultural land and 60-65% of the GAO), and roughly 43,000 peasant farms (8% of the agricultural land and 5- 10% of GAO). Compared with corporate and peasant farms, the household plots are largely subsistence-oriented. In a survey carried out in 2005, Lerman et al. (2006, p. 88) determinedthat the average household plot sells 21% of its agricultural output and consumes 48%, with the rest being stored and used as intermediate inputs. Analogous shares for the corporate (peasant) farms are 57% (64%) and 10% (9"/0),respectively (see Table 1for farm size distribution). 4. For largely historical reasons, there is a clear East-West gradient in the share of household plots inGAO across Oblasts, with shares ranging from highs of near 90% inthe West, to slightly under 50% in the East and South (Appendix 2 Table 3). There is also a statistically significant correlation between an Oblast's share of national agricultural output and average agricultural wages in that Oblast, with wages increasing by roughly 25 Hryvnidmonth per one percentage point increase in agricultural production share. However, this relationship is weak (explaining only roughly 23% of the variation in wages between Oblasts), and says nothing about the underlying causalities, which likely involve wage levels inother sectors. Many of the Oblasts that make above average contributions to Ukraine's agricultural production and in which above average agricultural wages are paid (e.g. Dnipropetrovsk and Kiev) are also characterised by above-average overall economic performance. - 1 - Table 1: Distribution of farms in Ukraine by size (2006) Source: State Statistics Committee of Ukraine. 5. The share o f agriculture in production and employment tends to fall in the course o f economic development, as the shares o f first the industrial sector and later the service sector increase. Figure 1 is a Leamer triangle (Leamer, 1987) inwhich each vertex represents one o f the three aggregate sectors; agriculture, industry and services. Each sector's relative share of total economic activity in the economy i s measured by the distance from the side opposite its vertex. By construction, the sum o f the three sector shares indicated by any point inthe triangle is 100%. Hence, any economy can be characterised by a unique point inside the triangle, the location of which describes that economy's sectoral composition. For a cross-section o f Former Soviet Union (FSU) countries and the EU, Figure 1 illustrates the trend o f declining agricultural and industrial shares and increasing service share as per capita GDP (represented by the size of a country's point) increases. It also shows that Ukraine has followed this trend in the years since independence (see also Table 2, Appendix 2). - 2 - Figure 1: T h e sectoral composition of the economy in the European Union and Former Soviet Union countries (2002) 90 80 70 60 50 40 30 20 10 -\\\ % Industry Source: Own calculations (World Development Indicators, various issues). 6. However, in the case o f Ukraine the trend displayed in Figure 1 i s not a result of textbook long-run forces (relative sectoral rates o f technical change, Engel's Law, etc.) at work in a full- employment economy. The entire Ukrainian economy, including agriculture, i s operating well below its production frontier. Tiffin (2006) presents the results o f econometric efficiency estimates that suggest that Ukraine was producing only 22% o f the output it could given its factor endowments in 2000, down from 49% in 1990. Hence, shifts in sectoral GDP shares since independence have been primarily driven by the sector-specific depths of the transition crisis up to 2000, and different rates o f partial recovery since. Agriculture's GDP share could remain constant or even increase in the medium term in Ukraine if sectoral reforms and restructuring were accelerated. Furthermore, the absolute size o f both agriculture and food processing in Ukraine has increased in real terms since 2000, and this trend could continue, even if agriculture's relative contribution continues to fall. Similarly, successful adjustment to increasing domestic and foreign demand for higher-value food products would increase the agri-food sector's ability to generate skilled, high-wage employment. - 3 - Ukraine's agricultural potential 7. Ukraine's agro-climatic endowment provides the basis for a large potential in agricultural production. Over 40 million hectares of agricultural land, of which roughly 32.5 million hectares are arable (FAO), provide an excellent basis for the production of temperate crops and livestock products. Over one-half of Ukraine's arable land is covered with humus-richchernozem (`black soil') that is ideally suited for field crop production. The two main belts of this soil inthe world are located in i)Ukraine through southern Russia and into Siberia, and ii)the Canadian Prairies. Roughly one-third of the worldwide stock of chernozem is located inUkraine. 8. Dueto Ukraine's relatively low population density', area-based productionpotential implies export potential. Although incomes have grown rapidly since 2000 (Appendix 2 Table 2), increasing domestic demand for food, Ukraine has the capacity to produce much greater volumes o f temperate grains, oilseeds and livestock products than its (shrinking - see Appendix 2 Table 2) population can consume. Ukraine's agricultural export propensity is supported by additional geographic advantages.The country's Black Sea harboursremain ice-free year round and provide direct access to world markets. Moreover, Ukraine is close to important agricultural import marketsinthe Middle East, the FSU, NorthAfrica andthe EU. 9. These natural advantages are moderatedby several important factors. Precipitation i s often a limiting factor for crop production, falling from an average of roughly 700 &year in the Northwest to as low as 300 &year as one moves South and East. Winters can be harshand are not always accompaniedby enough snow to protect winter crops and provide sufficient moisture inthe spring. Drought and/or winter-kill has a significant impact on agricultural productionevery 3-5 years; examples of this being the poor and very poor harvests recorded in 2000 and 2003, respectively. According to some forecasts, global warming will exacerbate drought problems in the future, with Ukraine becoming hotter and drier on average. 10. Another limitation is, paradoxically, soil fertility. The rolling landscape that characterises much of Ukraine's agricultural heartland is susceptible to erosion. Penkaitis (1994, p. 16) cites Ukrainian sources that refer to over 12 millionha of arable land as being significantly affected by erosion. As a result of distorted incentives, the vaunted chernozems have in many locations been strippedof their nutrient and humus content over decades, compounding problems with moisture retention inyears of low precipitation (see also Breburda, 1990; Spaar & Schuhmann, 2000; IER, 2006b, p. 2). The Chernobyl nuclear accident created additional limitations in the form of radioactively contaminated farm land. As the prevailingwinds were blowing from South to North when this accident occurred, muchof this contamination affected regions inwhat is now Belarus (e.g. Gomel) and Russia (e.g. Bryansk).However, 4 of the 10 most affected regions inthe former Soviet Union (Kiev, Zhitomir, Chernigov and Cherkassy in descending order of contamination) are inUkraine (Penkaitis, 1994, p. 16). 11. Finally, as agricultural competitiveness is increasingly determined by transformations that take place post-harvest ina complex food chain, the importance of natural conditions i s declining. Anderson (1993, p. 305) illustrates that at the outset of transition the FSU was endowed with a ' Ukraine's population density was 79 inhabitants/km2in2003. By comparison: World average46; India-325; China-1 34; USA-30; Argentina-14; Russia-8 (United Nations Statistics Division, 2007). Ifonly agricultural land is considered, Ukraine's population density (1.17 inhabitants/agricultal ha) is less than the world average (1-28) (FAO, 2006). - 4 - low stock of capital per worker and a high stock of natural resources per worker relative to the rest of the world. As agri-food systems become increasingly capital intensive, the comparative advantage implied by this ample natural resource endowment diminishes. As is outlined in greater detail below, Ukraine's most important agricultural handicap and the essentialthreat to its competitiveness in agriculture is that it combines its endowment of high-potential agro-climatic and geographic assets with insufficient amounts of complementary inputs such as humancapital, marketing systems and policy facilitation. This is largely a result of Ukraine's difficult post- Soviet agricultural legacy. However, with each passing year, reasons for limitations in the sector's competitiveness must increasingly be sought in inadequate agricultural policies leading to insufficient investment inthe period since Ukraine's independence. 11. Outlookon future agricultural marketsand the positioningofUkrainian agricultural products Recentandforecast developmentson internationalagriculturalmarkets 12. The overall outlook for agriculture world-wide is bullish. Prices for major agricultural commodities (grains, oilseeds and livestock products) on world marketsare strong and increasing in real terms after almost a century of decline.2 Of course, claims that the long-run decline in agriculture's terms of trade i s coming to an end have often turnedout to be premature inthe past. However, there are indications of a fundamental shift in the constellation of rapid technical change against a background of more sluggish demand that has driven declining agricultural terms of trade for decades. Constraints on global availability of land and water are increasingly binding. Marginal yield returns to conventional plant breeding programs for the major crops are declining, and genetic engineering has not (yet?) produced major yield increases of its own. While these factors reduce the growth of farm commodity supply, rapid income growth especially in South and East Asia - where populations are large and income elasticities of demand especially for livestock products are high - is accelerating growth in demand for livestock products and in derived demand for the grains and oilseeds needed to produce them. Growing demand for biofuels is adding to this fundamental shift, although so far most of this demand hinges on subsidies and tax exemptions for biofuel production and use inthe EUand the US. 13. Figure 2 presents data on the development of price indices for cereals, oilseeds and meat since 1980, and Figure 3 shows representativeworld market prices for wheat, oilseeds and butter since 2002, together with the OECD's forecasts up to 2018. In Figure 2, the strengthening of prices in recent years i s clearly visible. The OECD forecasts in Figure 3 suggest that prices are expected to remain strong in the medium term. FAPRI (2006) and other forecasts are generally similar. 2 At the moment (early 2008), international prices for grains and oilseeds are peaking at levels that are much higher than anything seen in recent history. It is not clear what share o f this peak reflects long-run trends, and what share is due to short-run imbalances and speculative forces. Agricultural commodity prices are highly volatile and assembling consistent long run price series is difficult. This complicates attempts to identify and test the statistical significance o f long-run trends. For a discussion o f the relevant issues see IMF (2006b, Chapter 5). - 5 - Figure 2: IMF agriculturalcommodity price indices and correspondingquadratic trends, 1980-2007 (1995 = 100) 170 = -CCereals -CVegetableoil +Meat 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 {ource:IMF (2006a) and own calculations. Note: Cereals includes wheat, maize, rice and barley. Vegetable oil includes soybean, soybean meal, soybean oil, coconut oil, palm oil, sunflower oil, olive oil, fshmeal and groundnut. Meat includes beeJ lamb, pork andpoultry. See IMF (2006a) for exact definitions of the component prices and methodologv. All linear and quadratic trend terms are significant at the 2% level or better. 