The Effect of Foreign Direct Investment on the Supply Chain of Central and Eastern European Countries

Copyright © 2004 South-Western Doc. Ing. Artan Qineti, PhD. Department of Economics Faculty of Economics and Management Slovak University of Agriculture in Nitra

Copyright © 2004 South-Western „The existence of free markets sure does not exclude the role of government. To the contrary, the role of government is crucial as a forum for the definition of “the rules of the game”, as well as a referee for the interpretation and implementation of approved rules. Markets however, narrow the set of issues that have to be decided about, through political instruments, thus minimizing the scale of government direct participation in the game. “ Milton Friedman, Capitalism and Freedom

Copyright © 2004 South-Western Introduction One of the main problems of the agricultural sector and rural areas in CEEC and Central Asia during the transformation process was the disruption of relations and interlinkages between farmers on one side and input suppliers or wholesalers on the other. The consequent privatization and restructuring of farms and sectors in all segments of food chain caused serious deformations.

Copyright © 2004 South-Western As a result (of this process), many farms and rural households have been exposed to restrictions and problems regarding input supplies (animal feed, fertilizers, varieties, capital, etc.) as well as selling their products. In addition to these problems, another negative factor has played an important role: inefficient (absenting) public institutions required to support market oriented transactions like for example respecting property rights and contracts.

Copyright © 2004 South-Western With the absence of efficient public institutions, private contractual initiatives arise (often coming from large food and agro-food companies) with the objective to overcome mentioned obstacles. Large retailers, agro- food companies and food processors, often in the framework of their own restructuring or after the inflow of FDI start implementing contractual mechanisms with farms and rural households, as well as providing basic inputs in order to provide them with raw materials or supplies at the required quantity and quality. Such process of interlinked contracts has been growing fast in the agriculture sector and rural regions of CEEC and CA.

Copyright © 2004 South-Western Objective In this lecture we try to partially analyze certain issues related to vertical coordination in agro- food chain of CEEC and CA, as well as identify certain alternatives leading toward improvement of policies, institutions and investment that could be implemented by governments and supported by international institutions, in order to improve the links within agrarian marketing, processing chain as well as to increase farmers access to input and output markets.

Copyright © 2004 South-Western Content 1. MODELS OF VERTICAL INTEGRATION AND COORDINATION 1.2.Theoretical and empirical models of vertical integration of food supply chains.

Copyright © 2004 South-Western 1.2.Models of vertical integration of food supply chains. Figure Triangular structure VC Wholesaler / Processor Bank Agricultural farm Triangular chain of vertical contracting Example: Retailer / processor guarantee for bank loans to the supplier Source: Swinnen (2006)

Copyright © 2004 South-Western 1.2.Models of vertical integration of food supply chains. Figure Mechanism on Special Utility Wholesaler / Processor Bank Agriculture farm Mechanism on Special Utility Example: FDI is specialized on financing and the mechanism on special utility is set up to distribute the risk between partners. Example: Group of farmers found a cooperative as a MSU. MSU Input Supplier Source: Swinnen (2006)

Copyright © 2004 South-Western 1.2.Models of vertical integration of food supply chains. Figure Leasing of modern agriculture mechanization through Common leasing project Processor Provider of modern mechanization / techniques Agriculture farm Common Leasing Project with Processor Source: Top Agrar, (2004) Project

Copyright © 2004 South-Western 1.2.Models of vertical integration of food supply chains. Figure Borrowing from partner food processor. SpBracovateľ Agriculture farm Source: Van Berkum (2004) Input supplier Processor Bank Processor as a financial institution

Copyright © 2004 South-Western 1.2.Models of vertical integration of food supply chains. Figure Four degree model of vertical coordination. Brewery Barley producer Malting company Vertical coordination in beer production - Core business: beer production. - The need for vertical integration in order to secure high quality barley varieties from the seed provider. - The general strategy implemented differently in different countries according to local conditions. - Attracting foreign investors in order to increase the efficiency of non-core businesses of the firm, as well as setting up different programmes of assistance to farmers. - Programs for market interlinkages. Provider of Variety Source: Swinnen (2006)

Copyright © 2004 South-Western 1.2.Models of vertical integration of food supply chains. Table 1.1. The share of farms selling based on contracts. Notes: RIF – registered individual farmers, NRIF – non-registered individual farmers. Source: Leuven ACE databases. CzechRep. NRIFRIFSlov. Rep.HungaryBulgaria Individual farmers Sales of plant production with contracts Sales of animal production with contracts Sales of live animals with contracts Sales with contracts Corporate farms Sales of plant production with contracts Sales of animal production with contracts Sales of live animals with contracts Sales with contracts

