Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2006 Agriculture Reforms: Irrigation Water

Charges and Land Policy

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10. Fertilizer Subsidy Programme in Sri Lanka

10.1 Introduction As in many countries of South and South East Asia, Sri Lanka has pursued self sufficiency in rice as a politically attractive national policy goal. But in addition, it has long been concerned with issues of equity as well. These twin objectives have led agriculture, particularly paddy production, to occupy a special place in the policy formulation process. Besides massive investments in improving irrigation and agricultural research and extension activities to achieve food self sufficiency in the long run, a number of short term policy tools were also adopted in Sri Lanka, including tariff policies, price policies and input subsidy policies such as enactment of a fertilizer subsidy scheme. Fertilizer subsidies have been widely used in Sri Lanka since 1962 with the intention of encouraging the use of fertilizers and off-setting the adverse effects of low crop prices and high cost of production. It initially covered only paddy but later was extended to all other crops in 1985. The government withdrew the fertilizer subsidy in 1989, but restarted the scheme in 1994. Originally it applied to urea, sulphate of ammonia, muriate of potash and triple super phosphate (TSP) but, a revision made in 1997 restricted the fertilizer subsidy only to urea since it is the most widely used fertilizer in Sri Lanka. The method of deciding on the subsidy varied from time to time to be either a fixed sum per unit amount of fertilizer or a variable sum to maintain a fixed price in the market1. This policy brief examines the efficacy of fertilizer subsidies as a policy tool, examining the costs and benefits of such schemes in the pursuit of the countrys broader development goals. 10.2 Fertilizer Subsidy as a Policy Tool A fertilizer subsidy can be considered as a useful policy tool for promoting fertilizer use and decreasing the cost of production of small farmers. Sri Lankas agriculture sector has shown little dynamism in terms of its contribution to the countrys overall growth performance. Nevertheless, the sector plays a key role as a source of employment to the vast majority of the rural population. Subsidies to the farming community are, therefore,
In 2005, the fixed rate of subsidy was Rs. 23,000 per metric ton of urea. It was revised in late 2005, fixing the price at Rs. 350 per 50 kg bag of urea regardless of world market price.
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Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2006 Agriculture Reforms: Irrigation Water Charges and Land Policy

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viewed as a means of sustaining and ensuring livelihoods and income opportunities in the rural agricultural economy. While the cost of production of crops continues to rise as a result of increasing input prices, the increase in crop prices has remained relatively low. One way of remaining profitable, economical and competitive is to attempt to lower the unit cost of production by making greater use of inputs such as fertilizer. Nevertheless, the rapid increase of fertilizer prices in the world market has continued to adversely impact the poor small holder farmers, and increased the demand for fertilizer subsidy. Fertilizer subsidies, therefore, are expected to provide fertilizers to farmers at affordable prices while ensuring adequate returns on investment to the producing units. However, the resulting yield increase has to more than compensate for the increase in cultivation cost, i.e., increased revenue generated by the subsidy has to be higher than the increased cost from the subsidy. There are numerous reasons for governments to subsidize fertilizer as a policy. The two main reasons, however, can be viewed as political and economic. From a political perspective, the key reason has to do with exchanging political favours which is said to create political benefits. From an economic perspective, the main purpose of the fertilizer subsidy is to reallocate resources with the intention of altering economic activity and behaviour to achieve a desired outcome. Economic arguments for using fertilizer subsidy includes off-setting various market imperfections, exploiting economies of scale and more specifically, meeting social policy objectives such as protecting the poor, changing the income distribution and retaining people in farm business. 10.3 Empirical Implications Fertilizer costs account for a significant proportion of the cost of cultivation of rice, accounting for over one-fifth of the total cash cost of cultivation and more than a half of the material cost. One of the major constraints facing agricultural activities of farmers has been the increasing world market price of fertilizer. This has had both adverse economic and political implications on individual farm families as well as on the overall economy as a whole. The latter is reflected in the amount spent on fertilizer subsidy which has increased substantially; more than 10 times from Rs. 0.6 billion in 1994 to Rs. 6.8 billion in 2005, equivalent to 0.3 per cent of total GDP.
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There are many arguments in favour of and against a fertilizer subsidy scheme attributed to farmers, consumers, government, environmentalists, etc., with both economic and non-economic implications. The benefits of a fertilizer subsidy are argued to include the following: fertilizer subsidy will stimulate fertilizer demand and enable the marketing of inputs to obtain benefits from economies of scale and thereby reduced prices of other inputs; increased use of fertilizer may in turn lead to higher agricultural output or incomes of farmers and traders. This will assist in ensuring greater degree of food self sufficiency in poorer countries; an incremental change in yield can have a significant impact on trade flows increasing agricultural exports and decreasing imports. It saves foreign exchange and at the same time it earns foreign exchange; and it will also generate several non-economic benefits whose economic impacts are difficult to measure. It may provide social protection by improving food security and alleviating poverty as a result of economic benefits i.e., yield and income increase.