14. The prices and price forecasts in Figures 2 and 3 are nominal and largely based on quotations inUS Dollars. Hence, how they translate into incentives for producers inUkraine will depend on the future development o f the Hryvnia/US$ exchange rate and inflation in Ukraine. Significant devaluation o f the Hryvnia as a result o f the financial crisis in 1998/99 corrected severe misalignment (Zorya, 2003) and provided agricultural producers (and other producers of tradable goods and services) inUkraine with a major boost in competitiveness. Recent years have been characterised by slow real appreciation o f the Hryvnia, partially eroding increases in international prices. Future competitiveness will depend on the continuation o f stable and sustainable macroeconomic policies and the avoidance o f major distortions due to macroeconomic misalignment. Agricultural producers in Ukraine are at an advantage vis-a-vis their competitors inenergy-rich Russia and Kazakhstan inthat they do not need to fear the effects of possible real exchange rate fluctuations and Dutch Disease phenomena due to energy price volatility. - 6 - Figure 3: Past and projected prices for major agricultural commodities (US$/t, 2002- 2017/18) 600 500 400 300 - - - A A - - A -- rn A 7 200 -+Wheat +Oilseeds --C Butter 100 0 I I I I I I I I I I I I 2002-2006 2008109 2010/11 2012/13 2014115 2016117 iource: OECD-FA0Agricultural Outlook2008-2017. ParidRome, 2008. 15. Along with prices, the volume of international trade for the major agricultural commodities has also grown in recent years, and is expected to continue to do so in the coming years, as illustrated inFigure 4. Again, OECD and FA0 (2006) and FAPRI (2006) paint similar pictures of growing world markets for farm products, with oilseeds, pork and poultry experiencing especially strong growth over the last decade, and expectedto continue to do so over the next. Ukrainianagriculturaltrade recent andforecast developments - 16. Has Ukraine been able to profit from recent trends on world agricultural markets, and what are the forecasts of its future participation? Turning first to the past, Ukraine's agricultural export performance over the last decade has beenmixed. The last decade saw rapid growth inUkrainian net exports of wheat, barley and maize, and significant contraction in exports of beef, pork and sugar (Appendix 2 Table 4). These trends must be interpretedwith caution, however, as they refer to a time span over which Ukraine underwent great economic upheaval, from the depths of the transition crisis in the mid-1990s to first sustained recovery and growth in the first half of the current decade. Some large percentagechanges intrade volumes are due to the basis effect of low (actual or recorded) trade inthe mid-1990s. Moreover, Ukrainian exports of many products, and especially grain, were highly volatile, with wheat exports for example falling by over 5 million - 7 - tons from 1999 to 2000, and over 10 million tons from 2002 to 2003 (Appendix 2 Table 4). Reducing these fluctuations -at least the partthat is due to inappropriate agronomic practices and policy-induced volatility - would contribute to Ukraine's international competitiveness by increasing its reliability as a supplier. Figure 4: World export volumes for major agricultural commodities, 1992-2006 and wojections through 2015 (1995-97 = 100) 300 `0' 2 250 II a: CI v, Q\ 2 200 W h3 0 k8 150 z! ; loo 1995-97 1999 2001 2003 2005 2007 2009 2011 2013 2015 --tCoarse grains +Wheat -A-Oilseeds *Beef&veal ++ Pork +Poultry -+-Cheese ;ource: OECD and FA0 (2006) and own calculations. Note: For dejnitions of theproduct aggregates underlying these export volumes, see OECD and FA0 (2006). For cheese the baseperiod (= 100) is 1999-2001. 17. Three destinations dominate Ukraine's exports (Appendix 2 Table 5). First, FSU countries, and especially Russia, play a dominant role as destinations for Ukraine's exports of dairy products. That this is a precarious trade structure became apparent in 2006, when Russia banned imports of dairy products from Ukraine for several months. Second and third, the EU and Mediterranean Rim countries of Northern Africa and the Middle East are the main destinations for Ukraine's exports of grains and oilseeds. The fact that Ukraine has succeeded in penetrating the EUmarket for these products is encouraging, as this market is one of the most demanding in the world as regards quality and safety standards. 18. According to FAPRI (2006) forecasts (Appendix 2 Table 6) Ukraine i s not expected to participate filly in the expected expansion of international agricultural trade through 2015. In general, domestic demand for food products is expected to grow relatively quickly with increasing incomes in Ukraine, while forecast growth in domestic supply is comparatively sluggish. Hence, for many agricultural products, Ukraine's export volume is forecast to fall - 8 - (Appendix 2 Table 6), and in some cases in which increased export volumes are forecast (e.g. wheat), these increases are less than required to maintain or expand Ukraine's world market share. Only in the cases of sunflower oil and meal, maize, pork, and broilers does Ukraine's world market share increase according to these forecasts. However, for the latter two products this increase actually refers to a reduction in Ukraine's share of world imports. Furthermore, increasing exports o f sunflower oil and meal in the past (Appendix 2 Table 5) and future (Appendix 2 Table 6) are a dubious success as they are subsidised by a 17% tax on exports o f sunflower seed that ensures domestic crushing mills low-priced raw material at the farmers' expense. Note, however, that these FAPRI forecasts are based on expectations o f continued slow reform and production growth inUkrainian agriculture. 19. However, there is currently no `absorption' problem on world agricultural markets. On the contrary, trade has expanded considerably and prices are strong, and no change inthese trends is expected in the medium term. Hence, there i s significant potential for expansion o f Ukrainian agricultural exports ifcompetitiveness constraints are addressed successfully. O f course, forecasts o f developments on world agricultural markets are notoriously difficult. Regardless o f future developments, Ukraine is not taking full advantage o f the window o f opportunity offered by current favourable conditions. This - along with the immediate costs it implies - will certainly not make things any easier should world market conditions become less favourable than currently expected. 20. Ukraine's recent WTO accession and the start o f negotiations o f a free trade agreement with the European Union (EU) offer attractive opportunities but also put additional pressure on Ukraine's agricultural sector to compete in domestic and international markets. On the other hand, the achievement o f WTO membershipand the start o f FTA negotiations with the EU signal a new resolve on the part o f policy makers in Ukraine. The resulting international commitments will discipline policy, reduce ad hoc interventions, improve Ukraine's agricultural market access, and expose deficits in agri-food competitiveness, thus heightening demand for policy reform and investment. Positioning Ukrainian agricultural products 21. The focus above has been on markets for bulk agricultural commodities such as grains and oilseeds. However, as per-capita incomes and urbanization increase in key import markets, dietary changes will follow, leading to increased demand for livestock and processed food products. Will Ukraine satisfy this demand or will it remain primarily a supplier o f bulk raw materialsthat are processed elsewhere? Clearly, the more value that i s added inUkraine, the more growth and employment the country will realise. However, as a product's degree o f processing increases, so does the need for exporters to fulfill food safety requirements and quality expectations in target markets. This is an area in which agro-climatic advantages do not play a dominant role: establishing and maintaining efficient systems to foster and certify food safety and quality is a question o f institutions that no amount o f fertile soil or sunshine can replace. 22. As will be discussed below in Section IV under `factors constraining agricultural competitiveness', Ukraine faces significant challenges in the area o f food safety. To the extent that there are economies o f scale in the production o f safe, high quality agri-food products, the agricultural structure that Ukraine has inherited from Soviet times i s advantageous. This structure i s characterised by a relatively small number o f large farms capable o f cultivating large, uniform plots, presenting a relatively limited number o f control points, and providing attractive partners - 9 - for vertically integrated food chains. Hence, investments in food safety and quality systems can be expected to generate highreturns. 23. The analysis below will demonstrate, however, that Ukraine's primary agricultural competitive advantage in the short run lies in its potential as a low cost supplier .of raw and lightly processed agricultural commodities - especially grains, oilseeds and vegetable oils and meals. While the safety and quality demands o f the international grain and oilseed trade are certainly far from trivial (and growing increasingly complex due to the need to accommodate genetically modified crops), the hurdles here are lower than in the case o f most animal and processed food products. As the trade data presented above (Appendix 2 Table 5) illustrates, Ukraine has succeeded in penetrating the demanding EU market for grains and oilseed products in the past. Ukraine is not a net exporter of livestock products; the only exception is dairy products which are mainly destined for FSU countries where standards and certification systems, for historical reasons, resemble those in Ukraine. Tapping Ukraine's potential in the area o f grains and oilseeds i s a precondition for the competitive production o f exportable surpluses o f livestock products. Further development o f reliable and efficient monitoring and testing systems for Ukraine's grain and oilseed exports is a logical first step that can provide experience and a basis for the development o f more complex systems for other export products. 24. A related food quality issue concerns high-end, high-value added products of designated origin, products such as "Parma ham" and "Roquefort cheese". Collectivisation and the radical restructuring o f agriculture and food processing in Ukraine in the first half of the last century destroyed many artisanal traditions that are the basis for such products, and decades o f isolation mean that awareness o f remaining Ukrainian specialties in foreign markets i s With the exception o f a few niche products, therefore, exports o f such specialties cannot be expected to makea major contribution to the future development ofUkrainian agriculture. 111. The currentstatusofUkrainianagricultural competitiveness Indicators of agricultural competitiveness 25. Numerous indicators o f competitiveness have been developed and applied by economists. One approach, going back to seminar work by Liesner (1958) and Balassa (1965) i s based on the idea that competitiveness will be 'revealed' by a country's actual trade performance compared with other countries, regions or the world. A variety of 'Revealed Comparative Advantage' (RCA) indices have been developed based on this idea. RCA indices are usually justified on the grounds that most policy-induced distortions are on the import side, and that export performance will therefore provide a genuine reflection o f competitiveness. However, as is demonstrated below, this i s not the case inUkraine, where there are significant distortions on the export side as well. Furthermore, Banance et. al. (1987) demonstrate that there is a high degree o f inconsistency among alternative RCA indices, and that inferences are correspondingly sensitive to the particular index chosen. These concerns, coupled with the facts that Ukrainian trade statistics are often o f dubious quality and that trade has been very volatile for many key agricultural products, make us wary ofthe RCA method inthe context o fUkrainian agriculture. 