Posted May 1999
Posted May 1999
All member-based organizations -- be they small informal groups, farmers' associations, or co-operatives-- need savings and capital, i.e. cash funds used to finance operations and investments to grow. They can obtain this from two basic sources: from "outsiders" like banks, governments or suppliers, or from "insiders," either by retaining net revenues generated by the organization's business activities or from members themselves.
The conditions and terms under which member-users will voluntarily provide funds (financially contribute) to their organization depends on the rewards or incentives they receive, or expect to receive in return, i.e. in terms of access to services, control over decision-making processes or financial returns. These terms and conditions are also important because they define the nature and extent of the member's financial and ownership stake in the organization, and by doing so, indirectly influence the way the organization is governed, the level of member participation in decision-making, and its performance as a business.
This paper focuses primarily on the problem of mobilizing increased member capital within farmer co-operatives in Africa -- with particular reference to Kenya's co-operative dairy and coffee sectors-- and provides some observations regarding the strengths and weaknesses of various instruments for doing this within the Kenya context.
The paper points out that mobilizing member capital in Kenyan agricultural co-operatives is complicated by four factors: (1) a long tradition of heavy government involvement in the management and financing of farmer co-operatives and minimal member participation in decision-making; (2) capital shortages in government-supported rural credit institutions such as the Co-operative Bank of Kenya, once an important source of subsidized credit for co-operatives; (3) the recent liberalization of government-controlled coffee and dairy markets and increased competition from the private sector; and (4) strict adherence to the co-operative principles of "one member, one vote" and "limited return on capital."
One conclusion of the paper is that the success in encouraging increased member capital contributions under more liberalized market conditions, is "in getting the member investor incentives right," i.e. in developing new financial instruments that create expected future value for members and adequately reward them for their capital contributions, while at the same time protecting the co-operative character of the organization.
Times have changed. With prices falling in many parts of the world, money gains value over time instead of depreciating.... With lenders still charging interest, not only do debtors pay back more expensive dollars than they borrowed, they have to pay for that privilege (being able to borrow)[1].
Now these "favorable conditions of trade" are fast disappearing. As government services to co-operatives are privatized, markets liberalized, and co-operative access to externally-provided grants and subsidized credits reduced, agricultural co-operatives are experiencing more capital shortages . Unless they can adjust to the new conditions and become more financially self-reliant by tapping member funds to finance their business activities, many will simply disappear from the scene. In the author's view, this would be a great tragedy [3].
In 1993, the Food and Agriculture Organization of the United Nations (FAO) launched a research program to specifically address this "capital scarcity problem" in transitional and Third World countries. During the 1993-1995 period, FAO initiated a series of field studies on co-operative capital formation problems within agricultural co-operatives in Guatemala, India, Poland, Hungary and Kenya in collaboration with the Committee for the Promotion and Advancement of Co-operatives (COPAC)[4], independent researchers, the Finnish Co-operative Center (FCC) and participating national research institutions and co-operatives in those countries. Two years later, it undertook a second, more in-depth study of co-operative capital formation focusing on Kenya, in collaboration with Turku School of Economics and Business Administration and the Kenya National Federation of Co-operatives (KNFC) to explore further technical issues not covered in the 1995 study.
This paper is based on the above research and argues that increased member equity (member share capital) participation in agricultural co-operatives will improve the self-financing capacities of these organizations and will probably lead to increased member participation in decision-making within the co-operative and improvements in its business performance. It goes on to note that the mobilization of increased member capital in agricultural co-operatives in Kenya is problematic and will succeed only if the political and economic incentives that motivate members to contribute capital to the co-operative business are significantly changed to fit the new liberalized market conditions. The study provides some tentative ideas of how this might be done.
As in other countries of the region, government has played a major role as promoter, financier, auditor and sometimes even manager of co-operatives in Kenya. Within the co-operativized dairy and coffee sectors, its influence also extended into the processing and marketing of these products. The governance of the vertical co-operative structures that evolved within these two sectors reflected that history with the primary societies serving as the main milk and coffee collection points at bottom level, linked to secondary societies (district unions) at district level that provide additional service support to primary societies, which in turn were linked to tertiary level co-operative unions (federations of secondary co-operatives) at national level that assisted affiliated co-operatives in the processing and marketing of produce.
