Annex III. Synthesis Paper

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  This document has been made available in electronic format
          by the Committee for the Promotion and
            Advancement of Cooperatives (COPAC)
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ANNEX 3 

CAPITAL FORMATION IN AGRICULTURAL COOPERATIVES
IN DEVELOPING COUNTRIES: RESEARCH ISSUES, FINDINGS AND POLICY
IMPLICATIONS FOR COOPERATIVES AND DONORS
BY MR. J.D. VON PISCHKE

Abstract
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Empirical studies from Guatemala, India and Kenya were
commissioned to test hypotheses that the level and
accumulation of the capital of cooperative societies is
positively related to their growth, member control and
participation, and ability to manage risk.  Research findings
indicate that these variables are not closely related, but
that correlations vary greatly from case to case and from
country to country.  This appears to arise from differing
conditions in cooperatives and in the markets and regulatory
regimes that shape them.  Patronage appears to be the
operative focus for growth.  Capital is likely to assume
greater importance as cooperatives operate in increasingly
competitive markets. 
 
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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.  


1.   Introduction and Background to the Research 
 
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.1  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.   

The meeting constituted an initial effort to consider whether
empirical research into cooperative capital formation could
provide an opening for new initiatives in cooperative
promotion, focusing on capital formation as a means of
increasing member participation and  control.  Member
participation and control occurs through patronage, general
meetings, committee work and audits.  
 
A perspective introduced at that meeting was that cooperative
capital has a qualitative dimension.2  The customary view of
capital is quantitative, viewing capital as funds measured in
the fungible currency units used to measure commercial
performance.  Accounting obviously assumes that each dollar,
pound, peso or dinar on an accounting statement is equal to
every other.  The qualitative dimension is based on the
proposition that different types and sources of capital have
different degrees of what might be called "cooperative power."
Some types and sources of funds do a better job of promoting
cooperation and empowering cooperative societies to achieve
that mix of ideals, democratic processes and commercial
performance that constitutes the promise of cooperation and
that creates the epic of member-controlled self-help
activities. 
 
It was proposed at the initial open forum that the qualitative
aspect could be expressed, at least for analytical purposes,
by a weighting attached to accounting quantities in different
balance sheet accounts. The system proposed assigns weights to
the liabilities and net worth (passif) side of the balance
sheet based on perceptions of the extent to which each source
or form of funding is related to member commitment or loyalty.
Member commitment is implied by the terms and conditions
attached to various forms of capital.  
 
The concept paper viewed collectively-owned nonrefundable
capital ("institutional capital") as embodying the highest
level of commitment to the cooperative in view of its source,
which is the members and their decisions to retain funds, and
its terms and conditions, which make it withdrawable only in
liquidation.  Institutional capital was accordingly viewed as
having the highest possible quality. The next highest quality
was member subscriptions that could be withdrawn upon a
member's termination of membership, followed by reserves held
for specific purposes and having a long life. Members' funds
placed temporarily with their cooperative, such as deposits,
credit sales and allocations not paid immediately in cash were
considered the lowest quality member capital. Nonmember
capital was likewise weighted.  Details are provided in Annex
A of this paper, which is extracted from the 1993 paper. 
 
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. 
 
a)  Research Objective 

Research was commissioned to determine empirically: 

1) whether higher levels of capital formation stimulate or are
associated with 

i)  cooperative growth, measured by increases in the  volume
of business turnover and in the number and proportion of
active members, and 
ii)  greater member participation and control; and 

2) whether the quality of cooperative capital is associated
with capital accumulation and member control. 
 
b)  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 does encourage the
search for meaningful differences within classes or types of
cooperatives.  
 
Hypothesis A.  The greater the proportion of member-owned
funds to term debt and evergreen (permanent) working capital
loans from nonmember 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 nonmember funds, and the higher the quality
of capital, the greater the ability of the cooperative to
manage risk and adversity, including unfavorable trends in the
prices of the commodity(ies) 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. 
 
c)  Background on Fieldwork in Three Countries 
 
Three countries were selected for research: Guatemala, India
and Kenya.  Each is a developing country with a history of
cooperation extending for more than 50 years.  Each has a
large agricultural sector.  
 