3Vodka and Crimean ,champagne' wines are exceptions. - 10- 26. A second approach to measuring competitiveness is causal and attempts to measure factors that influence competitiveness, such as the institutional environment, infrastructure, macroeconomic stability and cost structures. At an aggregated level, this has led to indices such as the `Growth Competitiveness Indicator' (GCI) developed by Sachs and McArthur, and the `Business Competitiveness Indicator' (BCI) developed by Porter, both of which can be found in the World Economic Forum's Global Competitiveness Report (e.g. WEF, 2006). These `broad brush' measures are certainly interesting, but our focus here is on individual agricultural products. 27. For these reasons, we employ Domestic Resource Cost (DRC) analysis to cast light on the competitiveness of Ukrainian agriculture. The DRC is one of many indicators that can be calculated using the Policy Analysis Matrix (PAM) framework developed by Monke and Pearson (1989). The PAM is a product of two accounting identities, one defining profitability as the difference between revenues and costs, and the other measuring the effects of divergences (distorting policies and market failures) as the difference between observed private values and social values that would prevail if the divergences were removed. The structure of the PAM is presented in Table 2, and detailed definitions of the terms in it as well as information on the calculation ofthe DRCs presentedbelow are provided inAppendix 1. 28. The DRC method compares the cost of domestic resources measured at social prices (inthe numerator) to value added measured at social prices (in the denominator), calculated as the ratio of G to (E-F) in Table 2. The use of social prices throughout ensures that the DRC measures whether employing scarce domestic inputs in the production of a good i generates a positive return for the country as a whole. Ol. If the DRC i s smaller than 0, then the denominator (E-F) must be negative, in which case revenue does not even suffice to cover tradable input costs, let alone domestic inputs.Inthis case, production of the good inquestion is clearly not competitive. 29. A weakness of the DRC method as it is usually applied is that it i s based on average or `typical' data for a sector or industry. The conclusions that can be drawn on the basis of average or typical indicators become progressively weaker as the heterogeneity of the underlying population grows. Evidence from numerous studies that apply empirical efficiency analysis techniques (data envelopment analysis - DEA; stochastic frontier analysis - SFA) to farm level data in Ukraine and other FSU countries points to a very significant heterogeneity, with many farms operating at a great distance from the frontier defined by the best-practice farmse4For example, the results of Lissitsa and Odening's (2005) DEA analysis indicate that the distribution of efficiency among large farms in Ukraine in 1999 was bimodal, with one peak in the 30-40% efficiency range, a mean efficiency of 46%, and a second, smaller peak of "star performers" operating at 90-100% efficiency relative to the best practice frontier. Comparing these 1999 results with results from earlier years, the authors also find that the efficiency distribution has grown more heterogeneousover time, and that the most (in)efficient farms have tendedto remain most (in)efficient. This evidence corroborates the observations of farm management specialists who have practical experience with conditions inUkrainianfarming (e.g. Lischka, 2005). 4 See, for example, Galushkoet al. (2004), Kurkalova and Jensen(2002) and Lissitsa and Odening (2005). - 11- Table 2: The Policy Analysis Matrix (PAM) Revenue costs Profits Tradable inputs Doiuestic factors Accounting inPrivate lk )I (Financial) Prices A = C P B=Zn,q` C = zagF<' D = , 4 - B - C J=1 j=b+l Accotuiting in Social E=Cs F =CaP<' It G = caI,V' I? H = E - F - G (Econonlic) Prices j =1 J=k+1 Effects ofPolicy arid Market Failures I = A - E J = B - F I Source: Monke and Pearson (1989). 30. For this reason, and as outlined in Appendix 1, farm-level data are used to calculate DRC distributions for major crop and livestock products in Ukraine.' This procedure makes it possible to determine for each product what proportions o f the farms in Ukraine are characterised by DRCs less than 0, DRCs between 0 and 1, and DRCs greater than 1, and what proportions o f Ukraine's total production o fthese products occurs on the farms ineach category. The calculation o f DRC distributions i s a purely descriptive technique, but its use here i s motivated by the hypothesis that Ukraine has the potential to be internationally competitive in most important temperate crop and livestock products if barriers to competitiveness are removed so that many more farms are able to operate at the levels o f efficiency that currently only the very best attain. 31. The data employed are Ukraine-wide farm-level accounting data from 2004 and 2005 provided by the State Statistics Committee o f Ukraine. In Ukraine, all corporate farms are required to file standardised reports on their input use, production and sales each year. This i s in contrast to most OECD countries, for example, where much more detailed data are collected from representative samples o f farms. Data quality i s an important issue in analyses o f this nature. Farmmanagers may distort their reports ifthey believethat this might influence their tax burdens or eligibility for subsidies. There i s no information available on such distortions in the data employed here, But clearly Ukraine would be well-advised to implement a modern collection system for farm accountancy data such as that employed in the EU, for example. This would provide policy makers with more detailed, accurate and timely data. Some conditions have changed in Ukrainian agriculture since 2005, but most o f the factors that affect competitiveness have not. Hence, the main results presented below, and their interpretation, remain valid. Clearly, the competitiveness o f grains and oilseeds production will have benefited from higher world market prices in recent months, although this effect has been mitigated by export restrictions that depress domestic prices for these products. Data for 2006 only recently became available, and ongoing work is studying changes in competitiveness at the farm level using spatial panel econometric techniques. 'Aseparate Policy Note on The Competitiveness of Bio-Energy in Ukraine is currently being prepared(an advanced draft is available as o f July 2008). That Note illustrates in detail competitivenessaspects along the value chain from agricultural raw productsto the biohel end-products. - 12- 32. A limitation of the DRC analysis employed here is that it is based exclusively on the large corporate farms in Ukraine, and does not consider the individual farms (household plots or peasant farms). This is not an important omission for the major cereals and oilseeds, which are primarily produced on large corporate farms (Figure 5). However, household plots are responsible for a much larger share of the potato, fruit, vegetable and livestock production in Ukraine. Unfortunately, detailed data on methods and costs of production for household plots is not available. This may not be such a handicap for competitiveness analysis, however, as it is arguably the large corporate farms that will determine the international competitiveness of Ukrainian agriculture, while the household plots, which market only one-fifth of their output (Lerman et al., 2006) remain largely subsistence-oriented.6 Figure5: The share of households intotalproductionof agriculturalproducts,2004 (YO) 100 90 80 70 W $ 60 -5c0 50 .I Y 2 40 a E4 2 30 20 10 0 'ource:State Statistics Committee of Ukraine. The currentstatus of Ukrainianagriculturalcompetitiveness 33. Results of the DRC analysis for major crop products in 2005 and 2004 are presented in Figures 6 and 7, and key results are summarised in Table 3. Results for 2005 and 2004 are qualitatively similar, and the following discussion focuses on 2005, The distributions reveal that for wheat (44%), sunseed (41%) and barley (25%), relatively large proportions of the farms in Ukraine produce competitively. For maize (13%), rapeseed (lo%), soybean (8%) and potato This is not so say that householdplots andpeasant farms haveno role to play inthe future of Ukrainianagriculture; some will certainly take advantage of niches and the flexibility that goes along with being small to develop into successfulenterprises. - 1 3 - $q-Jy--j Figure6: Domesticresourcecost distributionsfor major crop productsinUkraine,2005 WHEAT BARLEY CORN d $j-Jq--jg!Ki 5 0 2 0 5 cl :I:m] O -1 0 1 2 3 5 -1 -05 0 0 5 1 1 5 ?I -05 0 0 5 1 1 5 SUNSEED SOYBEAN RAPESEED $ 3 $:_ii. c 0 4 0 2 1 O -1 0 1 2 -85 0 0 5 1 SUGARBEET POTATO 5 0 5 0 2 ;;m 02 -1 0 1 -85 0 0 5 1 Source: Own calculations. Figure7: Domesticresourcecost distributionsfor major crop productsinUkraine,2004 gim WHEAT BARLEY 21 I 1 5 iIO%/ CORN fJ----J d$ 1 0 2 0 5 O -1 0 1 2 01 -05 0 0 5 1 1 5 ?I 0 1 2 SUNSEED SOYBEAN RAPESEED $ 3 c 0 5 1 3 5 -1 -05 0 0 5 1 1 5 -85 0 0 5 SUGARBEET POTATO '"I 1 1 5 14 96% 3% 1%-+ i? 5 0 5 n -1 0 2 0 4 ource: Own calculations. -14- (6%), the corresponding proportions are smaller. For all o f these products, the competitive farms account for a disproportionately large share o f the total production by corporate farms inUkraine. This effect is especially extreme inthe case o fpotato production. However, since corporate farms account for less than 5% o f all potato production in Ukraine (Figure 5), this result - which suggests that a small number o f large farms are heavily concentrated in potato production, perhaps for seed and special processing uses - i s not representative. Table 3: Summary of DRC resultsfor major crop products 2004 KDRC< DRC>1 DRC1 0.37 2.65 -1.11 0.35 2.95 49.1% 16.2% 30.6% 55.8% 13.5% 36% 14% 42% 44% 14% 0.46 2.87 -0.82 0.37 2.73 20.5% 12.3% 55.8% 34.0% 10.2% 14% 10% 66% 25% 9% 0.28 5.38 -0.68 0.28 4.36 27.2% 12.8% 49.4% 34.9% 15.7% 10% 7% 80% 13% 7% 0.33 2.77 -0.91 0.30 2.49 53.0% 12.2% 32.0% 58.9% 9.1% 32% 11% 48% 41% 10% 0.32 3.45 -0.48 0.37 2.96 45.4% 3.2% 64.2% 27.9% 7.9% Share ofthe~ O U in D total number of farms 12% 3yo 87% 8% 4% 0.42 3.19 -0.32 0.27 1.91 15.9% 7.4% 65.8% 28.7% 5.5% 4% 3yo 87% 10% 3yo 0.53 3.41 -0.74 0.52 2.77 11.6% 10.1% 86.7% 5.9% 7.4% 3yo 6% 94% 2% 4% 0.34 2.52 -1.35 0.26 2.10 23.2% 7.2% 37.5% 51.0% 11.5% 3% 1% 91% 6% 3yo Source: Own calculations. 34. Before proceeding with the discussion o f these results, we briefly note the contrast between the distributions presented here and average DRCs that would result from the use of aggregated data. For wheat in2005, for example, it can be shown that the average ton o f wheat was produced at a DRC o f 1.37. This result, taken at face value, would suggest that there are problems with the - 1 5 - competitiveness of wheat production in Ukraine, obscuring the fact that 44% of all wheat producing farms, and 56% of all the wheat produced in the country, are competitive. This highlights the main advantage of the disaggregatedDRC distribution analysispresentedhere. 