Social capital Institutions

Posted March 1996

Capital Formation in Agricultural Cooperatives in Developing Countries: Research Issues, Findings and Policy Implications for Cooperatives and Donors

Summary of an analytical paper
by J.D. Von Pischke,
FAO Cooperative Finance Consultant

Introduction and background

The research and the conference for which this paper has been prepared arise from concerns about cooperative capital formation that have been developed since 1992. Observers in FAO, COPAC, ILO, the World Bank and other agencies had noted that capital formation is at times a major challenge for cooperatives, which often appear to be undercapitalized. Many cooperatives and even entire movements may lack the financial base required for growth and sustainability: a condition that appeared especially serious in agricultural cooperatives.

Undercapitalized societies face an additional disadvantage in surviving and prospering in an environment that includes commercial, political and public policy risks. Liberalization of markets through structural adjustment is changing the competitive environment in which cooperatives operate. At the same time it was increasingly clear that donor funding for cooperative development is likely to diminish. Cooperatives have the capacity to create infrastructure that in many cases appears unlikely to be constructed by others, at least within a reasonable time horizon. Inattention to member capital formation can retard or preclude such development.

These converging concerns and observations led COPAC to develop a series of open fora on cooperative capital generally and to commission empirical research on capital formation and its relation to the overall well-being of cooperation, which clearly requires member participation. These activities were inaugurated in the COPAC Open Forum on "Revitalising Cooperatives in Developing and Transitional Economies: The Role of Members' Capital" convened in Rome, 2-3 March 1993.

A second COPAC Open Forum, "Revitalising Cooperatives in Developing and Transitional Economies: The Role of Members' Capital - Review of Progress and Future Developments," was held in Geneva on 5 October 1993. A research design proposed at the earlier meeting had been field tested and reviewed by the Institute of Rural Management at Anand (IRMA) in India. Its discussion led to a call for further work, which is embodied in the three studies that form the basis for the present review at this Technical Workshop.

This paper summarizes research on cooperative capital formation in developing country agricultural cooperatives, based on fieldwork in Guatemala, India and Kenya. This research was commissioned by COPAC (the Committee for the Promotion and Advancement of Cooperatives) with financial and technical support from FAO's People's Participation Service.

Research objectives

Research was commissioned to determine empirically

Hypotheses tested

Four research hypotheses were proposed to test relationships between capitalization, commercial performance and member participation and control. As is customary and useful in research, the hypotheses were stated boldly so that they could be tested unequivocally. Also, a standard of comparability was stated: "otherwise similar cooperatives." This standard cannot be fully met in every respect in the social sciences: no two cooperatives are alike in all aspects except their capital structure. However, this standard working capital is excluded to avoid extra computations related to short term changes.
Hypothesis A. The greater the proportion of member-owned funds to term debt and evergreen (permanent) working capital loans from non-member sources used by otherwise similar cooperatives, the greater the member control and the greater the growth rate of the cooperative.
Hypothesis A is the most simple of the tests. It suggests that member control and growth are directly related to the proportion of the cooperative's resources supplied by members. Seasonal working capital is excluded to avoid extra computations related to short term changes.
Hypothesis B. The higher the quality of capital in otherwise similar cooperatives, the greater the member control and the greater the growth of the cooperative.
Hypothesis B is the simple test of the quality of capital. Quality would be measured by comparing total weighted liabilities and net worth with total unweighted or accounting liabilities and net worth. No specific weights for different types and sources of funds were recommended in the research design.
Hypothesis C. The higher the growth of member-owned funds in otherwise similar cooperatives, the greater the member control and the greater the growth of the cooperative.
Hypothesis C relates the extent of member capitalization to member control and growth. Societies that are accumulating funds are expected to be more vigorous commercially and to practice cooperative democracy, ensuring member control.
Hypothesis D. The greater the quantity of member-owned funds in proportion to non-member funds, and the higher the quality of capital, the greater the ability of the cooperative to manage risk and adversity, including unfavourable trends in the prices of the commodity (or commodities) the cooperative trades, inflation in countries where inflation is a macroeconomic problem, political change and turmoil, dissension among members, and other factors that cannot be accurately predicted but which lower returns to the cooperative.
Hypothesis D incorporates elements of A and B while introducing a new standard: the ability to manage risk, to withstand shocks from the economy, the market, the political and regulatory environment or from within.

The diversity of findings in the three studies gives a multi-faceted picture of cooperation and its financial aspects. In general, the India study found the most evidence that affirmed the research hypotheses while the Kenyan research found no conclusive evidence to support the hypotheses. This contradiction is not necessarily a disqualifying feature of the social sciences because reality is also complex. It may also reflect the context of cooperation: in the more market-based Indian case the hypotheses tend to apply, while in the more heavily regulated Kenyan situation their validity is restricted.