These countries were selected from a larger field.  Ten
countries in which FAO has cooperative projects were
identified.  Funding was located for three and research was
undertaken on three continents in order to spread the work
widely and to avoid concentrations that could bias results.   
In India the task was assigned to IRMA, which has an active
cooperative research program and a capacity to undertake
fieldwork, incorporating research specialists, trained
enumerators and close ties with the cooperative sector.  In
the early 1990s IRMA was involved in path-breaking
applications of modern theories of management to cooperative
analysis. 
 
In Kenya the cooperative superstructure was enlisted to
undertake fieldwork.  This consisted of the Kenya National
Federation of Cooperatives, the Ministry of Cooperative
Development and the Finnish Cooperative Development Center
Cooperative officers contributed to the field surveys.
 
Mr. Peter Marion, a consultant, was selected for the Guatemala
study.  His qualifications include his long involvement with
cooperatives in that country, his knowledge of the major
indigenous language as well as Spanish, and his experience as
a finance professional.   He was assisted in his study by the
National Savings and Credit Cooperative Federation of
Guatemala. 
 
d)  Research in Other Countries 
 
COPAC believes that the only other wide-ranging research
undertaken during the study period was commissioned by the
World Bank.  This work was undertaken to provide insights into
how the Bank could interact most usefully with cooperatives. 
No specific model was expected to arise from this work, but
those concerned felt that more information could be used
broadly to make the Bank more effective in the many countries
in which it supports projects.  The Bank's study had four
major topics:  1) the legal framework for cooperation and the
relationships between cooperatives and their constituents, 2)
specific key features in cooperative management and
operations, 3) financial aspects of cooperatives and 4)
cooperatives' social role.  COPAC documents were shared with
the Bank team responsible. 
 
A workshop was held on 21-22 April 1994 to review findings. 
Sessions were focused on the conceptual framework, World Bank
experience and other experience with cooperatives.  Papers
were presented by Bank staff and by consultants based in
France and Qubec, Canada.  (Papers are listed in Annex  B.)   
Considerable attention was devoted to efficiency.  Data from
France showed that different cooperatives have different
strategies regarding the role of member financing and the
level of payments to members per standard unit of produce
delivered.  In three groups of cereal cooperatives studied in
1981-84 those with the highest proportion of self-financing
paid the highest prices to members and also were best able to
cope with adversity over a longer period.3   

2.   Methodological Issues Facing this Research  The research
described here faces methodological issues that, when defined
or recognized, help to establish its usefulness.  These
observations are organized under six headings contained below
in this section. 
 
a)  How Should Cooperative Business Performance Be Measured?  

It is often maintained that conventional financial analysis as
applied to for-profit enterprises is not appropriate for
measuring the commercial performance of cooperatives.  This
particular problem seems to attract less attention now than in
the past, and the attention directed toward this issue is more
informed.4  This change possibly responds to the commercial
environment in which cooperatives operate.   Markets for
agricultural commodities  are becoming more competitive in the
commercial sense.  Good commercial performance is required for
survival as markets chip away at inefficiencies and as
governments respond to the costs of inefficiencies.  As
subsidies diminish, commercial performance will command
greater focus and traditional tools of financial analysis will
be perceived as more relevant by cooperators. 
 
However, performance measurement can be ambiguous for
nonprofit organizations.  In this context, for example, good
business performance may consist of the ability continually to
attract subsidy from governments at home and abroad so that
activities enjoyed by beneficiaries, i.e., members, staff,
regulators and promoters, can continue.  The debate on
measuring cooperative business performance has traditionally
focused on the difference between the surplus captured by the
members individually and that retained by the cooperative as
an entity distinct from its members.  Of course, an important
strand in cooperative thinking has been that the cooperative
has no commercial existence separate from that of its members,
that agricultural cooperatives are in fact extensions of
members' farms.5  

This debate is complex.  It may be a device that reduces the
problem of the allocation of the surplus to a simple
tug-of-war, not unlike that between trade unions and
management, or possibly stockholders and management in joint
stock companies.  It can also point to new ways of viewing the
debate.  Financial analysis could treat all benefits as
occurring at the level of members.  This could provide
important insights into member incentives to participate in
cooperative democracy and to be loyal to their society.  
 