35. For sugarbeet, only 2% of the farms inUkraine are competitive, and these account for only 6% of all sugarbeet production. This confirms the results of earlier analyses (e.g. Strubenhoff and Nivyevskiy, 2006; von Cramon-Taubadel, 1999) that demonstrate that sugarbeet production i s only competitive under very limitedcircumstancesinUkraine. 36. DRCs for major livestock products in 2004 and 2005 are presented in Figures 8 and 9 and Table 4. Across the range of livestock products, the shares of competitive farms are similar to the shares for crop products. 40% of the farms that produce eggs have DRCs between 0 and 1; corresponding shares for beef, milk, pork and poultry are 22, 20, 8 and 4%. These competitive farms again account for a disproportionately large share of the production of these products (eggs 93%; milk 49%; pork 35% and poultry 21%). The only exception is milk, where the 22% o f the farms that are competitive account for only 16% of the production by corporate farms inUkraine. This might be evidence that among the corporate farms that produce milk in Ukraine, those that are relatively small tendto be more competitive thanmany larger ones. Figure 8: Domestic resource cost (DRC) distributions for major livestock products in Ukraine,2005 c n 0 2 0 5 !I -05 0 0 5 1 1 5 2 3 5 -1 -05 0 0 5 1 1 5 POULTRY c $ 0 3 n$ 2 :0 2 1 3 -05 0 0 5 1 0 3 . 2 - 1 0 1 2 3 4 EGGS 3, -85 0 0 5 1 Source: Own calculations. ~ ~~ 37. In2004 and 2005, and for all crops and livestock products except wheat in 2005, the modal DRC is less than 0. This indicates that for a large group of farms revenue does not even suffice to cover the costs of tradable inputs, let alone domestic inputs. These farms are subtracting and not adding social value by producing the products in question. Even if the resulting products are - 16- being exported, Ukraine is on balance losing foreign exchange in the process. More detailed analysis - for example using information on the location o f individual farms in the dataset, their degrees o f specialisation, factor intensities, locations etc. - i s required to determine what factors influence whether a farm is c~mpetitive.~ The available evidence suggests, however, that efficient and inefficient farms often exist side-by-side even inthe most agriculturally favoured regions of Ukraine. It i s a well-known phenomenon in agriculture that unprofitable farms can continue to operate, at least for a while. Especially older owner-operators who see few alternatives outside farming will implicitly accept a low effective compensation for their labour and management inputs or a below-market rate o f return on the capital tied up in own equity (buildings and land); the farm's capital stock will be allowed to rundown (negative net investment); in extreme cases, plots o f land may be sold to provide periodic liquidity injections. There are limits to this under market conditions, however, especially for larger corporate farms that depend on loans and must pay hired labour. In the case o f the Ukraine, the fact that large numbers especially o f value subtracting corporate farms continue to operate suggests that both positive incentives and market disciplines are needed to ensure that less efficient farms either improve or exit, freeing up resources for more efficient use by others. !;;I- Figure 9: Domestic resource cost (DRC) distributions for major livestock products in Ukraine,2004 s =;;;I ~~~~ 0 4 n5 0 2 02 -0 5 0 0 5 1 POULTRY E3 45 ~ $ 0 6 i.".I 1 c 8 0 4 1 .a 0 0 5 3 5 -1 -05 0 0 5 1 1 5 2 p3 1 .a 0 0 5 ource: Owncalculations. 7Nivyevskiy and von Cramon-Taubadel(2008) analyze factors that affect the competitiveness and efficiency of milk producing farms in Ukraine using spatial econometric techniques. The results indicated that spillovers between neighboringfarms take place, and that proximity to milk processing plants that have invested has a positive impact on competitiveness. - 17- Ishareofthe group intotal number of farms 37% I 2% I 58% I 2% Source: Own calculations. 38. The empirical analysis presentedhere demonstrates that many Ukrainian farms are able to produce wheat, sunflower seed, barley, eggs, beef and milk competitively. The same is true for maize, rapeseed, soybeans, and pork, but for smaller proportions of the producing farms. For all products, the majority of the farms inUkraine are currently not able to produce sufficient surplus to cover the costs of domestic and tradable inputs. In many cases, the value of production does not even suffice to cover the cost of tradable inputs, indicating that production is subtracting, and not adding value. Overall, the findings here correspond well with Lischka's (2004, p. 110) estimate that roughly one-half of the farms inUkraine are ",.. severely threatened ... [elnterprises of highly questionableviability". 39. The fact that many farms are able to produce competitively bodes well for Ukraine's international competitiveness in major temperate agricultural products and processed foods. Realizing Ukraine's competitive potential (in other words, shifting the distributions presented here) is a matter of (i)increasing the efficiency of production so that the great majority of farms in Ukraine can produce as efficiently tomorrow as the best farms do today, and (ii) developing marketing and processing systems so that Ukraine's ability to produce competitive raw products on the farm i s translated into competitiveness on world markets and for high-value added agri- food products. 40. The following chapters IV and V present factors constraining agricultural competitiveness and measures to increase it. The coverage of the sectoral issues and potential remedies presented in these chapters is broader than what the DRC-based analysis of sectoral competitiveness (chapters I- 111) alone can support. By drawing on evidence from other recent analyses (von Cramon-Taubadel and Raiser, 2006; von Cramon-Taubadel et al., 2007; World Bank and OECD, 2004; World Bank, 2008b; Zorya, 2006), however, the DRC analysis is integrated into the broader picture of overall sector development. -18- IV. Factorsconstrainingagricultural competitiveness inUkraine 41. The factors constraining agricultural competitiveness in Ukraine can be classified in many different ways. Factors overlap and can amplify one another, and factors that are o f primary importance for one product or process may be irrelevant for others. The following list beginswith general factors and proceeds to more specific ones. A unifying theme throughout is that all the factors discussed below are man-made; they can be changed if they are understood and confronted with sufficient political will. Agricultural competitiveness in Ukraine i s mainly constrained by the often glaring inefficiency of state s u ~ ~ osystems at three fundamental r t levels. The first o f these i s the macroeconomic level. Macroeconomic instability throughout the 1990s, beginning with hyperinflation in 1992-1994 and culminating in the' financial crisis o f 1998/99, severely handicapped Ukrainian agriculture (Zorya, 2003). Inthe mid- to late 1990s, the de facto adoption o f a nominal Hryvnia/US$ exchange rate anchor coupled with continued double-digit rates o f inflation lead to significant overvaluation o f the real exchange rate. This taxed sectors such as agriculture that produce tradable goods. The financial crisis in 1998/99 'corrected' this overvaluation and increased the competitiveness o f agriculture. Since then, agriculture in Ukraine has not suffered from similarly blatant macroeconomic imbalances. Nevertheless, a number o f measures have had important influences on the development o f agriculture. These include: 42. Taxation. Frequent ad hoc changes to the taxation system and especially the question of VAT refunds on exports have plagued agriculture. Until today, the government failed to implement the expected VAT reform inthe agriculture sector in 2008. Ingeneral, exporters who face the prospect o f an uncertain or unlikely VAT refund respond by adding corresponding risk premia to the margins that they deduct from border prices to determine the prices that they can afford to pay at the farm gate. In the final analysis, therefore, failure to refund export VAT has the same impact as a tax on agricultural exports, lowering the farm gate price and masking some o f the competitiveness identified inSection I11above. 43. Regulation. Inthe World Bank's Doing Business project', Ukraine in2008 ranked 139 out of 178 countries worldwide inthe "ease o f doing business" overall index which measures the extent to which a country's regulatory environment is conducive to the operation o f business. In line with this ranking IER (2006a) provided information on Ukraine's exceedingly complex and costly import regulations for important agricultural inputs such as farm machinery and agro- chemical products, and the amount o f discretion that customs authorities wield in implementing these regulations. The regulatory environment in Ukraine increases the costs o f doing business and forces economic activity into the 'shadows'. It slows the rate of technology transfer into Ukraine and fosters corruption. 44. At a second level, Ukraine lacks a consistent strategyforfostering rural developmentand combating rural poverty. There are indications that economic growth since 2000 has reduced the incidence o f absolute rural poverty in Ukraine.g Nonetheless, disparities between regions have been maintained, disparities within the income distribution have increased, and local pockets o f http://www,doingbusiness,org/ Measuredagainst an absolute poverty line, the rate of poverty inUkraine was 29.5% in 1995 (World Bank, 1996). It increasedto 32% in2001, then fell to 14% in2004 and 8% in2005 (World Bank, 2007b). The poverty rate in rural areas is above the national average but has also fallen, from 25.1% in2003 to 11.3% in2005 (World Bank, 2007b). - 19- poverty remain. Large parts of the rural population produce for subsistence on their household plots, participating little or not at all in the cash economy. While the household plots represent a valuable social buffer in the transition process, and the success of the household plots in increasing production of livestock and fruit and vegetable products since the onset of transition (see Figures 5 and 10) i s rightly acknowledged, the household plots also pose future challenges. Most individual household plots and peasant farms cannot capture economies of scale in production (see Table l), their size and number can make it difficult to capture economies of and scale up- and -downstream from agriculture (input supply, assembly of appropriately sized lots for processing, food quality control). Figure 10: Grossagriculturaloutput in Ukraineby type of farm, 1990-2006 (1990 = 100) 160 140 120 100 80 60 40 20 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 &All farms -+-Household plots and peasantfarms -*-Corporatefarms ;ource: StateStatistics Committee of Ukraine. 45. Furthermore, much of the increased volume of production on household plots since the onset of transition (see Figure 10) must be attributed to their relationships with large corporate farms. For the operator o f a household plot, the link between effort and reward i s obvious; for the (often identical) employee of a corporate farm, this link and the incentives it creates are often comparatively tenuous. The often underemployed members of the corporate farms are given or take inputs such as feed, fertiliser or young livestock (e.g. piglets) for use on their household plots. Corporate farms are often obliged to tolerate this leakage in the interests of `keeping the peace' in the local community, and because stemming it (e.g. guarding fields and barns, monitoring employees) is costly. Corporate farms also provide services such as ploughing to - 20 - household plots. Even where these indirect and direct forms of support are being brought under control (according to Lerman et al. (2006), householdplots on average now reimburse76% of the costs of the support that they receive from corporate farms), farms often remain responsible for providing elements of what is referred to as the `social sphere', which includes schools and child care services, perhaps maintaining the local fire station and repairing local roads. While responsibility for the social sphere is increasingly being transferred to local authorities, Lerman et al. (2006) report that 27% of the farms surveyed in2005 had not yet undertakenthis transfer. 