Copyright © 2004 South-Western 1.2.Models of vertical integration of food supply chains. Table 1.2. The share of Czech farms that receive inputs based on sales contracts (%)*. Notes: * Share (%) of farms that used these inputs in Source: Leuven ACE database. IndividualFarmers Input typesNon-registeredRegisteredCorporative farms Varieties (seeds) Fodder cereals Grass forage or other animal feed Industrial fertilizer Chemicals Concentrate fodder Fuel for tractors Irrigation Other inputs

Copyright © 2004 South-Western 1.2.Models of vertical integration of food supply chains. Figure 1.3. The share of farms selling with contracts. Source: White a Gorton, Relations Spot markets All farmers Small farmers Large farmers Contracts All farmers Small farmers Large farmers Own farms Other agents 27,2 25,0 15,6 41,3 36,2 37,0 6,4 16,7 43,5 41,3 25,5 61,7 43,8 58,3 8,3 28,6 47,1 44,2 25,5 73,1 46,2 69,2 17,8 46,2 50,0 47,2 23,1 77,4 49,1 73,6 26,4 49,1

Copyright © 2004 South-Western 2. FDI AND RESTRUCTURING : DAIRY SECTOR IN CEEC vertical coordination has an increasing tendency in the whole CEEC region, its development is strongly determined by reform policies, vertical coordination starts in its early stage as forms of support in providing input supplies, extension services and simple loans, and later as the system of vertical coordination improves, it is realized in the forms of such instruments such as collaterals or provision of investment loans. vertical coordination plays a crucial role in the most developed CEEC and regarding other countries from the region, convergence is expected.

Copyright © 2004 South-Western 2. FDI AND RESTRUCTURING : DAIRY SECTOR IN CEEC Figure 2.1. Dairy production in selected CEEC, % %* Notes: * 1992 = 100 for Russia and =1993 for SR and ČR. Source: : Swinnen, own calculation and FAOSTAT. data

Copyright © 2004 South-Western 2. FDI AND RESTRUCTURING : DAIRY SECTOR IN CEEC Figure 2.2. Yields in selected CEEC, % = 100%*

Copyright © 2004 South-Western 2. FDI AND RESTRUCTURING : DAIRY SECTOR IN CEEC Figure 2.3. Farm structure according to size – market research in Poland Notes: * 1992 = 100 for Russia and =1993 for SR and ČR. Source: : Swinnen, own calculation and FAOSTAT. data

Copyright © 2004 South-Western 2. FDI AND RESTRUCTURING : DAIRY SECTOR IN CEEC Figure 2.4. Effects of economic reforms on the development of retail in CEEC* Note: * 1992 = 100 for Russia and =1993 for SR and ČR. Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Russia, Slovakia, Ukraine Source: Swinnen,own calculation FAOSTAT data.

Copyright © 2004 South-Western 2. FDI AND RESTRUCTURING : DAIRY SECTOR IN CEEC Figure 2.5. Effects of economic reforms on support programs for farms in CEEC dairy sector* Note: * 1992 = 100 for Russia and =1993 for SR and ČR. Albania, Bulgaria, Poland, Slovakia Source: Swinnen, own calculation from FAOSTAT data

Copyright©2003 Southwestern/Thomson Learning

Copyright © 2004 South-Western 2. FDI AND RESTRUCTURING : DAIRY SECTOR IN CEEC Figure 2.7. The share of suppliers owning cooling tanks Source: Swinnen, own calculation from FAOSTAT data.

Copyright © 2004 South-Western 2. FDI AND RESTRUCTURING : DAIRY SECTOR IN CEEC Effects of introducing vertical coordination and restructuring in dairy sector: Payment delay Deliveries and productivity Quality Investment and access to loans

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Table 3.1: Main characteristics of each stage of retail transformation Characteristics Stage CommunismTransformationGlobalization Concentration in retail sector Main source of capital FDI Share of modern retail chains Share of large multinational retail chains Location of modern chains High Dometic - Low - Low Domestic Purchase of exist. subjects Low In the cities High Foreign Greenfield High Everywhere Source: Dries a kol., 2004

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Retail system during communism was organized in three phases: since the 50-ies state retail chains owned regional distribution centers, that sold mainly processed products, Since the beginning of the 80-ies agro-combinats opened retail sales centers, selling own products (Podravka, Voce a Dona – agro-combinats with processed vegetables), State retail chains had very few or did not have at all fresh vegetable products, mainly they were sold in private markets and small shops. Private subject and state storage centers provided fresh fruits and vegetables from non-formal traditional wholesale subjects, that transported supplies from rural areas directly from farmers, who produced and sold at market. Some suppliers provided some products (in limited quantities and variety) imported (tropical fruit) from other socialist countries.

