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Contract farming in China: perspectives of farm households and agribusiness firms.

INTRODUCTION

Over the past 25 years, the Chinese agricultural sector has been fundamentally restructured. Agricultural production and farm household income has grown rapidly, due largely to agrarian reforms undertaken by the government. Beginning in 1978, a series of institutional reforms significantly transformed a collectivised planned agricultural sector into something resembling a capitalist structure. The crucial milestones have been the abolition of the communal property base, the introduction of the household contract responsibility system, price and market liberalisation, the revision to the Land Administration Law in 1998, and, most recently, China's admission to the World Trade Organization (WTO) (Kedliker, 1992; Zweig, 1997; Oi, 1999; Whiting, 2001; Unger, 2002). The farm household has become an active agent in the marketplace in contrast to a passive production unit in the planned economy. After meeting some minimum production requirements from local government, farm households at the village level have certain rights to decide what they will produce and how to market their products. However, Chinese farmers face a number of challenges--low agricultural prices due to large stocks of products, lagging incomes and excess labour in the agricultural sector, among others. Externally, Chinese agriculture faces increasing competition from foreign products due to China's recent entry into the WTO and the continuing globalisation of agriculture. Domestically, Chinese agriculture has moved into a new development stage characterised by significant increases in the level of production, along with shifts in food demand as a consequence of urbanisation and rising incomes. Under these circumstances, millions of small-scale farm households in China are unable to compete effectively and respond to changes in domestic demand and withstand pressure from international markets. For many small holders, market access has become increasingly difficult and their incomes continue to lag behind the rest of the economy.

Agricultural officials in China are faced with the problem of how to overcome the limits imposed by a fragmented production system, improve the quality and competitiveness of agricultural products and raise the income of rural households. In 2004 a system of subsidies, along with infrastructure investments and reform in rural credit institutions, was introduced to improve the welfare of farm households (Gale et al., 2005; Gale and Collender, 2006). However, institutional innovations to create new ways of doing business also play an important role in China's attempts to modernise its agricultural system and improve rural incomes. One of these innovations is contract farming. Contract farming is a fairly new venture for the Chinese agricultural sector--one that emerged as a result of the government's agricultural industrialisation programmes.

Contract farming has a checkered history throughout the world. At its best, contract farming provides a means to manage complex production processes with greater precision than is possible through arm's length market transactions. This can result in higher quality, safer food with lower production and marketing costs. In some cases, particularly in developing or transition economies, contracting can overcome imperfections in input and output markets or institutional deficiencies by providing credit, seeds, machinery services, human capital and market access to farmers. However, without adequate competition among contracting firms, informed farmers and rule of law, contract farming may lead to economic serfdom for peasant farmers or a food system that meets the economic objectives of power elites (see, for example, Little and Watts, 1994; Runsten and Key, 1996; Eaton and Shephard, 2001; Allen and Lueck, 2003; MacDonald et al., 2004).

The agricultural industrialisation programme, of which contact farming is a part, has been supported and motivated by the Chinese government with the purpose of making agricultural production more profitable and competitive. Contract farming offers a means to effectively connect small-scale farmers and large-scale food processing firms. Local governments also recognised the potential of contract farming for transforming the structure of agriculture and raising farm income. Many have implemented a number of programmes and incentives, such as credit support and tax reduction for agribusinesses involved in contract farming.

Contract farming in China has made considerable progress since its emergence 20 years ago. Four characteristics can be safely generalised from its growth so far. First of all, the number of agricultural commodities produced under contract has increased steadily. Agricultural products produced or marketed under contract have grown from small-quantity locally specialised products, such as food oil and vegetables, to bulk commodities such as corn, beans, rice and wheat. For example, in Jiling Province, the number of contracted commodities has grown from 30 in 1999 to 70 in 2000. Second, the geographic distribution of contract farming has also expanded greatly. Initially, contract farming was developed in the economically advanced coastal provinces. Now contract farming is spreading rapidly into the underdeveloped areas of Central and Western China. Many firms sign contracts not only with local farmers, but also with farmers in other provinces. Third, the scale of products produced under contract (planted areas, volume of cash receipts and number of farmers) has also increased. According to the Chinese Ministry of Agriculture, the planted area involved in all types of contracts reached 18.6 million hectares in 2001, approximately 40% higher than in 2000 (Niu, 2002). Finally, the number and complexity of contracts have also increased. Beyond rather standard production and marketing contracts, some new contracts cover food transactions between main production regions and high demand regions and seed provision between farmers and research institutions.

According to the most recent survey from the Chinese Ministry of Agriculture, there were 4.6 times the number of organisations involved in agricultural industrialisation across 31 provinces in 2000 than in 1996. The number of farmers who signed contracts with firms increased twofold over the same period. The proportion of farmers involved in contract farming went up correspondingly, from 10% to 25% (Niu, 2002).

Table 1 shows the level and composition of firms or organisations involved in agricultural industrialisation between 1996 and 2000, the most recent data available. The dominant type of firm is the so-called 'dragonhead-driven' company. Dragon-head companies are agribusiness firms designated by national, provincial, municipal or county authorities with regard to their economic strength, operation scale, level of technology, management and their potential to improve farm incomes. For example, a national dragon-head firm must meet the scale and management criteria drafted by the National Agricultural Industrialization Development Joint Committee. Other rankings are specified by committees at corresponding levels. County-level dragon-head firms are the lowest level with the smallest size and impact within this ranking system. These firms agree to develop production or marketing systems that include market access, technology, technical assistance, credit and other inputs for local farmers. Most of the dragon-head firm systems involve the use of contracts. In exchange for their role in rural development, the dragon-head firms receive support from all levels of government and, since 2002, receive financing from the Agricultural Development Bank of China. In some cases, the dragon-head firms that are engaged in contracting are also encouraged to develop 'bargaining associations' for farmers in an attempt to create some degree of countervailing power.