46. In summary, corporate farms are often obliged to assume a variety of important social and infrastructural responsibilities in rural areas, filling a vacuum that is created by a lack of both consistent regional development policy and the fiscal decentralisation needed to permit local authorities to assume these responsibilities. The result i s higher production costs and less liquidity for agricultural investments. Perhaps even more damaging is the fact that `keeping the peace' and managing the social sphere often diverts a great deal of a farm manager's time away from questions of efficient production and marketing. 47. At the third level, Ukraine's direct agricultural support policy i s inefficient and distortive. Appendix 2 Table 7 provides information on fiscal support to agriculture in Ukraine, and Figure 11presents data on the composition of producer support. As Appendix 2 Table 7 makes clear, the Government of Ukraine has significantly increased the financial support that it provides to agriculture inrecent years (Zorya, 2006). In2006, total fiscal support for agriculture reached 14.4 billion Hryvnia or 2.7% of Ukrainian GDP. This level of support is comparable with that inother middle-income countries (Turkey, Mexico, Brazil, Russia). It represents a significant burden on the Ukrainian economy as a whole, and it allows some of the uncompetitive farms identified in Section I11to continue operation. 48. However, Figure 11 (next page) shows that this support has been erratic, fluctuating considerably from year to year inlevel and composition. Inparticular the market price component of producer support has beenvery volatile due to, among other things, exchange rate fluctuations (e.g. strong devaluation in 1997-98), shifts in net trade positions (e.g. net imports of wheat in 2000-01 and 2003-04) and various types of ad hoc intervention (e.g. periodic export restrictions)." The result has been a destabilisation of agricultural prices in Ukraine that is especially apparent when intra-annual price movements are considered, as is illustrated for the case of wheat in Figure 12. Figure 11 also shows that since 2000 budget expenditure for agriculture has increased but that this increase has been largely negatedby negative market price support. This `stepping on the gas pedal and on the brakes' simultaneously i s counter-productive and wastes limitedpublic resources. lo Von Cramon-Taubadelet al. (2007) discusses the evolutionofagricultural support policy in Ukraine in detail. -21 - Figure 11: The composition of producer support in Ukrainian agriculture, 1992-2005 (million US dollars) 4,000 2,000 0 -f .-8 -2,000 -4.000 -6,000 HMarketpricesupport 0Output subsidies61Inputsubsidies Other -8,000 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: von Cramon-Taubadel et al. (2007) and OECD (2005). Figure 12: Milling wheat prices in Ukraine and a comparable world market price for wheat, January 2000 -January 2008 (US$/ton) $400.00 $350.00 +Ukraine milling quality (111) EXW +US No 2 Soft Red Winter fob Gulf $300.00 $250.00 $200.00 $150.00 $100 00 $50.00 ource: UkrAgroConsult (various issues). - 22 - Note: The LXW price is an average price at grain elevators inland in Ukraine; the USprice is for an export position free on board at the Guy of Mexico. A USprice that is comparable in levels with the Ukrainian price would be somewhat lower (to accountfor the cost of moving grainfrom elevators to an exportposition). This adjusted USprice would be less volatile than that depicted in thefigure and therefore even less volatile than the Ukrainian price, unless there is a negative correlation between inlandprices and the cost of moving grain toport, which is unlikely. 49. Support is also highly variable across products (Figure 13 and Appendix 2 Table 8). Indeed, it is a striking irony of Ukrainianagricultural policy that it taxes the products that are, according to the DRC analysis above, most competitive (e.g. export products such as oilseeds via the export tax, and grains most recently via export quotas, now abolished) and protects those that are least competitive (e.g. import products such as sugar). To tax exports andprotect imports i s to follow a common policy recipe for which there are obvious political economic explanations (e.g. Kruger, Valdez and Schiff, 1986). But it is scarcely a recipe for fostering competitiveness. On the contrary, making the production of uncompetitive import products such as sugarbeet artificially profitable draws resources away from other crops where they would add, rather than subtract, social value. Figure 13: Nominal rates of assistanceto agriculture inUkraine, 1992-2005(YO) 1"" 80 60 40 g h 2z 2o 0 -20 -40 -60 Yource:von Cramon-Taubadel et al. (2007). 50. Support is also very unevenly distributed across farms. For example, roughly 7% of the subsidised farms received almost 75% of all budget support to livestock producers in 2004 (Borodina, 2006), and 14.7% of the dairy farms in Ukraine, accounting for 56.2% of the country's milk production, received 64.7% of the subsidies provided to milk producers in 2005 (Nivyevskiy and von Cramon-Taubadel, 2007, p. 6). All three dimensions of instability - erratic -23 - over time, variable across products and uneven across farms - are evidence of an unfocused policy that lacks strategic goals. 51. The variability referred to above is what can be observed ex post. Ex ante this already muddledpicture is further complicated by unpredictability. The grain export quota introduced in September 2006 and only recently abolished inMay 2008 is a case inpoint. Inthe first months of 2006 there was no indication that this measure was being prepared. The justifications provided for it are highly questionable, and the damage it has done to Ukraine's reputation as a reliable supplier of grain and a dependable place to invest in agriculture is immense". In the 2007/08 marketing year alone, the World Bank estimated that the export quota cost wheat and barley producers a total of about US$ 1.9 billion in foregone farm revenues. Lack of transparency and the government's ad hoc interference in agricultural markets reduce farm income and increase uncertainty andrisk. 52. Policy makers have taken too few steps to improve inefficient marketing and supply chains. For example, the information in Figure 14 (compiled from comparison of price quotations at various locations, and discussions with grain traders in Ukraine and Germany) illustrates that Ukrainian farmers get a much lower share of the export value of their wheat than farmers inGermany for example. Figure 14: Grainmarketingcosts inUkraineand Germany, 1999and2005 100 90 0Riskpremiumand 80 profit margin 2 70 a, a 60 0Infrastructure a a8 50 40 HPhysical losses k s0 30 20 Farm revenue 10 0 Ukraine 1999 Germany 1999 Ukraine 2005 Germany 2005 :ource:Strieweand von Cramon-Taubadel(1999), updatedon the basis of discussions with grain traders in Ukraine and Germany in 200.5. 'I Also see separate Policy Note on "Competitive agriculture or state control: Ukraine's response to the global food crisis", May 2008. - 24 - 53. Important components of the difference between Ukraine and Germany are physical losses (due to poor harvesting and storage technology on the farm), inefficient and expensive infrastructure betweenthe farm gate and export positions, and inflated margins due in large part to the uncertainties discussed above. Policy has actively contributed to perpetuating all of these problems. By taxing grain and oilseed production, policy has reduced the ability of farms to invest in technology that can increase production and reduce losses. By limiting competition in key areas of transport and marketing infrastructure (for example, the railroad system) and upholding highly inefficient state agents such as Khlib Ukrainy (Bread of Ukraine), policy has slowed improvements in marketing infrastructure and reductions in marketing margins. Government intervention on grain markets- export quotas in2006 being the most recent example -has repeatedlypunishedgraintrading enterprises that have investedinimprovingmarketing systems, especially at major inland elevators and at key Black Sea ports. The result has been significantly less investment than could have been the case, a reducedinflow of the international expertise needed to develop the high-speed, high-turnover logistic systems expected of a major player on world markets, and inflated risk margins as traders are forced to assume that whatever can go wrong probably will. 54. Policy makers often justify their intervention on grain markets by referring to the need to protect consumers from excessive prices and to curb rapacious traders who would otherwise export `too much', forcing Ukraine to import later in the marketing year. Even if these justifications are taken at face value (and possible rent seeking motives are discounted), the chosen policy response is highly inefficient. Lowering grain prices for all does not target assistance to needy consumers (von Cramon-Taubadel and Raiser, 2006)'*. Transparency and market informationsystemsthat reduce information asymmetriesare a muchmore effective way to preclude inefficient trade that destabilises domestic markets. If better information about trade flows and stock volumes was available, prices would respond as soon as it became apparent that `excessive' exports were threatening to put the country into a net import position. As a result, the exports in question would no longer be profitable and markets could not be manipulated in the alleged manner. The appropriate mix of public and private agricultural market information provision varies across products, countries and market structures. On Ukrainian grain markets, however, the problem to date has not been an inappropriate mix of public and private provision but rather the government's withholding of important market information(for example regarding the size of the grain stocks it holds). Uncertainty and information asymmetries put producers at a disadvantage vis-a-vis traders who are generally better connected and informed. This limits producers' marketing options, lowering farm-gate prices and hence creating disincentives for investments in production. Information asymmetries can also lead to problems of adverse selection and `hold up' inthe marketing chain, reducing incentives to invest inthe production of the quality requiredto penetrate international markets.This is especially true where production is more fragmented and quality is complex and difficult to produce, i.e. for many livestock, h i t and vegetable products. 