LITERATURE REVIEW

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CHAPTER 3

COF FE E PRICES ~ INFLATION AND THE NATIONAL OEBT

Various authors have analyzed the effects of coffee priees on its supply and demand. Others have analyzed the effect of coffee priees on the fiscal deficit which has implications on the i nf lat ion leve l . On the othe r ha nd, othe r au thors have re 1 ated coffee priees to inflation through the accumulation of foreign exchange reserves and the associated increase in money supply. The

national debt has also often been associated with the decline in commodity priees by other authors. This chapter analyzes al 1 these relations as explored by different authors and sets the research questions for this paper.

3.1 LITERATURE REVIEW

3.1.1 Farm Level Production Analysis

The re i s mu ch ev i denee to demonstrate positive response of domestic supply of coffee to changes in producer priees in severa!

developing economies (for example: Bond, ('1983); Akiyama and Varangis, ('1990); Trivedi and Akiyama, (1992)). Acc6rding to Bond (1983), in Africa, short-run coffee supply elasticities range from

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elasticities range from 0.44 (rest of Africa) to 1.33 (for- Kenya) . 38

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These e1asticities were ca1culated using data for the years 1946/47 to 1964/65. This ana1ysis shows that production response to priee changes in Africa is generally positive. This response by farmers shows how rational they are at the farm 1 eve 1 . The farmers' response in the short-run is low but with time the response becomes significant. This is so because i t takes time for the coffee crop to grow to productive age. Hence, given an 1ncrease in the real producer priee today, farmers will decide to either improve on their coffee farms or plant more coffee trees but the increase in production will only be realized later.

In the short-run, farmers fail to increase production of coffee significantly due to other priee factors like the non-avai 1abi 1 ity of inputs, aging trees, and weather conditions, among others. When these are rectified in the long-run, the supply response increases (Bond, 1983). This conclusion is confirmed by the results obtained by Akiyama and Varangis (1990) as presented in Table 3.1 below. It shows the estimates of short-, medium-, and long-term coffee supp1y elasticities for selected coffee producing countries.

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poor quality or non availability of data;

positive correlation between the producer priee and marketed output which indicates little about the causal relationships underlying the choices of economie agents between 1 e i su re and production, food c rops and cash crops, and, wage work and work on owned farms;

choice of output and priee variables. '

Whe reas sorne stud i es have used acre age and yi e 1 d as the dependent variables (for example, Askari and Cummings, (1977)), others have used the quantity produced because of lack of available data on acreage (Bateman, (1965); Behrman, (1968)). This has led to significant differences in the elasticity estimates obtained.

Estimated coffee supply models have indicated that even after allowing for the substitution affects, coffee production responds strongly to a r i s e in its producer priee (Maitha, (1970); Ford, (1971); and De Vries, (1975)).

Most studies have generalized supply response to relate most cash crops to producer priees. They have assumed that the response due to a priee increase and that due to a priee decrease were ot

UH::! ~>ômo magnitude. However, Olayem·i anci Oni ( 1872) t.est.Acl tnr·

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asymmetry in priee response in a study of cocoa farmers in Nigeria.

They postulated two forms of response:

a response due to an increase in priee that is greater than that for a decrease in priee; and

a response due to a priee decrease that is greater than that for a priee increase.

According to these authors, the first form of response would result due to the inability of farmers to uproot tree crops given the initial investment even though priees decline. It could also be due to the percentage of the farmers' income that is derived from that crop. If the crop generates more than 60 percent of farmers '

income, a decrease in its priee would mean a decrease in farmers' income leading to a decrease in the capacity to shift to other activities. On the other hand, an increase in the priee would increase farmers' income and this may lead to strengthening of the performance of the crop. The second form of response would occur if

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the producer priees have been declining for a long period or 1f they have been relatively very low. The authors, therefore, included a dummy variable in a multiplicative term with the producer priee to determine the asymmetry. Their results indicated the first form of response noted above.

3.1.2 African Coffee and the World Market.

si gn if i cant amou nt. The wor l d coffee market had been ope rat i ng under the International Coffee Agreement (ICA) export quota regime during the periods, September 1963 to September 1973 and October 1980 to February 1986. The ICA collapsed in July 1989.

The export quota system was an important element determining priees and outputs in the international marketing ot coffee. The ICA used the supply-demand relationships to determine the quotas. However, the political aspects of this international body played a significant role in the distribution of these quotas and the participation of governments in the enforcement of international trade negotiations (Lien and Bates, (1987); Bates and Contreras, ( 1988)).

