The Curse of the Kolchosen
02.12.2013 / Neue Zuercher Zeitung

Soviet heritage is cause for Russia’s agricultural struggle for international annexation. Farming and cattle rearing have potential, but the largest country in the world is lacking capital, consolidation and efficiency.

Benjamin Triebe, Ust-Labinsk

The Soviet Union greets from the walls but Ljudmila Demjanenko talks about competition. When a sugar refinery does not modernize and progress with the times, it will die, she says. Five factories in the region have already declared bankruptcy. Demjanenko’s sugar refinery in the South-Russian Ust-Labinsk region hasn’t yet. The factory is 55 years old and is still called ‘Freedom’ and can also not belie its Soviet origin in other ways. Large mosaic pictures in a socialist realist style decorate the walls of the production hall: workers on the fields, an over-dimensional turnip and a basket of fruit. At the entrance one are welcomed by 33 portraits that hang underneath the following headline ‘Our best workers’ (meant are those that exceeded expectations). Several stones have fallen out of the mosaic pictures, but this is also not the kind of modernization that Demjanenko was referring to.

Behind the possibilities

Russia agricultural prospects are rather dim. According to the Food and Agriculture Organisation of the United Nations, Russia, the largest country in the world by area, with about 120 million hectare disposes of one-tenth of global arable land. Despite this, Russia only contributes about 3% to global production of grains, 1% to vegetables and 4% to milk production. Out of the collectivisation of the Soviet Union and the privatisation in the 1990s has arisen a fragmented, internationally not competitive and inefficient agricultural sector, which cannot cover the demand of the country and often produces at too high a cost in relation to the quality that it provides. Furthermore since August 2012 and Russia’s accession to the WTO and the therewith connected tariff cuts, the agricultural sector has been facing an even more difficult situation.

A business that does not react to the market gambles on its existence. The sugar refinery “Freedom”, with an annual production of 83 000 tons, is one of the smaller ones in Russia, but it’s profitable. 500 people are working at the factory in three different shifts. Today Dmitri celebrated his 30th birthday, to which the banner at the main entrance congratulated. The sign is equally modern as the advertisement outlining targeted and current states of daily production. In the past 6 years approximately $18 Million have been invested in the plant, investment that was financed through profit. The need to modernise is on-going still as the equipment originates from two different eras: on the left the modern tanks and pipes for cooking the sugar syrup, on the right those tanks of the Soviet Union and the plant can’t be restored in one go because that would mean that production would have to stop. The WTO accession was good for the factory, says Ljudmila Demjanenko and it’s also been good for stimulating competition, of which she is not afraid.

Demjanenko manages the Sugar division of Kuban Agro Holding, a holding company of 30 agricultural companies within the very fertile Southern-Russian region Krasnodar. The portfolio spans from sugar production and grain cultivation to pig and cattle breeding and crop cultivation. Kuban Agro is part of Basic Element group, which the mogul Oleg Deripaska has built. Basic Element combines businesses that range from the financial service sector to aviation and has generated, by their own admission, 1% of Russia’s GDP. The agricultural sector, together with Kuban Agro, constitutes a small segment with 5000 employees. Deripaska grew up in the Ust-Labinsk region and now owns not only the regional airports but also approximately 80% of arable land that forms part of the city’s administrative district. Since 2002, the 45-year old mogul has bought agricultural companies which have existed since the 1950s to add to his holding company.

The reforms of the Soviet era have turned Russian agriculture upside down: towards the end of the 1920s land was seized, farmers had their lands disappropriated and large state-owned plants (Sowchosen) and agricultural cooperative societies (Kolchosen) were created. The freedom of establishment for farmers was rescinded. Morale was in a bad way and the system was inefficient. Waste and wear and tear increased dramatically and the state-directed economy caused an economy of scarcity. Famine occurred in the initial years and even in later years, productivity and profit remained low, in spite of forced use of machinery and chemicals; the few private businesses that were permitted did much better.

Turning point and descent

After the collapse of the Soviet Union workers received land shares from their former Sowchosen and Kolchosen, which attributed them a part of land. However, the person that wanted to become independent with their land claims, had to go through a scary registration procedure – hence many preferred to plant in their own garden instead. Meanwhile, in the former collective farms, capital and managerial capacity was lacking and the quality of the products was often deficient. From 1992 to 1998 Russia’s agriculture production shrank by about 40%. Today, the cultivated land area has equally decreased by about the same amount. Every fifth employable Soviet is said to have worked in agriculture during the 1980s; today it is 7%.

In the beginning, the government supported the peasants but these were however too small as to be productive and be able to invest. And parallel to the successors of the collective farms, corporations and conglomerates were being created through the purchase of land shares. Kuban Agro remains today one of the 20 largest agricultural firms with a turnover of $224 million in 2012 and net profit of $21 million. Despite, the sector remains fragmented. About half of total production is contributed by small or very small producers, which are forced to sell their small quantity of homogenous products with little profitability as they do not dispose of power to influence price to the processing industry or wholesalers. As a small number of chains repartition the retail trade market among themselves, it is ultimately the consumer that pays high prices.

Within the industry the magic words are therefore “vertical integration”: in developed and differentiated markets primary products or raw materials, such as seeds, can be bought quite cheaply and self-produced products for further processing can be sold with attractive profit margins. This changes, when only a few up- or downstream suppliers, with acceptable quality, are available in acceptable proximity. Then transport costs are high and margins are small. For this very reason even a company like Kuban Agro does not aim to increase size in its growth strategy, but instead focuses on expanding its business. It is cheaper to grow the seeds yourself than it is to buy them on the market – as a result, the seed plant was built. Even soya beans will see a new recycling plant, just like a slaughterhouse for cattle and pigs. Vertical integration has been envisioned for at least the next 5 years, says CEO Anton Ulanov. In addition all segments will be trimmed for productivity: “We cannot control the price, but we can control our costs.”