55. Effective national food safetv and qualitv assurance systems are essential to protect the health and safety of domestic consumers. They are also critical inenabling countries to assure the safety and quality of their foods entering international trade and to ensure that imported foods '*A separate Policy Note on Competitive agriculture or state control: Ukraine's response to the globalfood crisis was published by the World Bank in May 2005 (http://siteresources,worldbank,org/INTUKRAINE/Resources/ WorldFoodCrisisandRoleofUkraine.pdf). - 25 - conform to national requirements. The new global environment for food trade places considerable obligations on both importing and exporting countries to strengthen their food control systems and to implement and enforce risk-based food control strategies. In Ukraine, effective food control is undermined by the existence o f fragmented legislation, multiple jurisdiction, and weaknesses in surveillance, monitoring and enforcement. Moreover, access to food export markets will continue to depend on Ukraine's capacity to meet the regulatory requirements in importing countries, both public and private. Creating and sustaining demand for Ukrainian products inworld markets relies on building the trust and confidence o f importers and consumers in the integrity of their food systems. Ukraine has pursued continuously a path o f international integration and partnerships, resultinginboth opportunities and obligations with implications for its food safety system. Ukraine's WTO membership and its aspiration to engage in a closer partnership with the EU including a free trade agreement require that Ukraine approximate its legislation on Sanitary and Phytosanitary (SPS) measures with relevant EU legislation inthe agri- food sector while ensuring compliance with the WTO SPS and TBT Agreements, and generally modernize its food safety related quality assurance system. As trade intensifies and quality requirements in markets increase world-wide, food safety control and quality assurance systems need to be strengthened. Domestically, rising incomes will lead to increased demand for higher quality food, especially for fresh fruits, vegetables, dairy and meat, and farmers and agro- processors - increasingly finding themselves in competition with high-quality producers on domestic markets (imports) and on export markets - need to comply, and certify their compliance, with higher standardsand stricter regulations. 56. Policy makers in Ukraine have not yet established a complete set o f land markets and conditions for the enforcement of bankruptcy proceedings in agriculture. Agricultural land lease has been possible since late 1998, and an active land lease market has developed in the interim.l3However, a moratorium on the sale andpurchase o f landhas been renewed twice, most recently in January 2007. Much anecdotal evidence suggests that farm land is being `bought' and `sold' despite the moratorium, via a variety o f shady arrangements that will be formalised whenever the moratorium is finally lifted. 57. Land lease i s a sufficient condition for land to `move' from less to more efficient managers. However, a transparent, formal market for land sale i s an integral element o f the development o f rural finance markets. Hence, the lack o f a market for the sale and purchase o f farm land has contributed to the underdevelopment o f agricultural credit markets in Ukraine (Striewe et al., 2001). Land purchase and sale would not lead to rapid, dramatic changes, but it would set in motion a virtuous circle whereby the availability o f collateral increases investment and productivity in agriculture, which in turn leads to increased land values, which make yet more collateral available, etc. The ongoing moratorium on the enforcement o f bankruptcy proceedings in agriculture has a similar impact on the development of agricultural finance. It also hinders the movement o f scarce agricultural assets from less to more efficient farm managers by allowing the former to continue operations longer than would otherwise be the case, thus slowing shifts in the competitiveness distributions presented in Section 111. l3 IER (2006b, Table 2) provides detailed information on the agricultural land lease market in Ukraine as of January 1, 2006. 88% of the agricultural land in Ukraine is leased, and the average annual payment amounts to roughly 115 Hryvniaha, of which 80% is paid inkind. - 26 - 58. By limiting the development of agricultural credit markets, missing markets for land purchase and sale and the lack o f bankruptcy enforcement have reduced especially medium- and long-term investments for example in farm machinery, on-farm storage, cooling (milk) and drying (grain) equipment, etc. Missing or outdated machinery and equipment in crop production results in sub-optimal input application (e.g. seeding density and depth, the timing and precision of fertiliser and agro-chemical applications, incorporation of crop residues and use of moisture- saving no- or low-till technologies), higher costs of production, lower yields, and greater harvest and post-harvest losses (volume and quality). In livestock production it results in sub-optimal feed preparation and storage (e.g. silage quality), animal health problems (e.g. respiratory diseases due to poor climate in barns) and an inability to invest in superior genetic material. Outdated milking equipment can also lead to animal health problems and lower the quality of the milk produced, especially inconjunction with inadequatecooling facilities. At the intersection of animal and crop production, missing investments meanthat very few farms are able to make the best possible use of manure to fertilise crops, ameliorate soils and avoid the environmental problems associatedwith inadequatemanure disposal. 59. Underlving and accentuating all the barriers to competitiveness listed above is a shortage of human capital. Farm managers in Ukraine often adhere to sub-optimal agronomic practices. The result i s low productivity and low quality output, waste and environmental damage. When asked, farm managers generally claim that a lack of capital for investments in modern technology is their biggest problem. However, the same managers rarely make the best possible use of the - admittedly scarce - capital that is at their disposal. Lischka (2004, p. 117) provides two examples: "Even taking into account the fact that soil preparation for the seeding of winter grains takes place with old and outdated machinery, insufficientcare and diligence when ploughinghas led to many fields becoming more and more uneven as time goes by. This makes the ensuing seedbed preparationdifficult and expensive. Ontop ofthis, managers insiston excessive seedingdensities of up to 500 seedsIm2,which increase costs further. Seeding does not take place at an even depth, and this increases the risk of winter kill. The resultingproblems become apparent when the crops re- emerge after the winter. Either extremely dense, sod-like stands of grain emerge that cannot be raisedto generate anythingclose to the economic optimum. Or a severe winter has wreaked havoc on the unevenly sown seed, leading to significant yield losses and in some cases necessitating complete re-seeding. Inthis way, poor managementexacerbatesthe prevailingshortage of capital. Feedproductionfor dairy cows on Ukrainianfarms generally takes place on a very extensive basis, ostensibly due to shortage of capital. As a result of this extensive production, land requirements of 0.8 to 1.0 ha per animal equivalent are common. Since optimising feed productionfor dairy cows could reduce the corresponding land requirements by 30 to over SO%, and since the land unnecessarily bound in this manner is taken out of potentialcash crop production, the opportunity costs of this poor management in feed productionare high. The result, again, is to exacerbate the shortage of capital." 60. Poor management also contributes to a lack of capital, because creditors will be very hesitant to lend money to a farm that has consistently underperformed and i s manifestly poorly managed. But the shortage of human capital does not only detract from competitiveness at the farm level. Producers and agri-food businesses lack knowledge of markets and marketing, including quality requirements in target markets and how to work towards fulfilling these requirements on the farm and in the food chain. And public institutions, such as the ministries responsiblefor identifyingpolicy needs and formulating and implementing appropriate responses, - 27 - suffer from a lack o f the necessary analytical capacity and in particular the ability to distinguish between private and social costs and benefits. 61. The root o f this shortage o f humancapital is an outdated and closed agri-food education and research establishment. An example o f the degree to which Ukraine i s isolated from international exchange and impulses in agricultural research and education i s its almost complete lack o f presence in international agricultural economics. The International Association o f Agricultural Economists (IAAE) has over 1000members worldwide; however only one member from Ukraine was registered for the 2005-2007 membership period. At the 2006 triennial IAAE conference in Brisbane, Australia, over 800 agricultural economists gathered for one week to present, discuss and debate, but not a single member from Ukraine was present (with the exception of a few young Ukrainians pursuing PhD studies in the EU and North America). Young Ukrainians who complete PhDs abroad have very few options to return home to teach and establish research programs; the difficulties begin with the fact that their foreign PhDs are not recognised in Ukraine. Within the agricultural education system in Ukraine, corruption is rampant, with admissions, grades and degrees often being purchased rather than earned (Schoreit, 2004). 62. These are all indications that the sizeable agricultural research and education establishment inUkraine isunwillingor unableto openup and serve as aconduit for new ideas andmethods. In the years since Independence, the system has demonstrated that it i s monolithic and hierarchical - with advancement more a function o f seniority than scientific creativity and output - and quite resistant to change, It does not produce the trained young individuals that Ukrainian agriculture requires, and it does not serve as an independent voice that informs policy makers and other stakeholders by subjecting policy proposals and developments in the sector to objective and public scrutiny. V. Measuresto increaseUkraine's agricultural competitiveness 63. All o f the barriers to competitiveness listed in Section IV are man-made. All can be reduced or eliminated with political leadership, the courage to set new priorities and break with past patterns of misallocation and neglect, and the will to work with partners (domestic and foreign private investors, international institutions) who can provide know-how and funding. The following list o f measures picks up many strands o f the discussion o f barriers to competitiveness inSection IV. 64. We broadly distinguish between trade, market and price support policies on the one hand (equivalent to "amber box" measures in WTO terminology) and investment measures ("green - 2 8 - to the extent that they are public investments) on the other. In the former category we advocate restraint and a reduction of the government intervention which, on balance, has greatly hindered the development of agricultural competitiveness in Ukraine. Domestic policy makers may feel that this restraint would unduly limit their ability to serve the interests o f their constituents in agriculture and rural areas. However, this would be to take an overly pessimistic view. Even without traditional trade, market and price support measures, a broad range of profitable, competitiveness-enhancing investment measures remains available to agricultural policy makers. Furthermore, there is compelling empirical evidence that a government's choice betweenproviding subsidies to private goods (such as market and price support) and providing subsidies to public goods (such as investments in research, education, and rural social services) has a major (positive) influence on agricultural growth and rural incomes (L6pez and Galinato, 2007). Countries that spend less on the former and more on the latter perform significantly better ininternational comparison.Hence, adjusting the policy mix away from market andprice support and towards public investment measures would make Ukrainian agricultural policy more and not less effective. Trade,market andprice supportpolicies 65. On May 16, 2008, Ukraine became a member of the WTO. This important success took many years to achieve, as accession negotiations beganin 1993 and sometimes appearedto falter due, among other things, to agricultural issues, But it is a success that has major implications for Ukrainian agricultural policy and participation in international agricultural trade, and that signals Ukraine's fundamental commitment to market-orienteddevelopment of its agri-food potential. 