The Indonesian island of Sulawesi has experienced rapid and unusual growth in cocoa production since 1980, surprising the world and making it the world's third largest cocoa producer. It is a major generator of export revenue, bringing in $166 million in 1993. From 1981 to 1996, the volume of cocoa beans exported has increased from approximately 7000 tons to 275,000 tons. Notable about this expansion is that the engine of growth has been smallholders, and that these farmers have come to enjoy a high proportion of the returns from cocoa exports. This case study, therefore, has the objective of identifying those characteristics of cocoa production and marketing that may be transferable to other smallholder export crops in Indonesia.

The production boom of cocoa in Indonesia was spurred by high world cocoa prices in the late 1970s, prompted by a sharp reduction in output from West Africa and the Dominican Republic. The increase in demand encouraged smallholders to invest in cocoa production, and total smallholder acreage expanded over 30-fold between 1980-1995, from 13,125 ha in 1980 to 418,400 ha in 1995. During the same time period, smallholder production increased from about 1000 tons to over 200,000 tons, and their share of total production (vs. private estates and government-owned estates) increased from 10% to 73%. Reasons for the success of the smallholder farmers include: an abundance of land available for cocoa production in Southeast Sulawesi, knowledge and capital disseminated by farmers who had experience farming in Sabah, Malaysia, government policy that required dissemination of seed from government and private plantations, and adequate transport infrastructure. Additionally, the cost of production for Indonesian cocoa smallholders is among the lowest in the world, due to efficient production methods, inexpensive labor, and a suitable climate and soil. Finally, smallholder entrepreneurship and a highly competitive marketing system with limited government intervention contributed to the expansion of cocoa production since 1980.

The chart below indicates that most of the increase in production has come as a result of land expansion rather than intensification of crop production.  Yields have remained constant, while the area harvested has grown rapidly.  Cocoa production has not yet reached a transitional stage that would encourage intensification.  However, the area harvested began to level off in 1993, and dropped in 1998.  Thus, it appears that the time may be appropriate for a focus on intensification efforts, which would increase yields.  Issues such as crop quality, research, disease prevention, and deforestation prevention are concerns closely related to a transition by means of crop intensification.  These issues are discussed below.

Source:  FAO Statistical Database

Marketing and Distribution

Unique to Indonesia's cocoa industry is its free marketing and pricing system. In most African cocoa-producing nations, a government marketing board controls prices, which benefits particular groups of people within a country at the expense of farmers. The administered prices also lead to inefficiencies because they do not transmit market signals correctly. This leads to distortions in resource allocation and an environment in which farmers cannot respond to fluctuations in world supply and demand (i.e. isolation from the market).

The free trade regime in South Sulawesi, on the other hand, has created a competitive environment and low marketing and distribution margins. The world price for cocoa is highly correlated with the fob (freight on board) price at Ujung Pandang (Sulawesi's major port), indicating that the system is transparent and pricing is competitive. Farmers have also benefited from a relatively good transport infrastructure in major producing areas, which has meant relatively low transport costs. Finally, cocoa is not subject to large government levies such as export taxes. These factors have allowed smallholder farmers to receive a high share of the export price for cocoa. A study done in 1995 found that cocoa farmers in South Sulawesi received 90% of fob prices. Some crops, such as cassava, generate only 18% of the fob price for farmers.

Government Policies

As mentioned above, the government of Indonesia has had a mostly hands-off policy with regards to cocoa production. The only tax producers are subject to is a value added tax imposed in 1995. The government food logistics agency, Bulog, has no involvement with cocoa. Export commodities such as cocoa have also benefited from macroeconomic policies that have created a favorable exchange rate and low inflation. For example, the real devaluation of the rupiah in 1986 meant higher real producer prices for exports. This of course is also true at the present time, in the midst of a financial crisis which has devalued the rupiah considerably. Also, the government has invested in rural infrastructure in the Outer Islands, such as roads and schools, which has helped to keep transportation costs down and encouraged expansion of smallholder cocoa.