In the particular case of coffee co-operatives, primary societies collect and normally process all coffee. Coffee district unions provide complementary non-marketing support services to affiliated primary societies, like bulk fertilizer supply, banking, and including management and accounting. With regard to marketing, primary societies send their coffee directly to the Kenya Planters Co-operative Union (KPCU), the coffee sector's apex organization at national level, nominally owned by the primary societies, but in actuality, heavily controlled by government. KPCU also does the milling and grading of the coffee. Coffee auctions and sales are organized by the Coffee Board, which is a government marketing board. In contrast, within the co-operative dairy sector, most primary dairy societies collect the milk and transport it to Kenya Co-operative Creameries (KCC), though the co-operative dairy sector's apex organization, which is also largely controlled by government.
While Kenyan dairy and coffee co-operatives are nominally referred to as "member-governed and member-financed" organizations based on the "one member one vote" principle, the management and financing of their day-to-day operations remains firmly in the hands of the co-operative unions which continue to select and pay the salary of the general manager of the affiliated primary society. Members voting in the Annual General Meeting theoretically have the power to set overall policy and dismiss a manager if he/she performs poorly; but in practice, this power is seldom exercised. As the Kenya study findings indicated, most members of the primary co-operative societies interviewed seemed to regard the management of their own co-operative as more responsive to the wishes of government, the union, or the general manager than to those of the members themselves.
During the 1960-1990 period, Kenya's dairy and coffee co-operatives operated within relatively protected markets and benefited from government grants and access to subsidized credit. The price that co-operative members paid for this support frequently translated into increased government intervention in running the co-operative's business affairs, management inefficiencies as more non-productive employees were hired, requiring higher marketing margins to be charged thus lowering net revenues to member producers, delays in payments, and a low sense of member ownership in the co-operative enterprise. But since the co-operative was the only permissible way in which small dairy and coffee producers could market their crops, the system continued to survive because of its monopsony position as sole buyer of these two products.
Certainly, the first place to look for internal capital is in the Profit-Loss Statement of the co-operative. If the co-operative enterprise is profitable then, the possibility exists to utilize some of these profits for increasing the working capital base of the co-operative and investing in new facilities and equipment. In the case of the five co-operatives studied, all were generating some net income, though net income margins could have been increased significantly through further increases in efficiency, automation of accounting and communication systems, etc. Yet there are other considerations.
Many observers of the Kenya dairy and coffee co-operative scene argue that the average Kenyan farmer has always been more interested in receiving immediate rewards rather than long-term future gains. They want to receive the highest price they can get for their products or pay the lowest cost for co-operative services received. While there may be some truth in these observations, we also know from the Kenya studies that when trust exists, and members see a worthwhile investment opportunity that holds expectation of future (individual or collective) gain, they are often willing to contribute. This was clearly seen in one coffee co-operative that researchers visited where most members also belonged to a co-operative savings and credit society (SACCO) located nearby. While this coffee co-operative struggled to mobilize sufficient working capital for its operations, the cash savings balances coffee co-operative members had deposited in the SACCO continued to grow. Presumably, that was because members had trust in the management of the SACCO and expected to receive a better financial return for their savings deposited there than had they invested the same funds in their coffee co-operative[7].
One of the motivating incentives for acquiring additional equity (ownership) shares within a corporate enterprise is to obtain more decision-making power and control over the enterprise; however, the co-operative's "one member-one vote" principle works against this. Each member has only one vote; thus, there is little incentive for the member to acquire more shares so as to gain more control over the decision making process. In that sense, co-operatives are much more democratic than corporate forms of business, but as all the FAO studies have also shown, some co-op members, due to their political influence, or their heavy volume of business transactions with the co-operative, may be treated as being "more equal than others."
The co-operative principle of "limited return on capital" creates other problems for member capital formation. Co-operatives are supposed to be "people-centered" organizations, not "capital-centered" enterprises; therefore, while earning return on capital invested by members is permissible, it shouldn't be excessive. Unfortunately within Kenya's dairy and coffee co-operatives, "limited return on capital" has often meant "no return on capital" at all. While Kenyan agricultural co-operatives are encouraged to allocate part of their surplus to pay dividends on member shares, in practice they seldom do so. In the five Kenyan co-operatives studied, none had paid a dividend on member shares for the last 8-10 years; most of the surplus had been returned to the members in the form of direct delivery payments[8].
While a "pro-payment, no-dividend" policy may appeal to member users, it is likely not to appeal much to member investors (in a co-operative they tend to be one-in-the same person). As we saw in the case of the previously mentioned coffee co-operative, members investors are more likely to invest their surplus funds in their co-operative only if the expected future value of their contribution (as measured in either monetary or non-monetary terms) looks attractive. This may partly explain why SACCOs have generally out-performed other forms of co-operatives in Kenya. They seem to have found a set of financial incentives which encourage member to invest in their SACCO rather than somewhere else[9].