Another approach rejects the concern that measurement of the
surplus and its division is the relevant strategic focus. 
This perspective is based on the longer run issue of
sustainability.  Relative levels of performance can be judged
by the survival of the cooperative over a long period, using a
measure as disarmingly simple as sales turnover.  If the
surplus is insufficient or its allocation not realistic
commercially, if members are not loyal, if risk is not
managed, if management is not competent, turnover will decline
over the long run.  The relevance of this concern grows as
markets become increasingly integrated and liberalized.  The
extent to which failures have undermined the cooperative
promise also creates space for a simple, long-term measure of
survival in a competitive world.   
 
Subsidy again requires a qualification to any measure of
sustainability.  If purchase of subsidized fertilizer is
possible only through a cooperative, the sustainability of the
society is tied to its subsidy monopoly.  If this is removed,
members may be able to find superior alternative sources.  The
real test of sustainability is found only in an efficient,
undistorted market. 
 
This research tries to take the long view because capital
formation is a lengthy process best approached systematically
and consistently.  It opts for relatively simple measures,
such as turnover as an indication of business growth, and uses
proxies to evaluate the degree of member participation. 
 
b)  Is Capital Formation a Result or Cause? 
 
Are capital formation, commercial performance and
participation linked?  If so, in which direction does
causality flow?  Is there a leading indicator among these
variables?  Is it possible to prioritize them for purposes of
management strategy or assistance?   
 
A priori and in the long run, capital formation is the result
of good commercial performance which generates the surplus
from which capital can be retained and which attracts
additional resources.  A strong capital position may attract
members to a cooperative if it permits more efficient and
dynamic provision of services.  But capital may also encourage
member participation that is "rent-seeking," an economic term
for behavior that does not contribute to the productivity. 
This may occur if members seek to capture the surplus for
themselves individually rather than collectively for the
business of the cooperative.  Collective rent-seeking may take
the form of demanding higher payouts that are not consistent
with the long run financial health of the cooperative. 
Individual rent-seeking can lead to defaults by members on
amounts due their cooperative, for example.  
 
These considerations suggest that member education for
participation may be the key element in commercial success and
survival, which would be consistent with traditional
cooperative principles and practice.  Without participation,
there can be no cooperation.  However, the nature of
participation is critical.  Commercial success and capital
formation appear to require a relatively long-term perspective
that would encourage members to leave funds with their
society.  This can occur only when members do not  extract the
greatest or most  prompt possible payout or demand the lowest
possible prices, or even impossible prices, for the goods they
purchase from their cooperative.  This question is central to
cooperative sustainability. 

The research design was not specific on the direction of
causality.  Hypotheses were based on the proposition that
these three variables are related, although it was hoped that
insights into cooperative capital formation would lead to new
perspectives on how cooperative development activities might
be designed. 
 
The research design addresses in a circular way the
possibility that capital formation may be a precondition for
rather than a result of successful commercial performance. 
The former would apply when a new cooperative venture is
established, requiring the injection of new capital.  A
venture that is undercapitalized could have more difficulty
becoming competitive than one that is adequately capitalized. 
The circularity occurs in the long run, such as the ten year
research frame, as increasing capital is required for growth
and to manage shocks that occur infrequently.
"Source of Capital" vs. "Terms and Conditions of Capital"
as an Influence on Cooperative Business Performance 
 
The research design proposes that capital be weighted
according to its provenance.  It assumes that source is the
basis for quality, that funds from different sources embody
different levels of commitment and confidence in the
cooperative.  This in turn assumes that commitment and
confidence are variables to be optimized, requiring a high
degree of both for commercial survival and member
participation. 
 