Two other government initiatives were a tree crop rehabilitation program and a smallholder plantation development program. The first mainly benefited estate holders, but it did provide smallholders with cocoa seeds. The second initiative was called P2WK (Perkembangan Perkebunan Wilayah Khusus, Plantation Development in Special Areas). It was aimed at smallholders and provided them with modest grants and reimbursement of land preparation, planting costs, and seedlings. Although the program increased planted area by 205,296 ha (of which about 63,000 was cocoa), it was criticized for targeting areas where the infrastructure was not adequate and the soil quality and climate were unsuitable.

Issues

Although the growth in production and exports has been remarkable in the past 18 years, there are several issues which must be addressed to maintain healthy, sustainable growth in the cocoa sector. These include quality, export marketing, oversupply on the world market, and disease and deforestation.

The quality issues involves the processing of cocoa beans, which can be sold either fermented or unfermented. Fermented beans are used for chocolate production and require a longer time to process, and sell at a price premium to unfermented beans. Unfermented beans are lower quality and used primarily for cocoa butter production.  They take only 1-2 days of processing, and sell at a price discount of about $100 per ton, or 7% of the value. Cocoa bean production in Indonesia is primarily unfermented, driven by the decline in production of unfermented cocoa by the Dominican Republic in the early 1980s. The Indonesian Cocoa Association, Askindo, has encouraged farmers to produce fermented beans in order to tap the premium market. However, there is little reliable and concrete information about price premiums passed on to farmers, and currently, there is sufficient demand for unfermented beans.

In order to switch farmers to production of fermented beans, several free market mechanisms will have to operate. First, transparency in price information (through media such as radio broadcasts) is necessary, to let farmers know the potential earnings increase they could gain from fermented bean production. Next, the premium paid for fermented cocoa bean exports needs to be passed back to farmers to reward them for their extra efforts. Exporters, middlemen, and farmers need to make sales and purchases at premium prices at every stage in the marketing chain. If one link does not pass along a premium, then it will never reach the farmer, and he will not be incentivized to produce the higher quality beans. Direct government intervention, such as export controls, would not be as effective as implementing mechanisms to ensure that the market can operate freely.

Another issue is export marketing, which includes a warehouse receipt proposal and risk management.  Cocoa exporters, as they become more established and financially well-off, they are becoming more conservative and protective of their gained interests.  An example of this is their resistance to a warehouse receipt system proposed by one of the world's largest cocoa brokerage houses.  Under this system, any exporter can deliver cocoa to a warehouse in Ujung Pandang, have the quality checked, and obtain receipts which can be used as collateral against loans.  The loans are provided by banks and the warehouse operators.  The advantages of this system are increased liquidity and greater transparency in price differentials depending on quality.  Large, established exporters are resisting this system because it takes away their advantages in providing financing to middlemen and collectors, and it also takes away their control of determining good quality cocoa.  The warehouse system would be an objective source of grading cocoa, whereas the current system allows the exporter to gain extra profits by sorting cocoa by grade and selling sorted good quality cocoa at a premium.

The risk management issue involves the ability of  smaller exporters and middlemen to use instruments such as futures, options, and forward contracts.  Large exporters are able to do this through overseas brokers, which may give them an advantage in securing cash flows.  The Ministry of Trade needs to consider how to make these instruments accessible to smaller operators.

A third issue is oversupply on the world market.  In commodity markets, the "adding up" problem can occur when the incremental growth in the production of a commodity results in an increase in export revenue proportionally much less than the rise in volume production.  This will lead to depressed world cocoa prices, which would undermine the welfare of cocoa producers.  This possibility may encourage the government to impose export controls to restrain increases in cocoa production.  However, export regulations in the past have led to problems such as smuggling and corruption.