One example is milk production: 1 litre of milk in the shop costs 60 Rbl. (sfr. 1.70) in the shop, of which the dairy farmer receives about one third. As so a large margin is lost during processing, Kuban Agro is thinking about doing this themselves as well. The milk for that will come from one of the largest cow barns in Russia a few minutes down the road. The flat-roofed barracks have only existed since 2008, in contrast to the antiquated tank vehicles, which in Soviet style, only display white-blue painted lettering saying “milk”. 7500 cows can be fitted on the site. However, as livestock farmer, Ljubov Gretschanaja explains, there are no Russian animals in the stalls, only Canadian ones, which have been reared for their milk production. The workers in these modern milking barracks are paid according to the amount of milk that they provide.

In September President Putin visited the barn. The plant profited from a state-run program, as almost all of Russian agriculture. The government pays subsidies for hectares cultivated, however this is considerably less than in Western Europe, as farmers complain. For some projects there are interest subsidy loans as all agricultural enterprises are exempt from tax on earnings. However, through Russia’s accession to the WTO the pressure is mounting: Russia has had to reduce its agricultural subsidies; initially to $9 billion a year for 2012 and then to $4.4 billion annually from 2018. The average import tariff for agricultural produce will be reduced from 13.2% to 10.8%. Strongly affected are wheat and milk products even though the transitional period can be up to 8 years. The industry is nevertheless complaining that she is not ready for this for this transition. Admittedly however the accession to the WTO had been under discussion for 18 years – nobody can say that this happened by surprise.

Investors wanted

The competition from abroad increased the importance of investing in-country; just as the in-country lack of capital required financial backers from abroad. One of them is the TKS Union, an association composed of two affiliated German companies. Together with the large German meat producer Tönnis, TKS owns two pig rearing plants in Belgorod and Woronesch in the South-West of Russia. The TKS was attracted by Russia’s growing appetite for pork, which is covered with less than 70% by local production as well as the high share of fertile black earth in this region. This black earth permits earnings in excess of 3.5 tons of wheat per hectare, which is 1 tons more than the country-wide average. This is significant, as a group of companies called Sojuz, which holds a stake in TKS, intends to cover everything from wheat production to feed production and hogs feed – vertical integration is intended here as well.

Towards the end of the year a new animal feed plant will start production and later a meat processor will be added. Until 2017 the Sojuz Group plans to expand their arable land from 45 000 to 60 000 hectares as well as increase their number of pigs bred from 650 000 to 1.5 million per year. These plants are to become the second largest pig producers in the country. The group achieved revenue of € 100 million in 2012 with its 750 employees and a plant result (Ebit) of € 21 million. TKS chairman, Georg Reese says that he can only report good things. One simply has to deal with the cumbersome bureaucracy, but the administration is working well. He said he felt welcomed as an investor in Russia.

The country has in fact its advantages: the purchase of one hectare of arable land costs € 500, compared to € 18 000 in Germany. As the government does not promote pork imports, and self-sufficiency will not be reached for years, according to Georg Reese, there is no price or cut-throat competition. The prices, at which pigs are being sold to slaughtering house, are up to one quarter above those in Germany. This and low personnel cost compensate for the shorter growing period that results from tougher winters and the lower revenue per region compared to the West.

Pressure to localize

Russia contributes its share to prompting foreign producers to invest in-country. Non-tariff trade barriers as well as unusually high health code requirements or obligations of proof for international food imports abound. Even production tools should preferably be manufactured in-country: for example since February exists an import restriction on harvester-threshers and their components, which is referred to as an “anti-dumping tariff” and amounts to 27%, in addition to the regular tariff of 5%. In July this punitive tariff was, for the time being, abandoned in response to strong protest, but it has not been abolished. Many believe that it is a case in favour of a shift towards outsourcing, for example Claas: the German agricultural engineering manufacturer was one of the first larger foreign industry representatives that opened a plant in Krasnodar. In May, Claas declared to increase capacity from 1 000 to 25 000 machines per year and to increase employee numbers from 200 to 500 until 2015, costing it € 115 million.

Whoever wants to sell something has to focus on the local market, says Valeri Masjukevitsch, head of a maintenance centre of Kuban Agro. The centre deals with 230 pieces of foreign machinery and is the largest in Eastern Europe. Masjukevitsch proudly presents the ample tarmac court yard that is empty: all machinery is operational and in the field – it is October, harvest time. The sales contracts have clauses that indicate that the manufacturer must train the technicians of the purchaser in how to maintain the machines. A need for repairs is evident because the soil is harder than in Western Europe, explains Masjukevitsch. The tractors have to withstand more and because of the larger plains they also have to cover longer distances. It is said that manufacturers in Russia hand over new tractors with the request to “to test them until they are broken” – this is to find out where the weaknesses lie.

The fault diagnostics for the entire agricultural sector are complex. Many aspects have improved when compared with the period shortly after Perestroika, but obstacles still remain: there is a high share of peasants and arable economy, which do not have a very entrepreneurial mind-set and which do not dispose of enough capital for investment. Then there is this dependence on political support and subsidies, which are too low to compensate for the developmental backlog compared to the West, where the state is more lenient. There are the market-dominated retail chains, which reduce the margins of agricultural plants. There are also worse weather conditions compared to Western Europe the tougher winters and the more frequent crop failure. And then there is also a WTO accession, which is the biggest problem of the industry and also its best motivation to become more transparent and more productive. Had there been an easy solution for Russia’s agrarian economy, it had already been found.