What can be made of the results? Are higher levels of capital formation associated with growth in patronage and membership, with greater member control and participation? Do they stimulate growth, member control and participation? Is the quality of cooperative capital associated with accumulation and member funding and control?

Results of hypothesis testing

Hypothesis A

This hypothesis was not strongly confirmed by the research. It appeared most applicable to a sample of cooperatives operating under considerable indirect regulatory control but in an active competitive market and, in a number of cases, under reasonably skilled management. The hypothesis, however, was not confirmed in the analysis of a sample of heavily - and often directly - controlled cooperatives in less competitive (or more monopolized) markets. In all cases patronage was seen as very important, as would be expected in a commercial activity, along with the degree of dependence on the cooperative as indicated by the proportion of members' income received through the cooperative, as would be expected in a democratically oriented activity. The Guatemala study suggests that the hypothesis may be meaningful only up to a point where healthy, dynamic cooperatives use non-member funds to leverage member funds and institutional capital. Such leverage permits greater strategic and competitive flexibility.

Hypothesis B

Except in the limited case where institutional capital was large, this hypothesis was not confirmed by the studies. The quality of capital over the ranges studied did not appear to be a conclusive explanatory factor determining performance. One possible explanation may be that where non-market arrangements strongly determined cooperative capitalization, the range of quality was relatively small, below thresholds of differences. Analysis was complicated by the subjectiveness of quality weightings of capital.

Hypothesis C

Observations broadly consistent with Hypothesis C were reported in the studies. The weakest element in the relationship proposed in the hypothesis seems to be member control, which is limited in Kenya and is expressed primarily through individuals' patronage decisions in each of the three cases.

Hypothesis D

This hypothesis was not explored in much statistical detail in the studies, precluding conclusions based on quantitative analysis.

Inter-temporal dynamics of cooperative capital formation

The studies highlight several intertemporal dimensions of cooperative capital. One is the paradox of institutional capital which, by definition, is not allocated to members but held collectively. These funds can give cooperatives a tremendous competitive edge because they are "free" to the society, requiring no remuneration, while the equity of non-cooperative forms of enterprises is the most expensive type of capital because it requires remuneration and has implications for control. However, earned institutional capital has a cost to members when it is accumulated by deductions from payments to them.

Unallocated reserves are treated as the highest quality, non-withdrawable except in liquidation: the greater the volume of these funds the stronger the society. However, the studies note that building them up creates a wedge between members' average share subscription and the book value per member.

This disparity can have important negative implications for democratic control. The wedge creates value for members only, and members will seek to capture and protect this value by limiting membership growth or by encouraging non-member transactions. This is an invisible side of the control issue. In this sense, the promise of cooperation as an inclusive means of creating, managing and sharing wealth will not be fully realized, even though the closed cooperative performs a useful economic service in the community. This goes against the principle of openness and a cooperative belief that it is wrong for one person to make a profit at the expense of another.

Reallocation of surplus institutional capital to members would pass value in the form of increased shareholding, thus decreasing the wedge. This should encourage open membership because existing members would not lose value by admitting new members. Kenyan members interviewed would have preferred to see surpluses allocated because this would make their membership a good legacy for their children. More data would be needed to answer the how-much-is-enough question and to determine if this effect is related to the size of membership.

Intertemporal conflicts arising from institutional capital have long bothered cooperators on the grounds that reserves accumulated by past members provide a free ride to future members. This conflict could be solved by having almost no institutional capital, allocating everything possible to members and requiring each new member to contribute an amount equal to the average book value per member with each retiring member withdrawing an identical amount. This could work against openness where book value is large, as reflected in the use of high entrance requirements in the form of expensive shares to exclude potential applicants. A means of mitigating this is to spread payments over time.

Cooperative principles and capital formation

The studies offer few conclusive implications for cooperative principles. Probably the most interesting finding, stated in a way that often has not been sufficiently stressed, is the perverse incentives that may arise from too much institutional capital. This possibility supports the principle of providing patronage refunds out of allocation of the surplus. Clearly there is a trade-off between cost reduction to the cooperative and these perverse incentives, and it would be useful to know where these curves cross. Could allocations payable in several years, creating a slowly rotating capital base, diminish both cost and perverse incentives? If so, to what extent, at what interest rates over what time period in different types of cooperatives?

Reliance on member funding appears to provide a cooperative with relatively inexpensive funds. This is consistent with the principle of limited returns to capital but also implies that slow growth is the natural state for cooperatives that are not viewed as creditworthy in the commercial market, that shun profitable non-member transactions or that seek to remain relatively independent while building high levels of solidarity.