The types of organisational relationships between farmers and agribusinesses over the 1996 to 2000 period are reported in Table 2. Contracts are the dominant form of farmer-to-firm relationships. Note, however, that the proportion of contract relationships dropped steadily from 70.8% in 1996 to 49% in 2000. This would suggest that although the volume of production under contract appears to be increasing in China, the proportion of firms involved in contracting is declining, presumably because other forms of business organisation, such as cooperatives or farmer-owned businesses, are becoming more prominent or are proving to be more effective. Consolidation of firms may also offer explanations; however, these trends may be offset by the Government of China's efforts to encourage new firm development. Note, too that cooperatives and farmer-owned businesses may also rely on contracts.

This paper presents information on contract farming from two independent surveys of peasant households and designated dragon-head firms. The survey data sketches out some of the characteristics of the participants in contract farming, the types of contractual relationships being developed as well as the perceived benefits and limitations of contracting. A brief profile of a contracting firm and a participating farm household is given in Box 1.
Box 1: Profiles

The firm

Zhongsu Limited is a provincial dragon-head food processing firm
headquartered in the city of Lanxi in Zhejiang Province. Its products
and brand name are well known throughout coastal China. The company
was founded as a village enterprise in Dongyang county in 1983 by a
farmer named Zhongshu. Originally, it processed pork and ham for the
local rural market. As the firm grew, it introduced new product lines
and expanded into urban markets. One of the newer products is salt
radish.

Salt radish is processed from water radish. Prior to 2000, Zhongsu
purchased water radish from middlemen who assembled supplies from
hundreds of smart farms. The supply of water radish and its quality
fluctuated wildly from year to year. In order to serve an increasingly
quality conscious consumer and to stabilise production levels,
Zhongsu decided to try contracting directly with farmers. However,
because water radish is produced on many smart farms, the company
found the cost of locating producers and monitoring production to
be excessive. Zhongsu contacted the local government of Yongchang
town, a water radish growing area and asked it to serve as an
intermediary between the farmers and the company. There are no
farmer cooperatives or bargaining associations in this area, so
the local government decided to serve as Zhongsu's agent.

Under the contract (see Appendix A) Yongchang town locates farmers,
supervises planting methods and delivers the output from 200 ha to
the processing plant. In return, Zhongsu offers participating farmers
a 3% premium over the local water radish price. Zhongsu has had a
generally favourable experience contracting water radish and has
expanded its contracting activities to other crops and regions.

The farm household

Huang Yougeng farms in Yongchang town with his wife and 17-year-old
son--a student in the local high school His wife works full time in
a local textile factory. Farming is Huang Yougeng's primary occupation
although he does some temporary work in town. The farm is 0.16 ha.
Before 1995 he grew rice. However, high prices for water radish
lead him to shift his production from rice to water radish in 1996.
As a small farmer, he sold his water radish crop to a local middleman
and accepted the vagaries of a very volatile market and, in his view,
a good deal of exploitation by the middlemen when supplies were ample.
Moreover, if the wholesale market for water radish was weak, middlemen
might not come to his village at all Huang Yougeng heard about
Zhongsu's contracting activities in 2002. He knew nothing about the
company or contracting. But he did feet comfortable entering into a
contract with the local government. Although the contract does not
offer risk protection, having market access and a premium over the
local paying price provided a sufficient incentive for Huang Yougeng
to continue with his contract since 2002.


SURVEY DATA DESCRIPTION

Farm-level data

Farm-level data were obtained through a survey conducted by more than 60 undergraduate rural-area students from Zhejiang University when they returned to their home villages during their winter break in February 2004. The survey contained questions on the farm household, farm production status and involvement in contract farming. Student survey enumerators were carefully trained before they returned home. Each student randomly selected 30 households in their home village to survey. The students returned 1,820 surveys of which 1,036 were complete and usable. Because many of the student volunteers came from Zhejiang, Jiangxi and Shangdong provinces, more data were collected in these three provinces. In total, the farmers included in the survey represent over 13 provinces and 47 counties, as shown in Table 3.

Firm-level data

Firm-level surveys were conducted by mail and through direct interviews. The survey was restricted to designated dragon-head firms. A preliminary survey, conducted in June 2004, was sent to a small sample of dragon-head firms across China. Return rates were so low that a national survey was abandoned. The low return rates were likely due to the unwillingness of the firms to share information with University faculty with whom they had no established relationships. Instead, to assure a high rate of return through mail surveys, the survey population was limited to dragon-head firms within Zhejiang province. Zhejiang University has a close relationship with many of these firms and we believed this would improve the return rate. The survey was mailed to 111 agribusiness firms in Zhejiang province with the assistance of the provincial government. A total of 80 usable completed surveys were returned. During the same period, we interviewed an additional 36 firms using the same instruments as the mail survey. The distribution of the various organisational types of dragon-head firms and their geographical locations are presented in Table 4.

FARMER HOUSEHOLDS

Incentives to engage in contract farming

Out of 1,036 farmer households included in the survey, as shown in Figure 1, only 220 households, or 21.2%, of the total have participated in contract farming. However, when farmers without contracts are asked whether they would be willing to engage in contract farming, 76.0% farmers answer positively. Only the remaining 2.0% indicate that they would not consider a contract if offered. The results suggest that most farmers view contract production favourably and would like to be involved in contract farming if offered the opportunity. The primary reason farmers do not participate in contract farming is the lack of opportunity--no firms in their area were offering contracts (Table 5). Other reasons include a lack of perceived benefits, by the households or a lack of interest from contractors operating in their area.

[FIGURE 1 OMITTED]

Table 6 illustrates several incentives identified by current contract producers that make them willing to engage in contract farming. Farmers strongly identify price stability and market access as the key advantages to contracts. Farmers' concerns about price risk reflect the sweeping price liberalisation in China's agricultural commodity markets and the absence of market-based risk management instruments. However, credit availability and technology support provided by contracting firms were also identified by some households.

