oversight

Cotton Program: The Marketing Loan Has Not Worked

Published by the Government Accountability Office on 1990-07-31.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

      Resources, Community,   and
      Economic Development    Division

      B-240157

      July 31, 1990

      The Honorable David Pryor
      Chairman, Subcommittee on Agricultural
        Production and Stabilization of Prices
      Committee on Agriculture, Nutrition and
        Forestry
      United States Senate

      Dear Mr. Chairman:

      In response to your request of March 20,1989, this is our report on the U.S. Department of
      Agriculture’s marketing loan program for cotton. As you requested, our analysis was
      conducted with a view toward identifying potential options for improving the program’s
      effectiveness. This report provides matters for congressional consideration to help ensure
      that the cotton marketing loan program’s objective is achieved.

      As arranged with your office, unless you publicly announce its contents earlier, we plan no
      further distribution of this report until 5 days after the date of this letter. At that time, we
      will send copies to the appropriate House and Senate committees and subcommittees;
      interested members of Congress; the Secretary of Agriculture; the Director, Office of
      Management and Budget; and other interested parties.

      This work was performed under the general direction of John W. Harman, Director, Food and
      Agriculture Issues, who can be reached at (202) 275-5138. Other major contributors to this
      report are listed in appendix I.

      Sincerely yours,




$!.     Dep@
      Assistant Comptroller General
Executive Summary


             The Food Security Act of 1985 introduced a new concept-the mar-
Purpose      keting loan-as part of the U.S. Department of Agriculture’s (USIIA)
             price and income support program for cotton. The marketing loan was
             devised to help keep U.S. cotton prices competitive in world markets,
             thus encouraging producers to sell their cotton instead of keeping it
             under loan and off the market. It is critical that U.S. cotton remain com-
             petitive in world markets because, historically, about one-half of U.S.
             cotton has been available for export.

             Because the effectiveness of the marketing loan program was in ques-
             tion, the Chairman, Subcommittee on Agricultural Production and Stabi-
             lization of Prices, Senate Committee on Agriculture, Nutrition and
             Forestry, asked GAO to analyze the marketing loan to determine if (1) the
             program is meeting its objective, (2) the Secretary of Agriculture has
             fully used his authority to make U.S. cotton competitive, (3) the Secre-
             tary has fully used his authority to maintain year-ending stocks at
             approximately 4 million bales, and (4) options are available to improve
             the program’s effectiveness.


             The overall objectives of USDA'S cotton program include (1) protecting
Background   U.S. farm income, (2) maintaining competitive U.S. cotton prices in
             world markets, and (3) managing cotton supply levels for domestic mill
             use and export. The federal costs associated with USDA'S cotton program
             from fiscal years 1986 through 1989 averaged about $1.5 billion a year.

             To help protect US. farm income, the 1985 act directs the Secretary of
             Agriculture to provide nonrecourse loans to cotton producers that allow
             them to forfeit their cotton to USDA as full loan repayment. A nonre-
             course loan, in effect, assures producers a guaranteed minimum price
             for the cotton they pledge as loan collateral. Nonrecourse loan rates are
             calculated by USDA following a statutory formula that is based on histor-
             ical market prices. The loans mature in 10 months, but they can be
             extended an additional 8 months, at the producer’s request, unless U.S.
             cotton prices are high relative to historical prices.

             The marketing loan changed the nonrecourse loan repayment process by
             permitting producers to repay their loans at the lower of the loan rate or
             the USDA-calculatedworld price for cotton. The marketing loan was
             devised in an attempt to keep U.S. cotton prices competitive in world
             markets. It was expected to provide producers an incentive during
             periods of low market prices to redeem their loans and to sell their
             cotton.


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                         Executive   Sumnuuy




                         As a tool for managing cotton supplies, the 1985 act authorizes the Sec-
                         retary to utilize, to the maximum extent practicable, an acreage reduc-
                         tion program (ARP) to help achieve an annual cotton carryover stock
                         level of 4 millon bales. Carryover stocks refer to the amount of U.S.
                         cotton on hand at the end of each crop year. For U.S. cotton, crop years
                         begin August 1 and end July 3 1.