Studies that have been carried out to evaluate the actual effects of the ICA on the producing countries and the entire world coffee market (Akiyama and Varangis, (1989); ( 1990)) have expla1ned that the export quota system led to a significant reduction in the variation of export revenues but increased the variation of export quantities. The results showed that for the period 1981-85, the quota system led to the holding of a high level of stoc.ks 1n producing -countries. At the end of 1985, the stock level was 33 million bags i nstead of the expected 22 mil lion bngs had t,hP quot.a system not been in place. In addition, export,s t,o quota mnrket.s were 62.5 million bags in 1986 instead of fi!) millinn t1;1g!;. According to these authors, such a system of quotas favoure~ large

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producers and exporters in terms of revenue. A significant increase in their experts lowered world priees which led to low marginal export revenues. This was a di sad v an tage to sma l 1 producers and exporters. Akiyama and Varangis ( 1990) madel led the production, export su pp l y and i mport demand for coffee. They specified the priee equation by iinking priees to stocks. On the ether hand, they spec if i ed the i mport demand in a convent i ona 1 manner as a function of the per capita incarne, population, tastes

and real retail priees. They specified real retail priees as a function of the exchange rate, inflation, and world priees. A time trend was used as a proxy for changes in tastes. 8 The estimates for the incarne and priee elasticities obtained for the period 1968- 86 were as given in Table 3.3 below.

Srt·1e assumption WRS thnt Bvery yoélr· new proouct.s cnmq int.o IIH' mnr·knt.. These new products have a possibility of diverting consurner·s' demand tr·on1 cotteH.

Therefore, as t ime goes on, the consumers' tas tes keep on changi ng and t.tn s rna y have an effect on·the demand for coffee in the world market. ·

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TABLE 3.3: INCOME AND PRICE ELASTICITIES OF COFFEE DEMAND FOR

estimated the priee and income elasticities of world coffee demand as -0.085 and 0.656 respectively.

Global coffee earnings fell below US$ 11 billion in the mid-1980s and Uganda's coffee export earnings in 1992 stood at US$

98 million compared to average annual earnings of US$ 300 mi 1 l1on between 1 982 and 1 989. The conti nued fa 1 l in wor l d coffee p ri ces and the resultant decline in foreign exchange earn i ngs torced coffee producing countries to seek a new International Coffee Agreement. African coffee producers in 1993 agreed to join the Latin American scheme and withhold 20% of the output from the world market to beost priees. A plan of action by members of the Inter-Africa Coffee Organization (IACO) had earlier on proposed a 15 percent retention scheme. By 1993, world coffee priees had started going upas a result of the earlier decision taken by Latin American countries to withhold 20 percent of their coffee exports.⁹

Attempts to regularize production and trade of coffee 1s not a new phenomenon. In the late 1950s a similar scheme was put in place.10 In 1959, sorne African countries including Cameroon and the

9Musoke David: " Africa to Withhold 20 Percent Gaffee Export." - Reuter News. In The New Vision, Vol. 8, No. 193, 17th August, 1993; p. 1 & 2 l~

Newspaper, Kampala, UgandaJ.

10 In October 1957, seven Latin Americancountries (Brazil , Colombia, t:ostn Rica, Fl Salvador, Guatenwlfl, Mexico flnd N"fc:aragua) agr·eect on n Wltllllolctlrl9 scheme ta arrest the decline in cotfee priees. This scheme pledged a ~ percer1t withholding of all exportable production up to 300,000 bags (60 kg each) and 10 percent thereafter except for the two 1 argest producers and ex porters ~ Rraz i 1 and Colombia) where the bulk of the stocks were accumulated. Brazil was supposed to

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Portuguese territories joined the scheme. However, British East Africa and Belgian territories declined to participate torma lly although they declared their willingness to limit experts during the year of the agreement (Vernon O. Wickizer, (1964)).

African support for the coffee scheme would mean that some 80 percent of the coffee output would be covered. The objective has been to force priees well above the historically low levels they have suffered since the collapse of the coffee pact in 1989. S1nce then, it is estimated that coffee producers have lost up toUS$ 10

bi 11 ion in revenue due to the fa Il in world priees. Afncan producers alone have lost more than US$ billion in sales since the collapse of the pact.¹¹ According to The Monitor, the success of the new plan would lead to withholding 10 million bags t60 kg each) from the world market during the 1993/94 coffee season.