Types of organisations that contract with farmers

Table 7 presents information on existing and preferred business relationships for the farmers. Agribusinesses, cooperatives and middlemen contract with farmers. Some village governments and Departments of Technology at the county government level (responsible for the extension of agricultural technology) also contract with farmers. Nearly 70% of all existing farm contracts are with middlemen and firms. However, farmers would prefer to increase contract relations with cooperatives and technology departments and reduce their relationship with middlemen and village governments. In many cases, middlemen are the only contracting alternatives available to farmers, since cooperatives are not well developed in China. The apparent preference of Chinese farmers for cooperatives deserves further investigation.

Types of contracts

Production and marketing contracts are the two dominant contract types (Table 8). Marketing contracts involve the collecting and selling of a variety of goods, without the contractor's active involvement in production. Production contracts often involve the provision of seed, fertiliser, technology and other inputs by the contractor (A sample contract is given in Appendix A).

Forms of contracts

Approximately 51% of all contracts are written and the remaining are oral contracts between agents (Table 9). But the choice of contract form is highly correlated with contractor type. Oral contracts are used primarily by middlemen and written contracts are used by firms. The reputation and local knowledge of the middlemen, who are from the same villages as the contracting farmers can substitute for a written contract. Outside firms prefer written contracts that clearly specify rights and responsibilities for both parties.

Contract specifications

Farmers with contracts were asked to provide information on contract duration. Long-term contracts (more than one year) account for only 17.7%; the remaining 82.3% of contracts were short-term contracts of less than one year.

Several price strategies often used in contracts are identified in this context. The flexible price strategy specifies the goods transaction price to be equal to the market price at delivery. The price floor strategy defines the delivery price to be the maximum of the market price and the floor price set in the beginning period. The fixed price strategy means that the delivery price would be fixed in advance of signing contracts. Approximately 44% of actual contracts reported in Table 10 specified a flexible delivery price that fluctuated with the local market. The second most common provision is the price floor, at 27.3%. Fixed price contracts accounted for 23% of the total. When farmers without contracts were asked about preferred pricing mechanisms, 68.6% selected a price floor and only 20.9% of farmers would shift to a flexible delivery price. Downside risk protection appears to be an important attribute lacking in current contract designs.

The delivery payment method, as reported in Table 11, is another critical contract specification that directly affects farmers. Three payment methods are used in most cases. These methods are cash payment at delivery, the prepaid deposit method that requires partial payment to farmers as a deposit in advance and the pay-after-delivery method that allows firms to pay the delivery price within a certain period after delivery. Cash payment at delivery is used in half of all transactions and payment after delivery accounts for another 22.3%. Most farmers would prefer immediate cash payments.

Enforcement and violation of contracts

Information presented in Table 12 indicates 60% of farmers with contracts did not have a conflict with the other party. About 35.9% of farmers reported infrequent conflict and 4.1% of farmers often had a problem with their contractor. As shown in Table 13, most conflicts were about price and quality terms. Quality standards vary widely, some set by the firms, others by the Chinese government or international bodies. The specific standards used generally reflect those required with specific product market. In addition, farmers reported that most of the conflicts were resolved by negotiation between farmers and buyers and only 2.3% of conflicts were resolved in court.

Farmers' perceived benefits

Farmers with contracts were asked to rank, using a Likert scale, a number of the potential benefits of contracting (Table 14). The primary benefits were improving quality of products, stabilising the sale price and lowering marketing costs. However, farmers did not perceive significant benefits in reducing production costs and increasing selling prices.

Econometric analysis

According to studies from Lajili et al. (1997), Rehber (2000), Sartwelle et al. (2000) and Key and McBride (2003), a farmer's choice to enter into contract farming is influenced by household characteristics, operation features, product categories, market attributes and underlying environmental conditions. A discrete choice model is constructed in this paper to test the hypothesis that a farmer's decision to engage in contract farming is affected significantly by the above factors.

In the discrete choice model, the choice by farmer households to participate in contract farming is influenced by the following five explanatory variables: (1) farmer household characteristics (P) that are reflected by education level and risk attitude; (2) the extent of production specialisation and commercialisation (R); (3) agricultural product categories (C); (4) market attributes (T) represented by degree of price fluctuation and distance to the target market; and (5) underlying environmental conditions (E) measured by the presence of a government support policy and transportation conditions to the primary market. The general model takes the form:

[A.sub.i] = F([P.sub.i], [R.sub.i], [C.sub.i], [T.sub.i], [E.sub.i]; [beta]) + [[epsilon].sub.i]

The above specification can be estimated as a logistic model where [A.sub.i] is the binary choice in which 1 denotes participation in contract farming. A maximum likelihood method is adopted to obtain the estimation results. The variables included in the estimating equation are listed in Table 15, along with their mean values. Risk aversion was assessed using farmer responses to a standard lottery with economically significant gains and losses and an expected value of zero. Price fluctuation was determined from a subjective estimate by the respondent.

Results and discussion

We used SPSS 11.5 software to run the logistic regression on the 1,036 observations in the farmer data set. Regression results are presented in Table 16. We briefly highlighted some of the key findings. We would have expected a positive relationship between a farmer's education level and his participation in contract farming, but the regression results indicate that a farmer's education level and attitude toward risk have no significant impact on his choice probabilities. The reason for this might be that there is only a slight difference in the farmers' education levels, with most at a very low level. The same logic accounts for attitudes toward risk, as most farmers rejected the reference lottery. Commercialisation in production is positively and significantly related to a farmer's acceptance of a contract. Note that this may reflect the impact of the contract on the farm's output mix. Distance to the target market has a significant positive impact on contract choice. If farmers are far from their target market, they would consider participating in contract farming. Most exporters contract for products with local farmers in order to ensure high quality, lock in adequate supplies and ensure timeliness for processed goods going to foreign consumers. Price fluctuations in target markets are not significant. Government support is another important factor that drives farmers to contract. Its coefficient is significant at the 1% confidence level in both models. Finally, there is a significant relationship between enterprise type and the existence of a contractual relationship. This may reflect the fact that farms with specific enterprises were selected for contracts, or that a contractual relationship causes the farm to adjust its output mix.