                               analysis shows that the marketing loan has not met its objective of
Results in Brief         GAO'S
                         keeping U.S. cotton prices competit&e in world markets. Specifically,
                         during crop years 1987 and 1988, when the world price was below the
                         loan rate, the marketing loan did not provide producers the needed
                         incentive to redeem their loans and to sell their cotton at the lower
                         world price. Producers lacked this incentive because the cost of
                         redeeming loans was equal to or higher than the world price. Thus, U.S.
                         cotton prices were not competitive in world markets, the world market
                         share of U.S. cotton fell as exports decreased, and U.S. carryover stocks
                         grew significantly above the 4million bale level targeted in the 1985 act
                         as producers tended to keep their cotton under loan.

                         Since passage of the act, the Secretary of Agriculture has considered
                         options available to him and has used his authority to implement those
                         program provisions and changes that were reasonable and prudent to
                         make US. cotton competitive and to maintain year-ending stocks at
                         approximately 4 million bales. Although these actions were steps in the
                         right direction, GAO believes that several factors continue to inhibit the
                         cotton program from working as intended. These factors are (1) a nonre-
                         course loan rate that is too high, (2) an 8-month loan extension for pro-
                         ducers that is routinely available, and (3) a mandatory ARP
                         announcement date that is too early. Addressing these factors will
                         require congressional action.



Principal Findings

The Marketing Loan Has   GAO'S analysis shows that U.S. cotton prices were not competitive in

Not Kept U.S. Cotton     world markets for a 14-month period during crop years 1987 and 1988.
                         From February 1988 through March 1989-the period of greatest price
Competitive              divergence-the price of U.S. cotton was above the world price by as
                         much as 10 cents a pound. Although the marketing loan repayment fea-
                         tures were in effect during 9 months of that price divergence period,


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                           Executive   Summary




                           U.S. prices remained above world prices. If the marketing loan program
                           had been effective, prices for U.S. cotton would have adjusted to be com-
                           petitive with world prices.

                           The divergence between the U.S. and world price was primarily the
                           result of producers not having adequate incentive to redeem their loans
                           and to sell their cotton at the world price. Producer incentive was
                           lacking because the cost of redeeming loans (including any associated
                           interest and warehouse charges) was equal to or higher than the price
                           producers would have received by selling their cotton at the world price.

                           One way to encourage producers to redeem their loans and to sell their
                           cotton would be to lower the nonrecourse loan rate to a level below cur-
                           rent market prices. In this way, producers would be less inclined to hold
                           their cotton under loan, or ultimately, to forfeit it to the government.
                           According to USDA, lowering the nonrecourse loan rate would, in the long
                           run, result in reduced program costs to the government.

                           An additional factor that makes it difficult for the marketing loan to be
                           effective is that producers are routinely provided an S-month extension
                           to their basic lo-month nonrecourse loan, which allows them to hold
                           cotton off the market for up to 18 months while they speculate on
                           higher prices. Providing the Secretary of Agriculture with authority to
                           extend the loan only when needed to minimize cotton forfeitures would
                           enable the marketing loan to work more effectively.


The Secretary Has          The Secretary of Agriculture has made several adjustments to improve
                           the effectiveness of the marketing loan program. For example, in August
Attempted to Improve the   1988 he announced that under certain conditions the government would
Marketing Loan Program     pay storage and interest costs for cotton under loan. These changes were
                           not fully successful in making U.S. cotton prices competitive in world
                           markets. Consequently, in October 1989 the Secretary made additional
                           changes in the program. For example, he required producers to pay
                           storage and interest costs during the S-month loan extension period. The
                           effectiveness of these latest changes has not yet been fully tested. Not-
                           withstanding these changes, GAO believes that two factors-the high
                           nonrecourse loan rate and the routine availability of the S-month loan
                           extension-continue to inhibit the marketing loan program’s effective-
                           ness. These factors will require congressional action.




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                                Executive   Summary




The Se<cretary Has              The Secretary of Agriculture has used his primary tool-the rn~41-1      an

Attemp %tnrl
        LCU
             tn lKn;ntain
              bU   lVlC%lJ
                          the   attempt to maintain cotton carryover stocks at the $-million bale level
                                targeted by the 1985 act. However, carryover stocks, ranging from 4.9
Target
z   1 Carq-------
              ~uver Stock       million bales in crop year 1986 to 7.03 million bales in crop year 1988,
Level                           have consistently exceeded this target.