According to a World Bank Quarterly Report (World Bank, March 1994), the retention plan which took effect from October 1993 has b_een work i ng w i thout mu ch prob 1 em in severa l countri es i ne l ud i ng Colombia and Uganda. According to this source, Brazil has not been able to retain stocks in the same way as in Central America because fore i ng exporters to reta in stocks cou 1 d be i nter-pret.eci ns nn withhold 40 percent while Colombia was supposed to withhold 15 percent. lins w.1s

.because of the comparative ~dvantage these countries had in storage fac1 lit1es.

11Laid.law Ken: "Producers Cut Coffee Output to Boast Priees"- ^Gern1111 News (London). In The Monitor, No. 91, Kampala, Sept. 21-24, 1993; p. 1 LB1-Weekly Newspaper, Kampala, U~da].

export taxon coffee, which is forbidden by Brazilian law. Reduced experts of arabicas from Central America and Colombia due to the retention scheme and the production declines have tightened supplies. He nee, stocl<.s kept in consumi ng countr i es a re bei ng

released. Colombia's 1993/94 crop and Brazil's 1994/95 crop are

also important factors expected tb influence world coffee priees.

Colombia's production in 1994 was expected to decline to about 14 million bags from the previous year's 16 million bags. Preliminary estimates of Brazil's 1994/95 crop are also as low as 22 million bags compared with 23 to 26 million bags in 1993/94. If these estimates materialize, a large proportion of stocks in consuming countries would be released, eausing world eoffee priees to r1se significantly.

According to World Bank estimates, on the world cotfee market, priees hit the bottom in 1993. Hopes tor reviving the International Coffee Agreement were frustrated and the Association of Cotfee

~roduc i ng Countr i es ( ACPC) was estab li shed to l aunch the stock retention plan. World coffee priees, deelining since the suspens1on of the ICA's export quota system in July 1989, started to recover in the summer of 1993. It is believed that the retention plan and reduced production in severa l major coffee export i ng countr i es supported the recovery. However, i t i s not. e ¹ ear whet.her- th 1 s

recovery is due to the plan or to reduced production. In any case, it is questionable whettler such a plan wi Il succe(~d in t','11Sing

priees for an extended period.

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3. 1 . 3 Coffee Priees and the Inflationary Process.

Commodity priees play a major role in the inflationary process. An increase in the international priee of an export commodity on which an economy depends will result 1n an appreciation of the real exchange· rate, independently of what the domestic monetary authorities do (Edwards, (1984)). Edwarcis used data on coffee from Columbia where it is a major export. According to this author, the hypothesis works through two mechan1sms:

One effect is an increase in the international priee of coffee whi ch augments the country' s foreign exchange

reserves through a bal ance of payments surplus. The increase in reserves will, if not fully sterilized, increase the size of the monetary base. This will result in an expansion of money su pp l y, i nf 1 at ion and real appreciation of the exchange rate. This monetary effect has been emphas i zed by other authors ( Musonda et a 1. ,

(1991); Davis, (1983); Bevan et al., (1989) and Kayizzi-Mugerwa, (1990)) .

The second effect works as follows: an increase in the priee

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of coffee when passed on to the producers, raises di sposab 1 e i ncome wh i ch l eads to an i ne rease in the demand for both tradeable and non-tradeable goods. If the p ri ce of tradeab le ( non-coffee) goods i s g i ven by the

world priee, the increase in disposable income (the real income effect) will result in higher demand by domestic consumers and hence higher relative priees on

non-tradeab 1 es and an appreciation of the rea 1 exchange rate. ¹² The rea 1 i ncome effect, however, i s un 1 i ke 1 y to work in a situation where a small proportion of the international priee is passed on very late to the producers (Ssemogerere, (1990)).

In his study, Edwards (1984) first analyzed the long run effects of changes in the priee of coffee on competitiveness and then he analyzed the relationship between coffee, money inflat1on and competitiveness. In the empirical work, he investigated if higher ( ·lower) priees of coffee have resulted in higher t lower)

rates of growth of the nominal quantity of money in Colomb1a for the period 1952-80. He then further analyzed the re·lationship between the rate of growth of money and inflation. He specified the change in money supply as a function of its lagged values up to three periods, the ratio of the fisca·l deficit to high-powered money and the priee of coffee. He then specified inflation as a fun ct ion of the change in mo ney su pp 1 y, rea 1 i ncome, the wor 1 d priee of treadables and a dummy variable to capture different inflationary regtmes. His results indicated that, with other

12using the purcl1asing power parity ratio arpr·oacll, t.t1e ren 1 exci1H119e ,·at.P is defined as the product of the nominal exché.H1ge r·ate anrl the r·atio of for·e·tgn to domestic priees. If domestic pt·ices increase, given tt1at tt1ey ar·e 111 tllP

denominator in the formula, the real exchange rate will decline .. Tllat is, the domestic currency will appreciate.