AGRIBUSINESS FIRMS

Of the 116 dragon-head firms included in the survey, 100 reported being involved in contract farming (Table 17). As shown in Table 18, the primary incentives for firms to contract are the stabilisation of the supply of raw materials and improvement of product quality. Reducing transaction costs and obtaining government support were identified by 16% and 20% of the firms, respectively.

Types of contract organisational chains

Agribusiness firms utilise a number of organisational or supply chains to contract with farms. In Table 19, different supply chains are identified with a plus sign to show the type of transaction link between corresponding agents. For example, 'Firm + Farm' tells us that farmers interact directly with firms, while 'Firm + Cooperative + Farm' means that agribusiness firms deal directly with cooperatives that collect the goods from farmers, with no transactions directly between firms and farmers.

The most common chain is the 'Firm + Farm,' used by half of the surveyed firms. 'Firm + Cooperative + Farm,' in which cooperatives link farms and firms like a bridge, is the second most common type of chain, used by 21% of firms. Some firms utilise local government authorities, and middlemen to establish contractual relationships with farms. We also find that the organisational chains selected by firms are related to farm size. More firms choose the 'Firm + Farm' chain with larger farms. Firms tend to use an intermediary in the supply chain to deal with small farms.

Types of contracts

Among the 100 agribusiness firms included in the survey, 63 firms signed marketing contracts with farms (Table 20). The type of contract depends largely on the categories of delivered goods. Marketing contracts are used more frequently in the fruit, vegetable and tea processing industries, whereas production contracts are more common in the meat and dairy processing industries.

Forms of contracts

Most agribusiness firms use written contracts (Table 21). The rank or hierarchy of dragon-head firms also influences the types of contracts selected. Lower ranking firms, particularly county-level firms, choose oral contracts more often, in part because they maintain close relationships with local farms and have confidence in each other.

Contract specification

The price floor is the most common delivery price specification approach used by firms (Table 22). The price floor is established by the contracting firm and is set near the cost of production. The objective of the contracting firm is to limit fluctuations in supply. This result is in contrast to the farmer survey that indicated flexible price contracts were the most common. Flexible price and fixed delivery price mechanisms are also used in some cases. When the rank of dragon-head firms is considered, the price floor strategy is preferred by firms of higher rank, whereas flexible pricing works better for lower-ranked firms. Owing to their strong financial status and the favourable public policy afforded them by government, highly ranked firms tend to make better use of the riskier price floor method.

The amount of price fluctuation in the local market is highly correlated with the type of price mechanism (Table 23). When the price is fairly stable, firms tend to accept fixed price and flexible price methods. Most firms select flexible prices as price fluctuation increases.

Table 24 reports the lengths of contracts used by various types of processing firms. Longer term contracts tend to be preferred in industries with longer replacement cycles--tea or livestock for example.

The length of the contract is also affected by the price fluctuations of the processed goods (Table 25). As would be expected, the wider the price fluctuation due to uncertainty about future prices, the shorter the contract period.

The type of processed good is strongly associated with the use of contracts by firms. All firms in the dairy, the aquaculture and honey industries in our survey make use of contracts, although the number of these firms included in the survey is small (Table 26).

Firms were asked to rank the importance of input quality using a four-point Likert scale (Table 27). Generally, the higher the quality requirement for the raw material, the higher the percentage of firms engaged in contract farming.

If the target market is in foreign countries, firms tend to use contracts more often (Table 28).

If price fluctuation in the local market is relatively high, firms are less likely to use contracts (Table 29).

Econometric analysis

As described in the preceding subsection, we categorise factors into three classes: type of firms (E) represented by their rank, characteristics of processed goods (P) denoted by the requirement on the quality of raw materials and corresponding industry and market attributes (M). The study only examines four typical goods: vegetables, meat, food oil and tea. Explanatory variables along with their mean values are listed in detail in Table 30. The general model takes the form:

[T.sub.i] = F([E.sub.i], [P.sub.i], [M.sub.i], [beta]) + [[epsilon].sub.i]

The dependent variable [T.sub.i] is binary, where 1 denotes participation in contract farming. A maximum likelihood estimation method is used to obtain the estimation results. Excluded classes are municipal firm type and all other product categories. The regression results are presented in Table 31.

Results and discussion

We are able to draw the following results from the sample data:

1. The rank of firms has a significant and positive effect on the use of contracts. This may reflect the fact that scale and reputation are viewed as favourable signals by farmers and makes them more willing to cooperate with highly ranked firms.

2. Characteristics of processed goods have a certain positive effect on the dependent variable, consistent with expectations. The firms in the fresh vegetable processing industry are more likely to use contracts, since firms need a stable and timely supply of raw goods that are quite perishable.

3. Price fluctuation in the target market has a significantly negative effect on the use of contracts. Firms tend to use contracts in a market with relatively less price variation.

Contract performance

The firm-level survey allows us to analyse the potential factors that influence a contract's performance and the likelihood of violation. We define acceptable contract performance if the ratio of acceptable contracts to the total number of contracts is 75% or greater. Our data indicate that 72% of firms with contracts have a performance ratio higher than the 75% benchmark. About 10% have less than 50% acceptable performance. Reasons for contract failure include unacceptable delivery quality and contractees selling products to other parties for a higher bid price. Resolution of contract disputes is difficult. As many as 53% of firms report that there is no way to resolve conflicts. Legal action occurs in 7% of contracting firms. Another 7% rely on local government to resolve disputes. Generally speaking, the legal mechanism used to guarantee high contract performance is less important than other types of informal mechanisms. Contract violation is strongly associated with farm size. We find that 79% of firms report contract violations with small farms, 14% with middle sized farms, and only 7% with large farms. Smaller farms may fail to perform well because they are not specialised and incentives for growers are weak.

The firm-level survey reveals that contract performance is influenced by the type of contract organisational chain (Table 32). Contract performance under the 'Firm + Cooperative+ Farm' chain is highest, with 'Firm + Middlemen + Farm' next. The 'Firm + Local or Village Government + Farm' supply chains have the worst performance.

