Contract farming, smallholders, and rural development in East Java, Bali and Lombok

• Assessment Institute for Agricultural Technology, East Java, Indonesia
• Bogor Agricultural University, Indonesia
• Brawijaya University, Indonesia
• Udayana University, Indonesia

In rural areas of developing countries, markets are often poorly serviced. Smallholders are unable to take advantage of market opportunities and must pay high costs to overcome market imperfections. Farmers often have trouble accessing credit, obtaining information on market opportunities or new technologies, purchasing certain inputs and accessing product markets. When markets are accessible, farmers may be subject to price fluctuations or inequitable prices. Such difficulties are barriers to their development and represent a 'bottleneck' in the development process. For smallholders, contract farming is a potential mechanism to overcome market imperfections, minimise transaction costs and gain market access. This approach has been implemented in other developing countries, and this project investigated its potential to provide smallholder-industry benefits in Indonesia.

This project had four main objectives: 1) to determine contract types used and commodities under contract in East Java, Bali and Lombok; 2) to determine benefits of contract farming; 3) to evaluate the market for contracted commodities and gain an agroindustrial perspective; 4) to ascertain the potential for smallholders in contract farming and the potential to improve policy.

The project was survey-based. After an initial evaluation, regionally important commodities with extensive contract farming were targeted for in-depth study within three sub-projects: 1) survey-based analysis of contract farming in the East Java region; 2) survey-based analysis of contract farming in Lombok and Bali; 3) analysis of Indonesian agribusiness (processing and exporting) firms that contracted smallholders in the study areas.
Special emphasis was given to design and testing of the surveys and to the systematic choice of survey sites. Data from the surveys enabled detailed analysis of: (1) the general benefits of contract farming; (2) the types of contracts that are most beneficial to smallholders; (3) the gender impact of contract farming; (4) the factors that lead certain farmers to enter into contracts. In addition to the survey, complementary information was collected about community characteristics, market structure and agribusiness activity. Such information assisted the interpretation of survey data and enabled researchers to understand the context in which smallholders operate.

Lists of commodities under contract in the East Java, Bali and Lombok survey areas were developed and representatives of the agribusiness firms responsible for the contracts interviewed. The types of contracting, the importance of the commodity to farmers and the structure of the industry were examined for each contract as a precursor to selecting the three contracts that would be used in the study. The interviews resulted in development of a classification for farm contracts based on the degrees of vertical and horizontal integration resulting from the contract, market dominance of contracting firms in markets for inputs and outputs in the contracted commodity and whether the agribusiness firm was privately or publicly owned.

All the contracts involved some vertical integration. In the East Java hybrid corn contract Pioneer purchases output, provides inputs, provides and enforces growing guidelines and bears risks of low quality but not of low prices or yields. The Bali contract for seed rice involved less vertical integration, with PT Pertani purchasing output but not providing inputs except for foundation seed and limited extension advice. The firm also provided growing guidelines, but since smallholders had experience in seed rice production these were not critical for contract success. PT Pertani does not bear risks associated with low quality, price or yield. However it does guarantee the market for output.

In Lombok, Nusantara Unggasjaya Mataram purchased output, advanced inputs, had strict growing guidelines and bore risk associated with quality and price but did not cover disease risk. Ranking the three contracts on the basis of vertical integration, the Lombok contract involved the most integration and the Bali contract the least. From theory, as vertical integration increases in a contract more transaction costs are saved and hence the contract becomes more valuable to its owner, creating both the means and incentives for firms to be generous with farmers when high levels of vertical integration are involved. This partly explains the econometric result that the East Java and Lombok contracts benefited farmers in terms of increased profits while the Bali one did not.

circumstances. Pioneer needed co-operation between growers for technical reasons and negotiating at group level reduced transaction costs of negotiation, extension, financial transfers and contract compliance. PT Pertani did not need horizontal integration (HI) for technical reasons but used HI to reduce transaction costs of negotiation, extension and financial transfers. It could not use HI to achieve contract compliance since individual contractors could be 'kicked out' of the contract without the whole group losing their contracts as would occur for technical reasons in the East Java contract. In the Lombok contract there was virtually no horizontal integration except for firm representatives addressing informal meetings of broiler growers for extension purposes. Contracts requiring group cooperation for technical reasons such as preventing genetic pollution between adjacent crops, coordinating village labour or sharing machinery or irrigation water were based on group level negotiation. However, in the Lombok contract where there was no technical basis for cooperation HI did not occur.

All three contracts were successful from the perspective of the agribusiness firms involved, inasmuch as the contracts had each been operating for at least five years and none of them showed any sign of joining the long list of 'failed' farm contracts in the developing world. The types of benefits experienced by smallholders were consistent with theory and each contract contributed positively to welfare of smallholders participating in them. All three contracts provided some access to credit or inputs and reduced smallholder risk by providing assurances the firm would purchase outputs. From a development perspective, all three contracts reduced absolute poverty. However, given the agribusiness firms in East Java and Bali favoured larger producers, the latter contracts probably increased relative poverty. In contrast, selection favoured smaller farmers in Lombok and probably reduced both absolute and relative poverty.

A theoretical framework for analysis of contract farming was developed to explain why contract farming occurred in some situations and not others, and what types of benefits both agribusiness firms and smallholders were likely to obtain from contracting. Institute Pertanian Bogor conducted a survey of agribusiness firms engaged in contract farming and centred in Jakarta. The results provided a detailed overview of contract farming practices from the perspectives of agribusiness firms.

There are three types of government policy that the Indonesian Government may consider to facilitate contract farming. These are: (i) adjusting the regulatory regime to reduce transaction costs for participants in contracts; (ii) government playing an enabling role to encourage contract farming; (iii) (perhaps the most important policy) is a 'do nothing' policy of not introducing new regulations for Foreign Direct Investment (FDI) and trade that would in fact discourage contract farming. Regulatory adjustments to create a desirable policy environment for contracting include reducing paper work for exporters, reducing certain import and export taxes, removing import restrictions, implementing food-safety standards, replacing crop production taxes with land taxes and deregulating prices in food markets. Removal of specific regulations can also directly facilitate contracting.

The enabling role of government in contract farming may work at two levels: macro and micro. Macro changes would improve the commercial
environment in which contracting occurs and would be directed at reducing costs of contracting for all parties. Micro reforms to facilitate contract farming are training, arbitrating disputes, undertaking research and providing extension services relevant to expansion of contracting. Training programs for smallholders in literacy, accounting and cash management may reduce miscommunication in contracts. Research on agricultural production and food processing, already undertaken by the Indonesian Government, may benefit from sharing information about research priorities and issues with agribusiness firms.