66. The benefits of WTO membership are manifold. As demonstrated in a recent paper by Melitz (2003) on the impact of international trade inthe presence of intra-industry heterogeneity (such as the heterogeneity inUkrainianagriculture documented inthe DRC analysis in Section 111 above), increasedexposureto international competition can generate benefits inthe form of intra- industry resource reallocations that lead to increases in aggregate industry productivity. WTO membershipwill also ensure that Ukraine benefits from Most FavouredNation status inits trade with other WTO members,and from access to the Dispute Settlement Mechanisminthe event of conflict. Finally, WTO membership will impose disciplines on Ukraine's agricultural policy, reducing distortions and intervention on agricultural markets. In particular, the conditions of Ukraine's accession to the WTO include the commitment that Ukraine will not make use of export subsidies. This effectively precludes any form of price support for products that Ukraine exports. Other important disciplines will limit the use of the export restrictions (export taxes and quotas) which policy makers inUkraine have resorted to (for oilseeds and grains) inrecent years. l4"GreenBox" measuresas defined under the WTO Agreement on Agriculture are measuresof domestic support to agriculture that have no, or at most minimal, trade-distorting effects or effects on production. Support needs to be provided through a publicly-fundedgovernment program (including government revenue foregone), not involving transfers from consumers, and the support in question must not provide price support to producers. Green box measures are exempt from reduction commitments and include (i)governmental services including research, extension advisory services, market information, pest control, inspection services, infrastructure; (ii)public stockholding for food security purposes; (iii)domestic food aid; (iv) direct payments to producers and decoupled income support; (v) government contribution to income insurance and income safety net programs; (vi) natural disaster relief includinggovernment contributions to crop insurance schemes; (vii) structural adjustment assistance through producer or resource retirement programs and investment aids; (viii) environmental programs; and (ix) regionalassistance programs. - 2 9 - 67. A durable solution must be found for the export VAT refund problem. Outstanding refunds must be repaid and an accountable and transparent mechanism put inplace to ensure that there is no further accumulation of unpaid refunds. Failure to do so will subject agricultural exporters to unjustified costs and risks, and these will continue to be passed on to farmers inthe form o f lower farm gate prices. 68. Anything that makes imports such as seed, agricultural machinery or agri-chemicals more expensive reduces Ukraine's agricultural competitiveness. Therefore, import barriers for such inputs should be reduced. Three sets o f measures would contribute to such a reduction. First, import tariffs should be reduced. Inrecent years, steps inthis direction have beentaken as a result of Ukraine's negotiations and preparations for WTO membership. Second, recognition o f EU product safety standards and certification would reduce non-tariff barriers to imports. Third, reform o f customs procedures would reduce additional non-tariff barriers inthe form o f delay and cost at Ukraine's borders. This third component is related to the second because complex, arbitrary and intransparent standards and certification requirements can provide customs officials with a pretext for extracting bribes inreturn for more expeditious processing o f imports. Reform o f customs procedures would also reduce the costs o f exporting, thus further increasing competitiveness. Since standards and certification, and reform o f customs procedures are essentially `investment' measures, we return to them below. 69. Intervention on individual agricultural markets should be reduced. As demonstrated above, intervention taxes Ukraine's most competitive agricultural products, and subsidises especially sugar, which i s the least competitive. This self-destructive policy has cost Ukrainian agriculture billions o f Hryvnia in revenue. Hence, measures such as export taxes and quotas should be abolished". The subsidisation o f sugar beet production should be phased out. Subsidies to livestock producers in the form o f VAT expenditures, which are poorly targeted and distort incentives, should be eliminated. The agricultural support measures that remain (Ukraine has negotiated an aggregate measure o f support allowance o f 0.613 billion US$ as one condition of its accession to the WTO) should be as non-distortive as possible. Targeted, direct income support and income stabilisation measures should be emphasised. To reduce policy uncertainty, market and price measures should be simple and transparent (simple price wedges, no quantitative restrictions) and measures that call for state spending (e.g. intervention purchases) should be sufficiently financed inorder to ensure effective implementation. Public andprivate investments in the competitiveness of Ukrainian agriculture 70. Further efforts are required to separate the so-called social sphere from the farms inUkraine. As part o f a broader reform of fiscal federalism inUkraine, the responsibilities o f central, oblast and local governments for social services, health care, infrastructure maintenance and schooling must be brought into balance with the financial capacities ofthese different levels of government to fulfil their responsibilities. Progress inthis direction would reduce the excess burdenon farms inUkraine, freeing management capacity and resources for core tasks in farming and marketing. It would also contribute to combating the perception that rural areas are backward and unattractive places to live, thus making it easier to attract and bind the qualified young workers and managers that a modern agri-food sector requires. l5While export quotas for cereals were dropped in May 2008, the risk of their re-introductionremains until the instrumento f export quotas as such is abolished. - 3 0 - 71. Iffarmers in Ukraine had received roughly the same share of fob grain prices as their counterparts in Germany, the 2006 harvest of roughly 35 million tons would have generated an additional 1 billion US$ of farm revenue, equivalent to about one-half of total government spending in support of agriculture in that year. To reduce marketing margins and increase farm gate prices there i s a pressing need to continue upgrading local storage facilities and inland transportation infrastructure for agricultural products. Ifthe steps outlined above to improve the trade, market and price policy environment were taken, many such investments in local, private assets such as grain storage and harbour facilities would be undertaken by private investors. However, other investments (e.g. in the intra-regional road and rail networks, and in the development of waterways) have public good characteristics that justify public and joint public- private investment. Public investment infeasibility studies and impact analyses (for example of a project to develop the Dnjepr into a major waterway for transporting bulk commodities) could focus attention and generate interest in some key projects. Another step towards improving grain and oilseed marketing infrastructure would bethe privatisation of the state-owned Khlib Ukrainy, which continues to own choice grain marketing assets (elevators, terminals) but is not subject to hard budget constraints. 72. Physical marketing infrastructure can only be usedto its full advantage ifcombined with the necessary expertise. Public investment to improve management along the food chain - especially training in the areas of logistics, the monitoring of food safety, and the implementation of traceability systems - would enhance Ukraine's agricultural competitiveness. Again, in a more stable and transparent market and price policy environment, large firms in particular could be expected to increase private investment in the necessary human capital. However, from a social perspective these private firms would probably under-invest as they train primarily for their own needs and not those of public institutions (e.g. ministries, monitoring bodies) and smaller firms that also require expertise. Hence, public investment in improved training facilities (e.g. introducing modem logistics and quality management courses into curricula at Ukrainian universities and management schools, establishing a corresponding research institute), perhaps in cooperation with private partners, would generate significant returns. 73. Ukraine should further harmonise its domestic legislation with EC food and feed law, codex alimentarius standards and WTO SPS standards. It should seek bilateral and multilateral assistance to upgrade its food safety and quality assurance systems, strengthening certification mechanisms and institutions for quality assurance and accreditation, establishing reference laboratories, and implementing GAP- and HACCP-compliant production and processing. Failure to address these steps will lock Ukraine into the low-quality, bulk commodities segment of international agricultural trade and delay its expansion into high-value added segments, thus reducing export prices and opportunities for diversification of rural economies and employment. In some cases (e.g. a large supermarket chain that maintains additional private quality and certification standards and sources products in Ukraine), private firms will undertake their own investments in food safety. Nevertheless, Ukraine needs to develop and maintain a positive `brand image' for Ukrainian agri-food products ingeneral. Quality problems ina single shipment can lead to border closings for an entire industry and tarnish this image. This highlights the very important role that public investment mustplay. 74. The need to modernize and streamline customs procedures was mentioned above. On the import side, this would contribute to reducing the cost of key agricultural imports such as seed and machinery. On the export side it would make Ukrainian agricultural products more -31 - competitive on world markets. Dependable and rapid customs processing can be especially critical for exports and imports of perishable agricultural products. In recent years, many countries have adopted software systems that automate customs procedures and reduce the discretion that can be exercised by customs officials. When Cameroon adopted such a system at one of its main ports at the beginning of 2007, customs revenues increased by roughly 3 million Euros (6%) inthe first month of operation (BMZ, 2007, p. 4). Even if customs revenuesincrease, importers as a rule incur less costs at the border under such automated systems than before because they are no longer subject to chicanery, delays and arbitrary decisions. Together with the recognition of EUproduct safety standardsand certification, investment inautomated, transparent customs procedurescould generate significant returns inUkraine. 75. Ukraine needs to invest in developing modern agricultural market information systems. If more timely and objective market information were available, the ostensible justification for many episodes of damaging state intervention on agricultural markets would be greatly weakened. Improvedmarket information would improvethe marketing options open to producers and reduce the problems associated with information asymmetries such as hold-up problems that can discourage investments inthe production of quality. 