Yield (mt/ha); Production (million mt)

4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 1983 1984 1989 1994 1995 1996 1997 1998 1999

Average yield (MT/ha) Production (mill MT) Fertilizer use (kg/ha)

500 450 400 350 300 250 200 150 100 50 0 2005

2000

2001

2002

2003

On the other hand, the arguments against a fertilizer subsidy include the following:

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2004

Fertilizer use (kg/ha)

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Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2006 Agriculture Reforms: Irrigation Water Charges and Land Policy

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even though a popular belief with regard to fertilizer subsidy is that it encourages fertilizer application resulting in a greater yield increase, it is rather doubtful that this is the case. For example, while fertilizer application rates more than doubled among rice farmers over the period 1983-2005, average yield increased by only about 9 per cent (Figure 10.1); one of the key disadvantages of a fertilizer subsidy is that it entails a high budgetary cost to the government. The fertilizer subsidy for crops accounted for Rs. 6.8 billion at a subsidy rate of Rs. 23,000 per metric ton in 2005 and is likely to exceed 0.4 per cent of GDP in 2006 when a 50 kg urea bag is provided at Rs. 350 with a fertilizer cost of Rs. 32,200 per metric ton in the present context;

fertilizer subsidy also encourages wasteful use of urea. Over application of urea relative to Potash (K2O) and Phosphate (P2O5) fertilizers will yield nutrient imbalances in the soil resulting in long term adverse effects on soil fertility. (Figure 10.2); improper and excessive fertilizer application, especially nitrates and phosphates cause serious harmful impacts on human health and on the environment as a whole. Fertilizer tends to leach away into down stream water bodies causing human ill health. Deposition of nitrates and phosphates in water bodies or Eutrophication causes excessive algae growth resulting in oxygen depletion, water contamination and fish mortality; fertilizer use in paddy has increased sharply as a result of the subsidy while it has shown a slight increase in the tea sector, although it was stagnant since the 1990s (Figure 10.3). Fertilizer use has been almost stagnant in all other crops for the last decade or so. Further, stimulation of fertilizer use for unprofitable and uneconomical ventures i.e., diversion of scarce resources from other productive investments by the fertilizer subsidy has adverse impacts for the long term sustainability of the economy; and

ineffective targeting has become a serious concern in the present context since a larger proportion of the subsidy is captured by wealthier rice farmers regardless of the objective of benefits accruing to resource poor small farmers.2 A larger share of farmers does not obtain the subsidized fertilizer at the subsidized price and a

About 51 per cent of the total rice area is cultivated by households in the top 40 per cent of the rural expenditure quintiles while only 25 per cent is cultivated by the households in the lowest two quintiles (World Bank, 2003, Sri Lanka Promoting Agricultural and Rural Non-farm Sector Growth, Report No. 25387-CE).

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substantial amount is sold on the black market due to poor targeting, combined with some amount of corruption of government officers.

200 180 160 140 ('000 MT) 120 100 80 60 40 20 0 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Year

400000 350000 300000 Metric tons 250000 200000 150000 100000 50000 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Paddy OFC*

Tea EAC*

Rubber Others

Coconut

Notes: OFC refers to Other Field Crops and EAC refers to Export Agricultural Crops.

Source: National Fertilizer Secretariat of Sri Lanka Statistics. 10.4 Conclusion While it may be argued that the fertilizer subsidy scheme moves the economy towards equity and security from an economic development perspective, there still remains some
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ambiguity on whether it can be justified. It is, however, clearer that the fertilizer subsidy scheme cannot be justified on grounds of economic efficiency. The yield increase achieved has been lower compared to the fertilizer usage since the enactment of the fertilizer subsidy scheme. It provides evidence that suggests the need for the following: (i) to correct problems related to the fertilizer subsidy and (ii) to move towards long-term policy goals. Nevertheless, a withdrawal of the subsidy may create serious problems to small scale farmers, particularly to those engaged in the paddy sector. A withdrawal of the subsidy and the likely increase in cost of production may cause a shift away from paddy. It may lead to an outflow of foreign exchange due to higher rice imports; and to greater poverty and landlessness in the rural sector and increasing malnutrition in the rural economy. Thus, what needs to be done is to manage the fertilizer subsidy effectively and efficiently targeting only the farmers who are in need of the subsidy. The governments role in this regard is to support resource poor farmers who are in poverty and who do not have enough purchasing power to buy fertilizer at market prices or acquire credit to do so. The key issues of concern in this regard are as follows:

proper identification of the proportion of farmers who are truly in need of the subsidy and proper distribution of subsidized fertilizer by a system such as a voucher scheme3 are of great importance. Farmers should be permitted to purchase fertilizer from any dealer who will be able to redeem the voucher with possibly a commission; fertilizer subsidy should not be confined to urea. However necessary steps could be taken to adjust prices of all fertilizers for minimizing nutrient imbalance and adverse environmental effects; steps should be taken to improve knowledge of farmers on scientific fertilizer application including accurate diagnosis of soil nutrient deficiencies, determination of fertilizer types and quantity; farmer attitudes should be corrected with a view to shifting the emphasis from increased use of fertilizers to use of organic, inorganic and biological fertilizers optimally; infrastructure facilities such as transportation and storage of fertilizer should be developed in order to prevent unnecessary delays in distributing fertilizers;

Voucher is a coupon carrying the name, predetermined quantity of fertilizer and cash value given to target farmers.

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there should be a better regulatory framework to prevent inefficiencies and failures such as selling vouchers to other farmers, selling poor quality fertilizers, etc.; and there should be a better monitoring mechanism to ensure the farmer uses the subsidy correctly. Efficient and appropriate and well equipped and staffed institutions should be established to ensure that subsidized fertilizer reach only the target farmers, and on time, in adequate amounts and at a minimal cost.

Since fertilizer subsidy is merely a short term policy goal, the government has a greater role to play in developing infrastructure, providing adequate agricultural research and extension, improving rural education and farmer capacity building as long term investments. These have to be coupled with improving the rural credit market in order to increase the availability of credit for farmers to purchase fertilizer. Greater attention should be paid to institutional development, including improving legal systems, introducing proper grading and standardization mechanism, infrastructure and market information. An improved economic environment for the agriculture sector will allow the government more leeway to phase out the fertilizer subsidy over time. Any attempt in this direction should be concurrent with the development of a competitive market. Private sector participation in fertilizer production and import should be encouraged while the government should play a regulatory role to ensure timely delivery of fertilizer of good quality and fair price to farmers.

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