The environmental issues surrounding cocoa production also are cause for concern.  The cocoa pod-borer was the main reason for stagnation of Indonesia's cocoa sector in the early 20th century, an insect pest that drastically reduces yield.  Measures for controlling this pest include eradication of affected cocoa trees and application of chemicals.  Both of these measures are costly and resisted by farmers.  Since this insect has the potential of destroying the cocoa subsector, stronger government support is needed to devise better control methods through research, extension, and mobilization of smallholders.  Another environmental concern is deforestation.  Many of the cocoa fields in Sulawesi were created by opening up forests, which carries the risk of erosion, reduction of watershed areas, and loss of biodiversity.  To counter this trend, new plantings of cocoa could be directed towards relatively degraded or underutilized land rather than forest areas.  Sulawesi has large grassland and scrub areas, which could be used productively if not severely degraded.  Another way to mitigate deforestation is to identify and demarcate the vulnerable and valuable forest areas.  This would be most effective if it were paired with economic incentives to encouraged farmers to plant cocoa on non-forest land.  Finally, research and development in the area of crop intensification would help to mitigate the problems created by land expansion.  As illustrated in the above graph, it appears that there is great opportunity to increase yields, and land expansion may be reaching its limits.

Lessons learned

What can this tell us about policies for other agricultural commodities in Indonesia? It appears that policy which allows free-market mechanisms to work efficiently is more desirable than direct intervention such as marketing boards or export controls.  Many crops in Indonesia are subject to government intervention, such as export tariffs, fertilizer and seed monopolies, and state-administered cooperatives.  With minimal government intervention, the entrepreneurial attitude of smallholders and a competitive marketing and distribution regime in Sulawesi have been allowed to flourish and have contributed to the success of cocoa exports.  Cocoa is now one of Indonesia's main export commodities, which has increased employment and raised incomes in rural areas.

Additionally, this case reflects a similar quality issue as is true for coffee.  Fermented cocoa beans, similar to Arabica coffee, is a higher quality and thus more highly valued crop. An obstacle to production of these more highly valued crops is that they require more intensive and longer processing periods.  An effective means of improving quality is to provide incentives to producers through transparent price differentials.  This could be achieved through an objective grading system, as proposed by the warehouse receipt system and the central coffee tasting/ grading system done by the Kenya Coffee Board and Mill.  These bodies could also serve to place a "stamp of approval" on these commodities, ensuring buyers that they have been inspected for quality by an independent body.  A challenge would be to keep systems such as these free from corruption, which is particularly widespread in Indonesia.  A corrupt environment would damage the free market mechanisms that have worked to create a competitive environment among cocoa traders.  Again, minimal government involvement may help to stem the effects of corruption.  Higher quality crops could also be achieved through extension programs to educate farmers about more productive farming and processing techniques.  Extension services also could help prevent expansion of crops into valuable forest areas.

A final lesson is that cocoa farmers have been able to gain a large share of export prices relative to other crops, helping to generate income for farmers and making it an attractive sector.  The three factors that have facilitated this are:  1)  low marketing and distribution margins, 2) adequate transport infrastructure, and 3) an absence of government levies.  Other crops could generate more income for farmers if distribution and marketing margins were kept at a minimum through intense competition among traders.  Lower margins through the value chain could also be developed through improved transportation, which would lower the costs to the collectors and middlemen.  An absence of government levies would also make the system more efficient throughout.  Finally, a measure which could lower costs for farmers and middlemen in  cocoa and other crops is crop intensification. Farmers may incur higher upfront costs to generate higher yields, but over the long run, the crops would require fewer inputs (i.e. labor, materials) for higher output.  Higher yields would also  be more efficient for collectors, who would be able to collect from fewer farmers to amass the quantity needed to sell to local traders or processors.

While cocoa farmers still have many challenges to face, such as quality issues, intensification versus expansion, and a maturing and increasingly protective export network, the free market system has up to this point helped to create a competitive cocoa subsector which has increased farmer incomes.  Of the lessons learned, this is probably the most valuable; Indonesian farmers are entrepreneurial and will react to worldwide demand if given transparent market information.  A free market can create a competitive value chain with low intermediary margins, thus rewarding the farmer according to price fluctuations on a worldwide level.  Other cash crops in Indonesia could benefit if the government allowed similar market mechanisms to operate.  Policy to improve transportation, support extension services, and strengthen research on improving yields and preventing disease would also assist in sustainable, healthy, and profitable cash crop development.