76. The absence of futures markets is often cited as a major weakness of agricultural commodities markets inUkraine. A functioning futures market would increasethe efficiency and transparency o f price discovery in Ukraine, and provide hedging instruments that reduce (or redistribute) risk. Public investment in feasibility studies and the design of a Ukrainian futures market for agricultural commodities could therefore contribute to improving competitiveness. Public financing could even contribute to the capital stock required to establish a fwnctioning futures market. However, it should be stressed that such investment would be in vain as long as government interventions in grain and oilseed markets prevail. The ever-present likelihood that grain export quotas and regional bans on movements of grain will be imposed generates basis risk that would make corresponding futures contracts useless to a potential hedger. Any indication that policy makers are attempting to influence the futures market in any way would sound its death knell. Instead of establishing a new futures market in Ukraine it might be more effective and considerably less costly to invest in establishing futures contracts with Ukrainian specifications on an establishedexchange elsewhere. Inthis manner, the credibility and liquidity of an existing exchange could be tapped. Modern electronic trading technology has greatly reducedthe importance of the physical location of an exchange. 77. Agricultural credit markets need to be developed further. In the medium term, the current policy of partial subsidisation of interest on credits to agriculture i s a comparatively efficient measure, provided the individual credits that benefit from interest rate subsidies are granted on an impartial, commercial basis. However, such subsidies can satisfy only a fraction of the demand for agricultural credit in Ukraine. Moreover, many of the steps above, by improving the competitiveness and earnings of Ukrainian agriculture, would further increase the demand for credit. Legalising the purchase and sale o f agricultural land and allowing creditors to enforce bankruptcy would expand supply. Although this has proven to be a very difficult and contentious area, international donors and their Ukrainian partners should persevere in their efforts to establishthe institutions neededto ensure transparent and secure land transactions. 78. Much more investment and effort must go into revitalising agricultural research and education in Ukraine. While investments in agricultural research and development (R&D) take time to bear fruit, there is overwhelming evidence that they generate significant payoffs. - 32 - According an analysis of 1673 publishedestimates (cited in World Bank, 2008a, p. 166), returns on investment in agricultural R&D average over 40%. Besides increased investment in agricultural R&D, priority should be given to restructuring the agricultural researchand education system so as to create alternatives to the existing hierarchies that stifle debate and block both the inflow of new ideas and the retentionheintegration of high-potential young Ukrainians. Internationally recognized accreditation procedures for universities (e.g. under the auspices of the EU's `Bologna Process') should be used to establish benchmarks and expose inadequacies. Mandatory and early retirement schemes for older colleagues, and the use of independent, international hiring committees, would create more opportunities for merit-based advancement and incentives for highly trained young Ukrainians to return home. Ifold institutions (the leading Universities and the Academy of Science) continue to resist reform, then new parallel institutions should be established to compete with them on the basis of output and performance. These steps are desperately needed to ensure that Ukraine produces the highly trained individuals needed to runamodernagri-food sector. Measuring improved competitiveness 79. It was argued above that realising Ukraine's competitive potential in agriculture is a matter o f i)shifting DRC distributions so that the great majority of farms in Ukraine can produce as efficiently tomorrow as the best farms do today, and ii)developing marketing and processing systems so that Ukraine's ability to produce competitive raw products on the farm is translated into competitiveness on world markets and for high-value added agri-food products. Monitoring the impact of policy reform and investment on these goals is difficult because of the need for a counterfactual (what would have happened in the absence of the reforms and investments in question). Despite this difficulty, there are obvious and straightforward criteria for the evaluation of some individual measures. For example, investments in automated customs procedures should lead to an increase in customs revenues, a reduction in average delays due to customs processing at the border, and an increased availability oftimely, accurate trade statistics. 80. The impact of reforms and investments on competitiveness for individual products can be monitored by extending the DRC distribution analysis introduced here as new years of detailed farm level data become available, To provide a sounder basis for the interpretation of future developments, the DRC analysis could also be extended back to earlier years to generate a longer baseline periodand informationon year to year fluctuations. More detailed analysis could further disaggregate DRC distributions by region, by farm size and degree of specialisation. Successful reforms and investments should be reflected inpronounced shifts of the DRC distributions, with the mid-range (Ol). 81. Improvements in competitiveness on world markets and for high-value added agri-food products can be monitored in several ways. More detailed, systematic analysis of prices and margins and farmers' shares in the food chain over time (along the lines of that provided for grains in Figure 14 above) and in comparison with other exporting countries would cast light on the efficiency of the food chain. Indicators based on trade performance (e.g. RCA - revealed comparative advantage) could be used to trace Ukraine's ability to compete on international markets for agri-food products. Such monitoring and evaluation would also provide a necessary ingredient for cost-benefit analyses of public spendingmeasures for agriculture inUkraine. - 33 - APPENDIX 1:THE DOMESTIC RESOURCE COSTSMETHODAND THE CALCULATIONOFDRCDISTRIBUTIONS 1. The DRC method To measure the competitiveness o f Ukrainian agriculture, Domestic Resource Costs (DRC) are calculated for major crop and livestock products. The DRC is one o f many indicators that can be calculated using the Policy Analysis Matrix (PAM) framework developed by Monke and Pearson (1989). The PAM is a product o f two accounting identities, one defining profitability as the difference between revenues and costs and the other measuring the effects o f divergences (distorting policies and market failures) as the difference between observed private values and social values that would exist if the divergences were removed. The structure o f the P A M i s presented inAppendix 1 Table 1. Appendix 1Table 1:The PolicyAnalysis Matrix (PAM) Revenue Costs Profits Tradable inputs Doinestic factors Accounting inPrivate k ?l A=<' B=CnBP,' c= &V,p D=..I-B-C (Financial) Prices J=1 )=&+I k n Accounrinp in Social H = E - F - G (Economic) Prices E=iqs F=Cn,,Cs G = CuI,r"j' /=I J=k+l Effects of Policy arid Market Failures I = A - E J = B - F Source: Monke and Pearson (1989) InAppendix 1Table 1: the subscript i refers to outputs andthe subscript] to inputs; a,. for (j = I to k) are technical coefficients for traded inputsinthe production o f i; aiifor (j = k+l to rz) are technical coefficients for domestic inputs inthe production o f i; Pj* is the price o f output i, evaluated privately (* =p) or socially (* s); = P,* is the price of traded inputj, evaluated privately (* p) or socially (* s); = = F$* i s the price of domestic inputj, evaluated privately ( * =p) or socially (* = s); Imeasuresoutputtransfers; Jmeasures inputtransfers; K measures factor transfers; D (=A-B-C) measures net private profits; H (=E-F-G)measures net social profits; and L measures nettransfers. - 3 5 - DRC i s calculated as the ratio o f G to (E-F) in the table above. Hence, it compares the cost o f domestic resources measured at social prices (inthe numerator) to value added measured in social prices (in the denominator). The use o f social prices throughout ensures that DRC measures whether employing scarce domestic inputs in the production o f good i i s really resulting in a positive return to the country in question. DRC<1 indicates comparative advantage - the social opportunity costs in terms o f domestic resources used are smaller that the corresponding social gain in terms o f value added generated. The opposite i s true for the DRC>1. DRC = 1 indicates that the economy neither gains nor loses from employment of resources inthe production o f i. The DRC method has the advantage o f being intuitively clear, reasonably easy to use and well established in applied economics. It also has several weaknesses. Inparticular, it i s based on the assumption o f fixed technical coefficients. Hence, it ignores possible factor substitution and cross price effects that could be expected to result from shifting production away from the observed point o f production characterised by private prices, to the hypothetical point characterised by social prices. Depending on the strength o f these effects, the DRC will be biased. The DRC may also be biased against activities that rely heavily on domestic inputs such as land and labour, and it is sensitive to the classification o f inputs into domestic and tradable (Masters and Winter- Nelson, 1995). 2. CalculatingDRCdistributions As discussed in Section 111, there i s ample evidence that the farms in Ukraine are highly heterogeneous. Calculating average or typical DRCs would therefore be o f dubious value. For this reason, detailed farm level data i s used to calculated DRC distributions for major crop and livestock products. For each farm in the dataset employed (see below), DRCs are calculated for each o f its major crop and livestock products. For each product, an estimate o f the resulting univariate density function o f DRCs across all relevant farms i s calculated using the kernel-based estimate proposed by Rosenblatt (1956). Note, however, that there i s an inherent discontinuity in the DRC distribution at 0, with values slightly greater than 0 reflecting very competitive farms, and values slightly below reflecting very uncompetitive farms. The kernel-based algorithm used to estimate the DRC distributions presented in this paper smoothes this discontinuity and, hence, creates the false impression o f a relatively highfrequency o f observations close to and equal to 0. For this reason, social cost benefit ratio (SCB: Masters and Winter-Nelson, 1995) distributions are also calculated and presented inAppendix 1 Figures 1 through 4 below. The SCB i s based on the same PAM components as the DRC. It equals the ratio o f the sum o f tradable and domestic input costs to the price o f the good inquestion, or (F + G)divided by E inAppendix 1 Table 1 above. The SCB i s always greater than 0, and a SCB less than (greater than) 1 indicates that total input costs are less than (greater than) revenue and that production is (is not) competitive. The SCB i s not sensitive to the classification o f inputs into domestic and tradable, and it i s not subject to the discontinuity that affects the DRC distribution. However, unlike the DRC, it does not distinguish between uncompetitive production that is merely unable to cover the opportunity costs o f domestic factors (DRC>l) and uncompetitive production that i s not even able to cover the costs o f tradable inputs (DRC