Table 33 summarises a number of contract provisions and performance. Marketing contracts perform somewhat better than do production contracts. Oral contracts appear to perform somewhat better than written contracts. The result seems contrary to expectations, but it indicates the importance of reputation and social networks in the Chinese rural economy.

The performance ratio is highest with a price floor and lowest for a flexible price mechanism. For payment method, the pre-paid deposit method has a better performance ratio than cash payment at delivery time or after delivery time. Comparing the length of contract period and performance rate suggests that contracts written for less than one year or longer than three years perform better, using the 75% benchmark.

The use of performance standards where a contractor specifies a minimum quality standard for example, significantly influences the performance rate. We also find that the use of direct incentives, such as bonuses to farms that successfully implement contracts, encourage a higher performance rate. Finally, the existence of an indemnification clause that requires compensation if the contract terms are violated also improves performance.

CONCLUSIONS AND POLICY IMPLICATIONS

This study examines the extent and performance of contract farming from the perspectives of Chinese farm households and contracting agricultural firms. The farm-level survey indicates that the actual proportion of farms engaged in contract farming is relatively low and significantly less than the proportion of farm households willing to produce under contract. A lack of contract opportunities is the most frequently cited reason, particularly for smaller farms. Farmers identify price stability and market access as the key advantages to contracts, while firms consider improved product quality as the critical incentive for contract use. The organisational chain 'Firm + Cooperative + Farm' appears to be viewed as the most desirable way to maintain contracts, although the use of middlemen and direct 'Firm + Farm' contracting are the most common types at present. Marketing contracts are more common than production contracts, both for firms and growers. Oral contracts are most commonly used by middlemen and county-level dragonhead firms because of strong social capital and social networks in rural areas. The price floor provision is favoured by most farmers because it limits downside risk exposure and still allows them to take advantage of price increases. Cash payment at delivery time is the preferred payment method. The short-term contract is the main type used with growers, but both the type of commodity and the commodity's price fluctuation affect contract length to a certain degree.

Logistic regression suggests that for farmers, acceptance of contracts is influenced by enterprise type, marketplace attributes, public policy and the farm's production characteristics. Econometric analysis also shows that quality requirements for delivered raw material, price volatility and public support policies encourage firms to utilise contracts.

The study shows that the overall successful implementation rate of contracts is still low. Key reasons for contract violation include the failure of delivered goods to meet the contract quality requirements and the sale of contract goods to other parties if prices are higher. Contract violation is common with smaller farms.

Our results also show that the degree of commercialisation is associated with a higher likelihood of contract farming. Public policies that encourage the adjustment of the agricultural structure so as to improve farmers' options for specialisation and commercialisation should be made right now. The development of farmer cooperatives is another critical public policy consideration. Firms have to incur increased contracting and monitoring costs when confronted with a fragmented farm structure. Bargaining associations or other types of cooperatives might reduce transaction costs and generate better performance. Further, a more stable external environment would increase the use of contracts and improve contract performance. In addition, better risk management instruments for both contractors and farmers should improve supply chain management. In the absence of welldeveloped futures markets, wider use of floor price provisions might offer a reasonable start. Public policy can encourage contract farming from the perspective of both firms and farms. Government has a responsibility to monitor the performance of contacts by protecting the rights of both parties. In addition, credit support, tax benefits and access to improved technology can encourage more dragon-head firms and farms to consider contract production.

APPENDIX A

AGREEMENT ON PLANTING WATER RADISH

Contractor: Zhongsu Limited Company, City of Lanxi

Contractee: The Government of Yongchang Town

In order to bring along and encourage farmers to develop contract farming and optimise agricultural structure, thus to ensure that farmers receive the substantial economic benefits, both contractor and contractee, through friendly consultation, have reached the following agreement on the water radish planting acreage of the farmers and the purchase of the yields:

1. Contractor will entrust contractee with the responsibility for planting techniques and acreage in some villages. Contractee will provide the farm households and the planting acreage that should be over 3,000 mu.

2. Contractee should be in charge of examining and supervising the farmers and to market to the contractor the entire planted water radish crop.

3. The quality standard of the water radish sold by the farmers should meet the demands determined by contractor.

4. Contractor offers a favourable price for the delivered goods: higher by 3 % than the local market price at delivery time.

5. On the expiration of the contract, contractor takes priority of renewing it if desired.

6. This agreement will be valid for 2 years.

7. This agreement becomes effective on the date of signing.

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HONGDONG GUO, ROBERT W. JOLLY, JIANHUA ZHU (1)

Center for Agricultural and Rural Development, Zhejiang University, Hangzhou, Zhejiang Province 310029, P.R. China. E-mail: guohongdong@zju.edu.cn

(1) The authors are Associate Professor, Center for Agricultural and Rural Development, Zhejiang University; Professor of Economics and former Graduate Assistant, Department of Economics, Iowa State University. Funding for this project was provided in part by the National Science Foundation of China (70373027). Journal paper of the Iowa Agriculture and Home Economics Experiment Station, Ames. Iowa; project number 5002, supported by the Hatch Act and State of Iowa funds.
Table 1: Types of organisations

Organisational forms 1996 1998 2000

1. Dragon-head firms 5,381 15,088 27,000
 % of total 4,5.51 49.93 41.0
2. Middlemen 3,384 8,024 22,000
 % of total 28.62 26.44 33.0
3. Government authorities 1,450 4,848 7,600
 % of total 12.26 15.98 12.0
4. Other types 1,600 2,384 9,600
 % of total 13.61 7.85 14.0

Source: Data derived from the survey of the Ministry of Agriculture,
Peoples Republic of China in 1996, 1998, 2000 reported in Niu, 2002.