Another factor limiting the return on member shares is their "non-marketability." According to most co-operative laws within the region, member shares are not transferable to third parties, implying there is no secondary market for member shares, and they must be resold to the co-operative upon the member's withdrawal. The purchase or sale value of a member share is also fixed at its "par value," i.e. the cash value of the share as set forth in the co-operative's constitution at the time of registration. That par value remains invariant, even if there is a change in the net worth of the co-operative. Thus, if a member wishes to leave the co-operative or sell some or all of his/her shares, the money he/she will receive from the co-operative for redeeming his/her shares will be equal to the par value of the share, multiplied by the number of shares the member redeems. Consequently, the member investor can expect no future capital gain (or capital loss) in cash money terms.
In the case of the Kenyan co-operatives examined, this represented another disincentive to members' investing in their co-operative. Were the expected future value of a redeemed share--at withdrawal time-- significantly greater than its purchase price, a member might be interested in purchasing more, but this was not the case. Each member knew that he/she will be repaid at the time of withdrawal, an amount equal to what he/she paid into the co-operative, no more, no less. Of course, during periods of inflation when money is losing its purchasing power over time, the prospect of being repaid in deflated currency is not very attractive. For this reason, members tended to purchase only the minimum number of shares required to maintain their membership rights, and seemed to have little interest in building the organization's net worth. Another factor related to the difficulty members faced in redeeming their share capital. The co-operatives also required a specific waiting period, before a member share redemption transaction can be made- usually around six months.
In conclusion, the limited return on member shares, coupled with members' low expectations of achieving any capital gains on future share tended to discourage members from accumulating more than a minimum of shares. These obstacles also promoted "free rider" behavior among co-operative members, where members started viewing their shareholdings more as a one-time expense in purchasing their "co-operative membership card" allowing them access to inexpensive co-operative services and more profitable producer prices, rather than as a long-term investment in the co-operative business' growth and success.
Another weakness of share redemption at par value is that it tends to operate in favor of new members vs. old. For example, suppose that one of the 100 founding members of a hypothetical dairy co-operative paid US$100 to join their co-operative in 1978, thus forming a total start-up capital of US$10,000. At that moment, the net worth of the co-operative was $10,000 and the average net worth per member was $100.
Now let's further assume that management's chooses to use a large proportion of the co-operative's net earnings to finance the growth of the co-operative business, thus there is no additional need for more member share purchases and that by the end of 1997 (i.e. twenty years later), the co-operative has achieved a net worth of US$500,000. If no new members have joined in the interim, then this would imply that the average non-market value of a founder's share (as measured in terms of total net worth of the co-operative --$500,000--divided by the total number of members (100) would have increased to $5,000!
Then suppose one of the founding members wants to retire, leave the co-operative and redeem his share capital. According to the cooperative's statutes, he will receive back only the original US$100 that he put in but not a penny more -- even though the value of the co-operative he helped build over a period of twenty years is now worth 50 times what it was worth originally. That's a bit discouraging. In contrast, a new member joining the co-operative in 1998 would be able to join the same co-op -- now with a net worth of $500,000-- at the bargain price of just $100! To preserve their own privileges and prevent this from happening, older members may decide to limit new memberships, thus creating a sort of "fortress co-op" or "private club" type situation in which potential new members are discouraged from joining, which would be in violation of another co-operative principle, that of "open membership" [10].
Institutional capital is the cheapest source of internal capital since there is zero dividend or interest costs associated with it[12]. It also differs from other forms of capital because it represents funds owned by all members collectively rather than individually. As a consequence, its ownership is diffused and not individually assigned. Because institutional capital belongs to "everybody," its control and use usually falls under the influence of those who manage the co-operative on a daily basis, i.e. the Manager and Board of Directors, rather the base members themselves[13].
As we have seen in the particular case of Kenya's dairy and coffee co-operatives, managers are selected and paid by the union to which the co-operative is affiliated and not by the co-operative. Since the manager is more financially dependent on and therefore more accountable to the union for his/her pay, and in view of the fact that control of institutional capital tends to fall under the control of management instead of members, the latter's incentives for accumulating larger amounts of institutional capital are few.