Could the same or more powerful insights be gained simply by
classifying cooperative funds according to their terms and
conditions, ignoring their source?  In other words, could a
portfolio approach be more instructive than an institutional
approach?  Key terms and conditions would include interest
rates, quantitative bounds set by loan sizes and credit or
borrowing limits, terms to maturity, flexibility and legal
standards of care exercised by the creditor when loan
contracts are not fully honored, and transaction costs arising
from the documentation, reporting and other measures required
to maintain a relationship with a creditor.  In certain cases
it could be difficult to determine exact terms and conditions
because some can become known only when distress or failure
occurs.  For example, what enforcement differences would
distinguish commercial bank credit from funds advanced by a
cooperative bank or bank for cooperatives when a borrowing
cooperative faces difficulties in behaving as promised in loan
contracts?   
 
The research design assumes that sources and terms and
conditions are highly correlated: insiders have interests and
incentives different from those of outsiders, promoters will
behave differently from creditors, and  commercial sources
will have funding and investment standards different from
those of governments or donors.  
 
There are clearly merits to the terms and conditions approach
because it transcends institutional biases.  But it was never
considered or brought up in research design, possibly because
cooperative issues and promotion are so frequently framed in
institutional terms.  
 

d)  Sampling Validity 
 
The major sampling challenge in this research is in
identifying similar cooperatives.  Large classifications such
as diary cooperatives and coffee cooperatives are used in the
Kenyan study, for example.  Members were selected for
interviews on a random basis from membership rolls.  It was
difficult in all cases to find societies for which ten years
of accounting records were readily available on a reasonably
consistent basis.  This criterion surely biases the sample in
favor of surviving societies and those having a relatively
high standard of accounting performance.  

The study attempted to use alternative means of obtaining
information and insights, primarily through case studies as
open-ended enquiries.  The results of this research cannot be
fully regarded as statistically rigorous. 
 
e)  Is Gender Relevant to Cooperative Capital Formation? 
 
Experiences with microenterprise finance strongly suggest that
in finance women behave differently from men.  Grameen Bank,
for example, began with approximately equal numbers of men and
women members.  As the Bank grew the mix of services it
provided and the delivery mechanism it used attracted
incredibly large numbers of women and many fewer men.  The
proportion of members who are women now exceeds 90%.   It is
very possible that gender is relevant to cooperative capital
formation.  However, this variable was not included in
research design and was not explored. 
 
 
3.  Review of Research Findings 
 
This review and the following synthesis section deal with
research results.  Because of their different approaches, the
distribution of information from each of the studies varies in
these two sections, while hopefully being balanced overall.   

a)  Guatemala 
 
The Guatemala study compares and contrasts two agricultural
service cooperatives, "Petrol" and "Export," over a period of
good economic growth.  One determinant of this selection was a
difficult environment during the 1980s that led to the failure
of many societies, reducing the number that would have good
financial data for a ten year period.  These are clearly not
otherwise similar cooperatives, but their completely different
business strategies provide powerful insights into cooperative
finance.   
 
The markets in which these two societies operate are
relatively free and competitive.  This situation requires good
management for survival and tends to lead to different
strategic responses by different cooperatives.  Cooperative
legislation is relatively favorable and supervision by
cooperative authorities does not take the form of
micromanagement. 
 
Both cooperatives accumulated unallocated surpluses, creating
a large divergence between the price of a share and book value
per member.  The study concluded that this creates an
incentive to limit entry and to increase nonmember patronage. 
Both societies benefitted from nonmember patronage, paid no
dividends on shares or interest on allocated surpluses, and
increased their active membership slowly or not at all.  Share
growth was slow as a result.  The number of nonmember users
increased more rapidly than the number of members.  Guatemalan
law requires that surpluses from transactions with nonmembers
be allocated to legal reserves (institutional capital) rather
than distributed to members. The similarity ends here.
Petrol was founded in 1969 by 36
members.  It operates a service station and an agricultural
input supply store that sell petrol (gasoline) and lubricants,
animal feed and health supplies, chemical fertilizer and other
inputs.  Petrol rents out a tractor for custom service.  It is
located in a state capital surrounded by a sparsely populated
area of relatively large  farms.  Members may take cash loans
and purchase on credit from Petrol, while nonmembers must pay
cash.  Patronage refunds, based on the proportional share of
sales to members, are retained for two years before payment in
cash. 
 