The Indian researchers strongly stress transparency in accounting and periodic external auditing. These are especially crucial when coops offer deposit-taking services and a bank strategy is followed. However, it also can contribute to the strong sense of solidarity required for the mutual strategy. Transparency seems most closely related to the principle of democratic control, which presumes an informed membership and a concern for social equity.

Strategy issues and questions

New issues and questions in cooperative finance arise in response to change in markets, in the legal framework, in the regulatory regime, in the availability of development assistance and in views of how the promise of cooperation can be realized. The role of capital is likely to be taken more seriously where competition increases as markets are liberalized and as incomes increase. It will also be of greater importance because leaders' time horizons may lengthen as more options open and as sustainability becomes of greater concern. More ways of financing will be explored and embraced within larger strategies of increasing patronage. Time will be spent, and hopefully wasted, by the least creative in attempting to maintain or revert to old habits associated with state-granted monopoly and dependency.

Opportunities to increase member financing in liberalized, competitive markets are suggested by techniques used in developed countries. Many are likely to be copied or adapted in developing country cooperation. These will permit an enlarged capital base using allocations to members promising future pay-outs in cash. Opportunities to increase non-member financing will blossom. They will depend greatly on the success of member financing and on definition of property rights because commercial and cooperative apex lenders will increasingly rely on commercial measures of debt capacity.

Questions to be answered include: What financing mechanisms will enable cooperatives to become more effective in more competitive markets? How can non-member funding be obtained in ways consistent with the objectives of cooperation? Will cooperative finance increasingly resemble corporate finance, or is the larger promise of cooperation still meaningful where competition creates efficiency, expands outreach and destroys monopolistic practices? What type of member education is appropriate where cooperative finance is sophisticated and complex? How can cooperative education communicate the social benefits of member control and of competitive markets?

Guidelines for financing sustainable agricultural cooperative development
Changes in cooperative financing that will contribute to sustainability will be accompanied by constructive opportunities at different levels for different parties. These parties include donors providing technical and financial assistance, governments and cooperative managers and leaders.

Because of factors having relatively little to do with cooperation, donors are increasingly likely to be of less importance and utility to cooperation in many countries. The assistance that remains is likely to stress commercial competitiveness because the costs of protection and monopolies are of increasing concern. This will require changes in the relationship between the state and cooperation, generally permitting greater powers to members and cooperative bodies, and greater willingness to abandon situations offering only dim prospects. Donors are in a position to contribute based on their own national or technical experiences with cooperation that are oriented toward competitive excellence rather than toward social policy. Cooperative managers and leaders are likely to become increasingly technical and commercial in orientation and, while not lacking in vision, less political and charismatic.


Sources

Rajesh Agarwal, K.V. Raju, K. Prathap Reddy, R. Srinivasan and M.S. Sriram, "Successful Capital Formation Strategies for Agricultural Cooperatives in India". Institute of Rural Management, Anand (IRMA). September 1994.

David W. Cobia and Thomas A. Brewer, "Equity and Debt", and David W. Cobia, Jeffrey S. Royer and Gene Ingalsbe, "Equity Redemption", in David W. Cobia, ed., "Cooperatives in Agriculture." Englewood Cliffs NJ: Prentice Hall, 1989. pp. 243-266, 267-286.

Gérard Deshayes, "Agricultural Service and Credit Cooperatives". 1994. 4 rue Henri, 94000 Créteil, France.

International Labour Office, "Cooperative Management and Administration". 2nd (revised) ed. Geneva: 1988.

Ivan V. Emelianoff, "Economic Theory of Cooperation". Ann Arbor, Michigan, USA: Edward Brothers, 1942.

Reazul Islam, J.D. Von Pischke and J.M. de Waard, eds., "Small Firms Informally Financed: Studies from Bangladesh". Dhaka: University Press Ltd., 1995.

Kenya National Federation of Cooperatives, Ministry of Cooperative Development and Finnish Cooperative Development Centre, "Successful Capital Formation in Kenya Agricultural Producers' Cooperatives". A research report prepared for the Food and Agriculture Organization of the United Nations. June 1995.

Land O'Lakes, Inc., "The 1991 Land O'Lakes Annual Report". Minneapolis.

J.D. Von Pischke, "Capital Formation and Performance: Issues in Cooperative Promotion". Paper prepared for the COPAC Open Forum, Rome, 2-3 March 1993.

A.E. Rasmussen, "Revolving Equity Capital", chapter xii, "Financial Management in Cooperative Enterprises". Saskatoon: Cooperative College of Canada, 1975.

John Rouse, "Capital, Participation and Cooperative Performance: The Importance of Member Equity Stake". Prepared for the IRMA Symposium on Management of Rural Cooperatives, 7-11 December 1992. Cooperatives and Rural Organization Group, FAO, 1 December 1992.



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