Unfortunately, current taxation laws in Kenya discourage the accumulation of co-operative institutional capital. Co-operatives have been subject to income tax since 1985 and taxes are charged on "total income," but deductions are allowed on up to 80 percent of that for dividends and bonuses paid to members[14]. To avoid paying higher taxes, many co-operatives therefore choose to redistribute as much of their net earnings as they can to members leaving little for direct reinvestment. Thus some modification in these taxation laws, for example, by reducing or eliminating the tax on retained co-operative earnings, might encourage more accumulation of institutional capital.
It is distinguished from "institutional capital" in three important ways -- all of which have an impact on co-operative governance and member participation in decision-making. Firstly it is individually owned and controlled in contrast to "institutional capital" which is collectively owned and controlled by the entire membership. In other words, member capital contributions remain the property of the individual contributing member. Secondly, it is provided by members to the co-operative only under certain agreed-upon terms and conditions which define the rewards, privileges of membership and incentives that motivate the loan, e.g. that define the period of time, the fixed or expected interest or dividend rate, certain redemption or withdrawal conditions or voting rights attached, etc.. And thirdly, it can be voluntarily withdrawn (redeemed) by the member.
The fact that member capital has economic value -- both to the co-operative and to the member -- and can be withdrawn at the member's request, makes member capital an important potential tool of co-operative governance; for example, if a particular member is dissatisfied with the co-operative, he/she has a right to withdraw and, after passing the required waiting period, the co-operative is obliged to repay the member the value of all his/her shares purchased, at par value. Thus members are able to influence decision-making within a co-operative not just by their individual votes but also by threatening to "vote with their feet", i.e. to withdraw their deposits or balances, or redeem their shares and withdraw from the co-operative.
Since the potential loss of a member would also involve a loss of capital to the co-operative and would be a visible sign of member dissatisfaction, the co-operative's management normally tries to keep these withdrawals and member defections to a minimum by improving the quality of member services. Given the fact that three of the main problems now facing Kenya's dairy and coffee co-operatives are: (1) a pressing need to mobilize more internal capital to finance continued co-operative business growth; (2) low rates of member participation in co-operative decision-making and declining co-operative member solidarity; and (3) declining quality of member services, and keeping in mind the above-mentioned considerations, mobilizing additional member capital would likely lead to performance improvements on all three fronts.
Since each of these methods of share capital mobilization involves the use of different incentives and modalities, they are dealt with separately below:
Two ways in which co-operatives could generate more member interest in purchasing additional shares would be either by paying more competitive member dividends on member shares or by introducing a share redemption policy which would better reflects the market value a share at the time of redemption. The apparent success with which rural SACCOs in Kenya are able to mobilize the savings of their members by paying attractive interest rates on savings leads us to conclude that both dairy and coffee co-operatives could raise more member capital simply by paying more competitive dividend rates on member shares. Another way is to periodically adjust the redemption value of shares to better reflect near-market prices.
While this mechanism would be relatively simple to administer, one problem it would generate would be that high-volume users of the co-operative's services would quickly increase their shareholdings faster than low-volume users. This could begin to violate co-operative law which states that no member may own more than 10% of the total share capital of the co-operative and might possibly lead to friction between large and small shareholders. Should this happen, the problem could be rectified by issuing the additional shares as a sort of "preferred shares" or in the form of bonds which would be of a fixed time duration, would carry a more attractive fixed dividend or interest rate and would be redeemable within a fixed period of time.
From the 1960s until the early 1990s, African farmer co-operatives operating in key export or strategic sectors of the economy (export crops, and in the case of Kenya, dairy production) enjoyed easy access to subsidised credit and grants from governments and donors to finance their business growth. The multi-tiered structures that evolved, primed by external funds from the top down and enforced by strong government control, created a co-operative leadership and management that was heavily accountable to higher levels of the structure rather than to membership at lower levels. This system is fortunately now being dismantled. Government is gradually withdrawing from the scene, subsidies are being cut, markets are being liberalised, and competition is increasing. Yet the financial dependence of co-operatives on higher levels remains. Consequently, many farmer co-operatives are beginning to suffer from severe capital shortages which are affecting their business operations. With declining credit worthiness and increasing burdens of debt, many co-operatives have had to turn to their members for financial support. But will members be interested in financing their co-operative?
In the case of the Kenya co-operatives studied, it has been seen that strengthening the self-financing capacities of agricultural co-operatives will not be easy; nevertheless, there plenty of room for hope. Certainly, the necessary pre-conditions for capital must be in-place. The enterprise must be able to operate at a reasonable profit and there must be a minimum level of trust in management's capability and transparency in communication between management and member. Furthermore, some changes in the country's co-operative law and tax laws will probably be needed to provide the a more conducive policy and legal environment to encourage more member capital formation. Yet more importantly, co-operatives themselves must find new ways to increase the expected future value of member contributions to the co-operative.