Petrol has had losses that suggest low member control.  The
first was from participation in a tomato paste factory with
several other cooperatives in collaboration with the
donor-funded National Finance Corporation.  The plant went
bankrupt in 1987, costing Petrol more than US$ 72,000.6 
Second, delinquencies amounting to 38% of outstanding loans,
or 7% of total assets, were concentrated in one member's
account.  Negotiations in 1990 led to rescheduling.  Finally,
in 1991 $18,900 was lost through defalcation and the general
manager resigned.   Petrol has reacted to a limited market and
bad experience by being cautious, building reserves,
minimizing borrowing and concentrating on efficient management
of its core activities rather than by expanding its relatively
small market share of the goods and services it provides. 
Total sales varied from $469,000 to $695,000 over the period
with no discernible trend; profits varied from $9,000 to
$33,000.  Patronage per member was $2,100.  In 1989 it raised
its minimum share to about $200, reportedly to exclude poorer
potential members.  Introduction of the tractor service in
1993, funded by a term loan, was accompanied by the
resignation of the entire board of directors.    
 
Petrol has become financially very strong, shedding debt.  By
1994 90% of its assets were member-funded, 84% by equity and
6% by debt.  Legal reserves amounted to 85% of total assets. 
However, its inflation-adjusted equity was declining about 1%
per year as patronage refunds outstripped annual profits. 
While legal reserves increased by almost $70,000 over this
period, due in part to profits on nonmember transactions,
retained earnings were virtually depleted by a decline of
almost $95,000. Average shareholding per member was $169 book
value per member, fully adjusted for bad debts and market
value of land owned amounted to $3,818.  Only three borrowing
members were in arrears. Delinquencies amounted to about 3% of
total assets and were falling.  From 1990 to 1994 the number
of members fell from 126 to 109 out of a growing local
population exceeding 16,000.  Petrol is portrayed as a buying
club with no signs of a dynamic future. 
 
Export began as a peasant association in 1967.  It markets
snow peas and vegetables and sells agricultural inputs.  It
built a plant in 1992 that has washing, packing and cooling
facilities.  Its members are poor, small farmers who work
their own plots in a densely populated rural area.  Export has
changed its legal status, product or service lines and
commercial focus several times in response to evolving
opportunities.  
 
Its first export sale occurred in 1989 and volume expanded
rapidly through 1993.  A large decline occurred in 1994 as
competition from other Guatemalan producers led to falling
prices and rising quality standards and because of discoveries
of pesticide residues in Guatemalan shipments to the US. Yet,
patronage per member approximated $1,300, a material sum to
members' households. 
 
Export has borrowed heavily to expand its trading volume by
increasing the number of its suppliers by offering production
advances, credit sales and commercially competitive
operations.  Prices and credit in the form of interest-free
90-day loans against a promise to deliver produce, are
identical for members and nonmembers.  Sources of funds
include member and supplier credit, interest-bearing loans
from members, advances from produce brokers, a commercial bank
line of credit, a subsidized development bank loan and
unallocated surpluses.  Share capital is insignificant.  The
ratio of member funds to nonmember funds declined from 7.5:1
in 1989 to 0.5:1 in 1994.  
 
Export's board has decided that while a ten year development
bank loan is outstanding, all surpluses will be retained. 
This has improved the quality of its capital.  Total assets
grew from $81,000 to $454,000.  Total equity increased from
$26,000 to $88,000, and virtually all of this increment arises
from additions to retained earnings.  Average shareholding per
member in 1994 was $7 while book value per member was $251
(before adjustment for possible bad debt losses).