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factors held constant, a higher (lower) priee of coffee will result in a higher (lower) rate of inflation.

More studies have demonstrated that when the producer priee of coffee increases, more resources will be attracted to the coffee sub-sector. This w i 11 'starve' the non-traded goods sec tor of resources. If this is not checked, the cast of production in the non-traded goods sector will go up and hence drive up priees (Musonda et al., (1991)). This derives from the 'dutch d1sease' theory (Younger S.P, (1992); Ravi Kanbur, (1993)). According to this theory, a booming sector will create problems for sorne other sectors of the economy. This sector may be the foreign aid sector (Ravi Kanbur, (1993)) or the export sector (Musonda et al., l19:11 );

Younger, (1992)).

From the structuralist point of view, an economy character1zed by scarc i ty of goods for consumpt ion and a weak i ndustr i a 1 base with limited response to priee incentives is prone to structural

inflation resulting from pricing poli6ies. This situation is brought about by su pp 1 y rigi dit i es and a ba 1 ance of payments problem (Ssemogerere, (1990)). According to this author, when coffee, i s pu rchased for cash, i t 1 eads to an i ne r-ease in purchasing power in the economy in the short-run. However, thP supply of goods and services on wh i ch ·ta spend tt• i s <-Hi ci 1 L ., on a 1

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·coffee ex ports i s received. The received l' o r-e i g n ex c t1 <H1 ge ,

however, does not lead to immediate importation. Meanwhile, the new purchasing power chasing very few goods shoots the priee level up and hence fuels the inflationary process. To aggravate the situation, two other factors play a role:

Sorne part of the foreign exchange earned from ex ports is used to pay international ob 1 i gat ions, and seme part

goes to servi ci ng the debt. Hence, at the end of the delay in receiving this foreign exchange, the economy does not import goods and services early enough to ease the inflationary pressure.

very few industries respond fast enough to p ri ce i ne re ases because they too depend on imported inputs.

In this regard, an increase in the priee of coffee may create conditions contra~y to itself. There is, therefore, a need to test the effect of an increase in the real producer priee of coftee on the general level of priees in Uganda.

3.1.4 Fiscal Deficits and the Inflationary Process

Fisca·l adjustment was urged on Atrican count.ries dur1ng thP 1980s to lead them out ot their economie malaise. However, uncertainty still surrounds the relations between t1scal po11cy and macroeconomie performance. Much of the blame tor the var-lous

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economie ills that beset developing countries in the 1980s: over indebtedness and the debt crisis, high inflation, poor investment performance and poor growth were attributed to expanding f1sca1 deficits (Easterly and Schmidt-Hebbel, (1993)).

There has always been ·a recurring question as to whether-larger public deficits are always associated with higher inflation.

Various authors have identified the relationship as blurred because governments finance deficits by borrowing as well as by print,ing money. The relationship is further blurred by other influences sucn as unstable money demand, inflationary exchange rate depreciations, widespread indexation and stubborn inflationary expectations

(Kiguel and Livitian, (1988); Dornbusch and Fischer, (1991)).

In a study on 10 countries¹³ for the period 1978 to 1988, Easte r 1 y and Schmi dt-Hebbe 1 ( 1 993) found th at re 1 at ions between fiscal deficits and inflation were difficult to establish. However, with low to medium rates of inflation, they established no relationship across countries between long term inflation and public deficits. On the other hand, they discovered that countries with the highest rates of inflation during the 1980s -Argentlna and Mexico - had significantly higher deficits than countr1es w1th

lower rates of inf lation like Colombia and Ghana.¹⁴

13Argent1na, Mexico, Co lombia, Chi le, T11ai land, Pélh:istRrl, Cotn ci' lvnrrn, Morocco, Zimbabwe and Ghana.

14Aithough by African standards Gl1ana is a h1gh inflation countr'y, lor· tllf-) countries cons1dered in tl1e study by tl1e above authors, i t was one of the lowest.

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The lack of correlation between fiscal deficits and inflation across countries is attributed primari ly to the different ways 1n which countries finance these deficits.

Large temporary terms of trade gains usua 1 1 y accrue ma 1 n 1 y as government revenue, either because the export commodity is publicly owned (as with oil) or because the government heavily taxes the

Large temporary terms of trade gains usua 1 1 y accrue ma 1 n 1 y as government revenue, either because the export commodity is publicly owned (as with oil) or because the government heavily taxes the