Table 2: Economic relationships between firms and farmers

Relationship structure in different years Firm numbers Percent

1996 11,824 100.0
 1. Contract relationship 8,377 70.8
 2. Cooperative 1,255 13.3
 3. Farmer-owned business 2,222 18.8
1998 30,344 100.0
 1. Contract relationship 16,948 55.7
 2. Cooperative 2,791 9.2
 3. Farmer-owned business 3,396 11.2
 4. Others 7,209 23.8
2000 66,000 100.0
 1. Contract relationship 32,340 49.0
 2. Cooperative 9,240 14.0
 3. Farmer-owned business 8,580 13.0
 4. Others 15,840 24.0

Source: Data derived from the survey of the Ministry of Agriculture,
Peoples Republic of China in 1996, 1998, 2000 reported in Niu, 2002.

Table 3: Regional distribution of farmers in survey

Regions Households (units) Proportion (%)

East Area 586 56.6
 Fujian 60 5.8
 Guangdong 50 4.8
 Jiling 61 5.9
 Jiangsu 23 2.2
 Shandong 128 12.4
 Zhejiang 264 25.5
Central Area 304 29.3
 Hubei 11 1.1
 Hunan 57 5.5
 Jiangxi 236 22.7
West Area 146 14.1
 Sichuan 58 5.6
 Yunnan 29 2.8
 Chongqing 30 2.9
 Guangxi 29 2.8
Total 1,036 100

Source: Primary survey 2004.

Table 4: Distribution of different types of firms

Types of firms Number Percentage

Privately owned 78 67.2
Collectively owned 5 4.3
State-owned 8 6.9
Joint-venture 11 12.1
Other 14 12.4

Source: Primary survey 2004.

Table 5: Reasons farmers do not contract

 No contracting No obvious Process too
 opportunities benefits complicated

Number 426 169 21
Percentage 52.2 20.7 2.6

 Buyers show no Total
 interest

Number 200 816
Percentage 24.5 100

Source: Primary survey 2004.

Table 6: Contract farming incentives

Incentives Market access Price protection Credit support

Number 124 73 17
Percentage 56.4 33.2 7.7

Incentives Technology support Total

Number 6 220
Percentage 2.7 100

Source: Primary survey 2004.

Table 7: Organisational types dealing with farmers

Type of organisation Middlemen Firm Village Dept. of
 government Technology

Actual percentage 34.1 34.1 12.7 5.9
Preferred percentage 18.0 32.7 8.8 14.4

Type of organisation Cooperative Other Total

Actual percentage 0.5 12.7 100
Preferred percentage 18.7 7.5 100

Source: Primary survey 2004.

Table 8: Types of contracts

Types of contracts Marketing Production Others Total

Households 149 61 10 220
Percentage 67.7 27.7 4.6 100

Source: Primary survey 2004.

Table 9: Forms of contracts (by percent)

Organisations Forms of contracts Total

 Oral Written

Middlemen 64.0 36.0 100
Agribusiness firms 14.7 85.3 100
Village government 75.0 25.0 100
Local authorities 61.5 38.5 100

Source: Primary survey 2004.

Table 10: Actual and preferred pricing mechanisms (percent)

 Flexible Price
 price floor Fixed price Others Total

Actual situation 44.1 27.3 22.7 5.9 100
Preferred 20.9 68.6 9.1 1.4 100

Source: Primary survey 2004.

Table 11: Payment methods and percent of contracts

Payment method Cash payment Prepaid deposit Pay-after-delivery

Actual 50.0 27.7 22.3
Preferred 66.4 27.3 6.4

Payment method Total

Actual 100
Preferred 100

Source: Primary survey 2004.

Table 12: Frequency of contract conflicts

 Never Seldom Often Total

Frequency 132.0 79.0 9.0 220
Percentage 60.0 35.9 4.1 100

Table 13: Reasons for contact conflicts

Issues Price terms Quality terms

Percent who have experienced 86.4 72.7

Issues Quality terms Delivery time

Percent who have experienced 6.8 18.2

Source: Primary survey 2004.

Table 14: Perceived farmer benefits from contract farming

Benefit None Somewhat Significant Total

Reducing production cost 31.8 54.1 14.1 100
Improving quality 7.3 58.7 34.0 100
Increasing selling price 22.3 65.4 12.3 100
Stabilising sale price 10.5 45.9 43.6 100
Reducing marketing cost 21.3 44.1 34.6 100

Source: Primary survey 2004.

Table 15: Interpretation and summary of explanatory variables

Variable names Definition Mean

Household characteristics (P)
 Education Level 1=below elementary school; 2.46
 2=elementary school; 3=middle
 school; 4=above middle school
 Risk attitudes 1=risk averse; 2=risk neutral; 1.06
 3=risk favorable

Operation features (R)
 Specialisation Income from main agricultural 0.45
 product/total income (%)
 Commercialisation Quantity of marketed products/ 0.65
 total production (%)
Product categories (C)
 Grain Dummy variable 1: yes 0: no 0.43
 Vegetable Dummy variable 1: yes 0: no 0.13
 Fruit Dummy variable 1: yes 0: no 0.06
 Tea Dummy variable 1: yes 0: no 0.01
 Edible mushroom Dummy variable 1: yes 0: no 0.04
 Floral crops Dummy variable 1: yes 0: no 0.02
 Poultry Dummy variable 1: yes 0: no 0.05
 Meat Dummy variable 1: yes 0: no 0.08
Market attributes (T)
 Price fluctuation 1=0%-10%; 2=10%-20%; 3=20%- 2.20
 50%; 4=>50%
 Target market 1=local market; 2=regional; 1.20
 3=foreign market
Environmental condition (E)
 Traffic condition 0=bad; 1=good 0.91
 Government support O=no support; 1=support 0.50
 available

Table 16: Farm-level logistic regression results

Explanatory variables Coefficient (B) Wald Exp (B)

Intercept -3.530 *** 41.759 0.029
Farmer characteristics (P)
 Education -0.058 0.459 0.944
 Risk aversion 0.285 1.342 1.329
Operation features (R)
 Specialisation 0.489 2.343 1.631
 Commercialisation 0.574 * 3.288 1.775
Product categories (C)
 Grain 0.401 * 2.665 1.493
 Vegetable 0.128 0.154 1.137
 Fruit 0.784 ** 5.248 2.191
 Tea 1.603 *** 7.887 4.969
 Edible mushroom 0.118 0.063 1.125
 Floral crops 1.179 ** 4.419 3.252
 Poultry 1.058 *** 7.944 2.880
 Meat 1.194 *** 13.750 3.302
Market attributes (T)
 Price fluctuation -0.110 1.762 0.896
 Target market 0.540 *** 10.161 1.716
Environment (E)
 Traffic condition 0.148 0.262 1.159
 Government support 0.662 *** 13.158 1.940
-2 loglikelihood 969.38
Chi-square value 93.23 ***
Nagelkerke [R.sup.2] 0.135

Note: *, ** and *** represent significance at 10%, 5% and 1% levels,
respectively.