As Von Pischke points out, finance has much to do with promises, control, expectations and and trust:
"Financial transactions monetize promises, exchanging cash in the present for a promise of future reciprocity...Equity markets create value when a corporation issues shares of stock, promising rights of control and promises of expected earnings that are traded for cast in the present....Thus value arises when a financial contract or promise is made or traded."
Co-operatives will have to look for similar approaches in mobilizing member capital. Building member trust in the co-operative will be an important part of that and will depend on increased transparency and accountability to members, the honoring of commitments and enforcement of sanctions. But it also will require improving the expected future value of member capital contributions to the co-operative, without undermining the basic co-operative principles of "one member one vote" and "limited return on capital" that distinguish the co-operative from other forms of business enterprise.
Increasing the level of member capital contributions in their co-operative will require imagination and hard work, but it will be worth the effort since, as Gélise mentions: "Through capital accumulation, and thus savings and productive investment, the people acquire political power, the only real power that can force governments to change their outlook and sometimes their agenda. Political power ultimately heeds nothing but the economic power on which it is based" [17]. Genuine co-operative businesses and member participation in their governance are based on much the same principle and their future survival will depend it.
The author would like to thank his colleagues: Seppo Ikaheimo and Pasi Malinen from the Turku School of Economics and Business Administration in Finland for helping him keep his arguments on-course. Special thanks are due to Pekka Jamsen, another member of the Turku team, for his in-depth observations on the Kenyan co-operative scene and for sharing his views on the financial problems currently facing Kenya's dairy and coffee co-operatives movements and to Jeff Dorsey, an economist and friend, who provided detailed and very useful comments on the draft.
On the other hand, the opinions expressed in this paper are those of the author alone and do not necessarily represent those of the author's organization, the Food and Agriculture Organization of the United Nations.
2. Gélinas, J.B., "Freedom from Debt : The Re-appropriation of Development through Financial Self-Reliance," Zed Books Ltd., London, 1998, p. 34. The figures are stated in current US dollars.
3. FAO, "Cooperativess: Has their Their Time Come - or Gone?," Rural Institutions and Participation Service, Food and Agriculture Organization of the United Nations, Rome, 1996
4. The Committee for the Promotion and Advancement of Cooperatives (COPAC) is an inter-agency committee of UN and NGO agencies whose members include FAO, the International Labour Office (ILO), the UN, the International Cooperative Alliance (ICA), the International Federation of Agricultural Producers (IFAP) and the International Federation of Plantation, Agricultural and Allied Workers (IFPAAW).
5. Jamsen, P., Ikaheimo, S., . and Malinen, P. Capital Formation and Kenyan Farmer Owned Co-operatives, Turku School of Economics ands Business Administration, Turku, Finland, (forthcoming)
6. Op.cit., pp. 108-237.
7. Ibid. p.109
8. Jamsen, Pekka, Comments on original draft paper, October, 1998.
9. According to the World Council of Credit Unions, Inc., 1996 Statistical Report, there were 1,229 cooperative credit and savings societies in Kenya serving a membership of 934,056 persons with aggregate member savings of over US$355 million, loans to members of just US$302 million, and total assets of US$ 523 million, indicating a high level self-financing and self-reliance.
10. This indeed happened in one of the co-operatives studied in 1995.
11. Rouse, J.G., and Von Pischke, J.D., "Mobilising capital in agricultural service co-operatives," Food and Agriculture Organisation of the United Nations, Rome, Italy, 1997, p. 12
12. There is, of course, an imputed economic opportunity cost to the member; nevertheless, in those cases where alternative rural investment opportunities are limited or lacking, that opportunity cost may be close to zero.
13. Of course, there are exceptions to this rule.
14. Ikaheimo, S., Jamsen, P. and Malinen, P., op.cit. page 26.
15. Jamsen, P. While this method could be used, it must be pointed out that it is a risky one and should not be done without proper financial accounting controls and systems. The failure of the Union Baking System (UBS) a banking system serving coffee co-operative unions and their memberships was partly due to an abuse of this method.
16. Von Pischke, J.D. Finance at the Frontier: Debt Capacity and the Role of Credit in the Private Economy, EDI Development Series, the World Bank, Washington D.C., 1991, pp.5-6.
17. Gelinas, op.cit., p 143.
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