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC The transition stage In the first half of 90-ties state and collective subjects of retail systems in region ceased to exist. This process was faster and more complete in the case of centralized retail systems in developed countries of the region (like Czechoslovakia). Privatization in this case meant immediate sale of centralized retail system to private wholesalers. At the same time it meant closure of state controlled retail. This process of system dismantling developed with a delay in countries of second and third wave. During this period private food wholesale subjects started to appear in the region, substituting for state or collective wholesale subjects.

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Globalization stage Retail sector transformation have been supported by deep transformation of procurement systems in retail chains. Changes in procurement systems were determined by the motivation to succeed in the ever growing competition of larger supermarkets and foreign investors. For this purpose, it was necessary to reduce costs, trade with consistent amounts and standard products as well as with higher quality and differentiated assortment with the objective to gain trade advantage. On the other hand, the capacity for organizational change and technological opportunities of retail systems was increased based on the transportation of larger quantities and technological know-how transfer of foreign retailers.

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC In order to satisfy the needs of retailers looking for alternatives to existing wholesale subjects and in line with achieving comparative advantages and reducing costs with increasing quality, leading retail in CEEC during last years tended to introduce new procurement systems characterized by 6 key pillars: Return to centralized procurement systems Orientation toward cross-border system Orientation on specialize wholesale subjects Using globalized logistics of multinational companies in order to improve rapidly procurement system Orientation on systems of preferred suppliers Orientation on private standards

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Source: Dries a kol., 2004

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure. 3.2: Development of modern retail market share *Modern retail sector includes hypermarkets and supermarkets.

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure 3.3: Retail chain share on the total retail turnover Source: Dries a kol., 2004

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure 3.4: Number of foreign supermarkets in CEEC, in 2002

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure 3.5: Number of foreign hypermarket in CEEC, in 2002 Source: Dries a kol., 2004

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure 3.6: FDI share in top 50 retail chains (%) Source: Dries a kol., 2004

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure 3.7: FDI share on total retail turnover (%) Source: Dries a kol., 2004

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure 3.8: Development of the number of hypermarkets in Czech Republic Source: Dries a kol., 2004

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure 3.9: The hypermarkets share in modern retail sector Source: Dries a kol., 2004

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure 3.10: Modern retail share on total retail turnover and GDP per capita. Source: Dries et. al., 2004, Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Russia, Slovakia, Ukraine

Copyright © 2004 South-Western 3. THE POSITION OF RETAILERS AND THEIR EFFECT ON AGRO-FOOD SECTOR OF CEEC Figure 3.11: Modern retail share on total retail turnover and the reform index in CEEC. Source: Dries a kol., 2004, Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Russia, Slovakia, Ukraine

Copyright © 2004 South-Western Conclusion Our analysis and other studies show that modern retail invest in the enlargement f local capacities especially in sub-sectors like fresh fruit and vegetable. Similar support packages are offered mainly multinational chains. Competition among retailers for high quality suppliers forces other retailers (including domestic ones) to follow the attitude of modern multinational chains in order to secure sufficient supply basis.

Copyright © 2004 South-Western Conclusion Many specialists emphasized the weak side of food supply chain in CEEC that affected the worsening trade balance between EU and CEEC in the last 20 years. Retailers investment and their induced changes within food supply chain can play a very important role in improving the competitiveness of agro-food sector in CEEC within EU.

Copyright © 2004 South-Western Conclusion Modern retail investment can and will have an effect not only on agriculture producers but also in a broader context on rural development. This includes better access to food products of higher quality and other product for rural households, as well as creation of job opportunities out of agriculture sector or indirectly linked to food supply chain. Investment in packaging, quality control, extension services probably will lead to creation of new job opportunities, but on the other hand tougher competition from retailer chains may lead to the exclusion of traditional sales subjects from the market.