Table 17: Firm types and contract farming

Type of firm Without contract With contract Total

National
 Quantity 1 9 10
 (%) (10.0) (90.0) (100)
Provincial
 Quantity 4 66 70
 (%) (5.7) (94.3) (100)
Municipal
 Quantity 7 16 23
 (%) (69.6) (30.4) (100)
County
 Quantity 4 9 13
 (%) (30.8) (69.2) (100)
Total 16 100 116

Source: Primary survey 2004.

Table 18: Main incentives to sign contracts

 Stable High quality Reduced
 supply of of delivery transaction
 raw material goods cost

Number of firms 78 77 16

 Stabilised Government Total
 delivery support
 price obtained

Number of firms 44 20 100

Source: Primary survey 2004.

Table 19: Farm size and organisational chains

Farm size Types of Chains (by percent)

 Firm+Farm Firm+Village Firm+Cooperative
 +Farm +Farm

Number of firms 50 8 21
Small 8.0 62.5 28.6
Relatively small 10.0 35.0 71.4
Large 66.0 2.5 0.0
Very large 16.0 0.0 0.0

Total 100 100 100

Farm size Types of Chains (by percent)

 Firm+Middlemen Firm+Local
 +Farm Authority+Farm

Number of firms 14 4
Small 21.4 25.0
Relatively small 78.6 50.0
Large 0.0 25.0
Very large 0.0 0.0

Total 100 100

Source: Primary survey 2004.

Table 20: Categories of goods and contract type

Categories of Goods Number of firms using Total
 contract type (percent)

 Marketing Production
 contract contract

Vegetable processing (%) 21 (66) 8 (34.5) 29 (100.0)
Meat processing (%) 4 (40) 6 (60.0) 10 (100.0)
Food oil processing (%) 10 (71) 4 (28.6) 14 (100.0)
Fruit processing (%) 3 (100) 0 (0.0) 3 (100.0)
Aquaculture (%) 6 (48) 8 (51.7) 14 (100.0)
Dairy (%) 0 (0.0) 3 (100.0) 3 (100.0)
Tea (%) 8 (100) 1 (0.0) 9 (100.0)
Silk (%) 0 (0.0) 2 (100.0) 2 (100)
Edible mushroom (%) 2 (50) 2 (50.0) 4 (100.0)
Bee honey (%) 1 (100) 1 (0.0) 2 (100.0)
Other goods (%) 6 (40) 4 (60.0) 10 (100.0)

Total 37 63 100

Source: Primary survey 2004.

Table 21: Contract forms and rank of firms

Rank of dragon-head firms Contract form Total

 Percentage of Percentage of
 oral contracts written contracts

National 11.1 88.9 100
Provincial 14.2 84.8 100
Municipal 12.5 87.5 100
County 66.7 33.3 100

Source: Primary survey 2004.

Table 22: Rank of firms and price specification

Ranks of dragon-head
firms Price specification Total

 Flexible Price Fixed
 price floor price Others

National 22.2 66.7 11.1 0.0 100
Provincial 28.8 57.6 4.5 9.1 100
Municipal 37.5 50.0 6.3 6.3 100
County 33.3 55.6 11.1 7.0 100

Source: Primary survey 2004.

Table 23: Width of price fluctuation and price specification

Width of price
fluctuation Price specification methods Total

 Flexible Price Fixed
 price floor price Others

Very narrow 25.0 0.0 50.0 0.0 100
Narrow 32.8 57.8 6.3 3.1 100
Wider 30.8 61.5 0.0 7.7 100
Very wide 56.7 10.0 0.0 33.3 100

Source: Primary survey 2004.

Table 24: Categories of goods processed and contract period

Types of goods processed Contract period

 Less than Over
 1 year 1-2 years 2-3 years 3 years

Vegetable 44.8 27.6 6.9 20.7
Meat 30.0 60.0 0.0 10.0
Edible oil 50.0 35.7 7.1 7.1
Fruit 33.3 33.3 0.0 33.3
Aquaculture 21.4 50.0 14.3 14.3
Diary 33.3 33.3 14.3 33.3
Tea 22.2 11.1 22.2 44.4
Silk 0.0 50.0 0.0 50.0
Edible mushroom 25.0 50.0 25.0 0.0
Bee honey 0.0 100.0 0.0 0.0
Others 30.0 40.0 20.0 10.0

Types of goods processed Total

Vegetable 100
Meat 100
Edible oil 100
Fruit 100
Aquaculture 100
Diary 100
Tea 100
Silk 100
Edible mushroom 100
Bee honey 100
Others 100

Source: Primary survey 2004.

Table 25: Width of price fluctuation and contract period

Width of price Contracting period (percentage of firms) Total
fluctuation
 Less than Over 3
 1 year 1-2 years 2-3 years years

Very narrow 50.0 25.0 15.0 10.0 100.0
Narrower 29.7 42.2 17.5 10.6 100.0
Wider 52.4 34.6 9.2 3.8 100.0
Very wide 53.3 38.7 8.0 0.0 100.0

Source: Primary survey 2004.

Table 26: Processed products and contract farming

 Without contract With contract Total

Vegetables 2 29 31
 6.5 93.5 100
Meat 2 12 14
 16.7 83.3 100
Edible oil 5 14 19
 26.3 73.7 100
Fruit 2 3 5
 40.0 60.0 100
Aquaculture 0 14 14
 0.0 100.0 100
Dairy 0 3 3
 0.0 100.0 100
Tea 1 9 10
 10.0 90.0 100
Silk 0 2 2
 0.0 100.0 100
Edible mushrooms 0 4 4
 0.0 100.0 100
Bee honey 0 2 2
 0.0 100.0 100
Other 4 11 15
 26.7 63.3 100

Source: Primary survey 2004.

Table 27: Input quality requirement and contract farming

Quality level Without contract With contract Total

Low 1 2 3
(%) 33.3 66.7 100
Relatively high 4 32 36
(%) 11.1 89.9 100
High 10 36 46
(%) 21.7 78.3 100
Very high 1 30 31
(%) 3.2 96.8 100

Source: Primary survey 2004.

Table 28: Target market and contract farming

Target market Without contract With contract Total

Domestic market 13 67 80
(%) 16.3 83.7 100
Foreign market 3 33 36
(%) 8.3 91.7 100

Source: Primary survey 2004.

Table 29: Price fluctuation and contract farming

Price fluctuation Without contract With contract Total

Very narrow 1 6 7
 14.3 85.7 100.0
Narrow 9 71 80
 11.2 88.8 100.0
Wider 4 22 26
 15.4 84.6 100.0
Very wide 2 1 3
 66.7 33.3 100.0

Source: Primary survey 2004.

Table 30: Interpretation and summary of explanatory variables

Variable names Definition Mean

Types of firm (E)
 National Dummy variable: 1=yes, 0=no 0.09
 Provincial Dummy variable: 1=yes, 0=no 0.60

Product characteristics (P)
 Categories
 Vegetable Dummy variable: 1=yes, 0=no 0.27
 Meat Dummy variable: 1=yes, 0=no 0.09
 Edible oil Dummy variable: 1=yes, 0=no 0.14
 Tea Dummy variable: 1=yes, 0=no 0.08
 Quality requirement 1=Low; 2=relative high; 3=high;
 4=very high 2.91
Market attributes (T)
 Foreign market Dummy variable: 1=yes, 0=no 0.31
 Price fluctuation 1=never; 2=narrower; 3=wider;
 4=very wide 2.22

Table 31: Regression results on factors that influence firms in
engaging in contract farming

Explanatory variables Coefficient Wald Exp (B)

Types of firm (E)
 National 2.57 * 3.81 13.10
 Provincial 3.18 *** 13.40 23.92
Product characteristics (P)
 Categories
 Vegetable 2.97 ** 7.85 19.40
 Meat 0.13 0.01 1.14
 Food oil 1.45 1.83 4.26
 Tea 1.39 1.00 4.00
 Quality requirement 0.23 1.30 1.26
Market attributes (T)
 Foreign market 0.03 0.01 1.03
 Price fluctuation -1.14 ** 4.14 0.32
Intercept 1.18 0.47 3.26
Overall tests
 Prediction accuracy 91.4%
 -2loglikelihood 67.05
 Chi-Square value 26.03 **
 Nagelkerke' [R.sup.2] 0.364

Note: *, **, *** represent significance at 10%, 5% and 1% levels,
respectively, based on t-values.

Table 32: Organisational chain and contract performance

Organisational chain Performance ratio

 <25% 25%-50% 50%-75% >75%

Firm+Farm 4.0 16.0 24.0 56.0
Firm+Village Government+Farm 0.0 25.0 25.0 50.0
Firm+Cooperative+Farm 0.0 9.5 14.3 76.2
Firm+Middlemen+Farm 0.0 14.3 21.4 64.3
Firm+Local Government+Farm 0.0 25.0 25.0 50.0

Organisational chain Total

Firm+Farm 100
Firm+Village Government+Farm 100
Firm+Cooperative+Farm 100
Firm+Middlemen+Farm 100
Firm+Local Government+Farm 100

Source: Primary survey 2004.

Table 33: Contract provisions and performance

 Contract performance ratio

 Less 25% 25%-50% 50%-75% Above 75%

Contract type
 Marketing contract 3.2 15.9 25.4 55.6
 Production contract 0.0 13.5 18.9 67.6
Contract form
 Oral 0.0 16.4 10.0 73.8
 Paper 1.2 9.5 21.4 67.9
Delivery price
 Flexible price 2.9 11.8 35.3 50.0
 Price floor 0.0 9.6 1.9 88.5
Payment method
 Cash payment 1.8 10.5 17.5 70.2
 Pre-paid deposit 0.0 16.7 8.3 75.0
 Payment-after-delivery 0.0 4.3 26.1 69.6
Contract length
 Less 1 year 2.9 11.8 8.8 76.5
 1-2 years 0.0 7.9 23.7 68.4
 2-3 years 0.0 20.0 20.0 60.0
 More than 3 years 0.0 0.0 22.2 77.8
Quality requirement
 With 0.0 0.0 9.4 90.6
 Without 4.3 31.9 38.3 25.5
Incentives
 With 0.0 5.7 20.0 74.3
 Without 3.3 23.3 26.7 46.7
Indemnification clause
 With 1.4 6.8 18.9 73.0
 Without 3.8 28.5 24.6 43.1

 Total

Contract type
 Marketing contract 100
 Production contract 100
Contract form
 Oral 100
 Paper 100
Delivery price
 Flexible price 100
 Price floor 100
Payment method
 Cash payment 100
 Pre-paid deposit 100
 Payment-after-delivery 100
Contract length
 Less 1 year 100
 1-2 years 100
 2-3 years 100
 More than 3 years 100
Quality requirement
 With 100
 Without 100
Incentives
 With 100
 Without 100
Indemnification clause
 With 100
 Without 100

Source: Primary survey 2004.
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Author:Guo, Hongdong; Jolly, Robert W.; Zhu, Jianhua
Publication:Comparative Economic Studies
Geographic Code:9CHIN
Date:Jun 1, 2007
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