                                The Secretary’s ability to achieve a target carryover stock level is
                                impeded by a legal requirement that he announce the ARP rate no later
                                than November 1 each year. USDA and industry officials believe that if
                                the ARP announcement date were delayed at least 2 months (from
                                November to January), the Secretary would have more complete data on
                                cotton production and could make more informed judgments about what
                                the appropriate ARP rate should be.


                                In providing options to help achieve the objectives of keeping U.S.
Matters for                     cotton prices competitive in world markets and maintaining target car-
Consideration by the            ryover stock levels, GAO believes that the Congress should consider
Congress                        including provisions in the 1990 farm legislation to provide for (1) a
                                lower nonrecourse loan rate that represents a fraction of the current
                                U.S. or world price, whichever is lower, to increase producers’ incentive
                                to redeem their loans and to market their cotton; (2) an S-month exten-
                                sion to the basic lo-month nonrecourse loan that would be available at
                                the discretion of the Secretary of Agriculture only when needed to mini-
                                mize cotton forfeitures to the government; and (3) a delay of the ARP
                                announcement date to provide the Secretary more time to obtain needed
                                data on cotton production.


                                Although GAO did not obtain formal agency comments on a draft of this
Agency Comments                 report, GAO discussed the information contained in the report with USDA
                                officials, and their comments have been included where appropriate.




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Contents


Executive Summary                                                                                    2

Chapter 1               The Objectives of USDA’s Cotton Program                                      8
Introduction            Why the Marketing Loan Was Established, and How It
                            Works
                                                                                                    10

                        The Marketing Loan’s Effect on USDA’s Cotton Program                        11
                        Objectives, Scope, and Methodology                                          12

Chapter 2                                                                                           16
The Marketing Loan      U.S. Cotton Was Not Competitive When U.S. and World                         17
                             Prices Diverged
Has Not Kept U.S.       Producers Lacked Incentive to Market Cotton at the AWP                      20
Cotton Competitive in   Additional Factors Make It Difficult for the Marketing                      22
World Markets                Loan to Be Effective
                        Administrative Changes to the Cotton Loan Program                           25
                             Have Not Been Fully Effective
                        Conclusions                                                                 26
                        Matters for Consideration by the Congress                                   28

Chapter 3                                                                                           29
The Secretary’s         Basis for the 4-Million Bale Carryover Stock Level
                        The Secretary Has Used the ARP in an Attempt to
                                                                                                    29
                                                                                                    29
Discretionary Actions       Achieve the Target Carryover Stock Level
Have Not Achieved       Delaying the ARP Announcement Date Could Better                             30
the Annual Target           Achieve the Target Carryover Stock Level
                                                                                                    31
Carryover Stock Level   Conclusions
                        Matter for Consideration   by the Congress                                  32

Appendix                Appendix I: Major Contributors to This Report                               34

Figures                 Figure 2.1: Relationships Between U.S. Cotton Price                         18
                            Overseas and the World Price
                        Figure 2.2: Relationships Between US. Spot Price, the                       19
                            AWP, and the Nonrecourse Loan Rate in the Domestic
                            Market
                        Figure 2.3: Relationships Between U.S. Spot Price, the                      21
                            AWP, the Nonrecourse Loan Rate, and the Cost of
                            Redeeming Cotton




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            Contents




            Abbreviations

            AFtP       acreage reduction program
            Ascs       Agricultural Stabilization and Conservation Service
            AWP        adjusted world price
            CCC        Commodity Credit Corporation
            GAO        General Accounting Office
            USDA       U.S. Department of Agriculture


            Page 7                                        GAO/RCED&%170   Cotton Program
Chapter 1

Introduction


                           Cotton is the single most important textile fiber in the world, according
                           to the U.S. Department of Agriculture (USDA). It is produced in about 75
                           countries and accounts for about 67 percent of all fibers used. China, the
                           Soviet Union, and the United States account for nearly 60 percent of
                           world cotton production, which, during the period 1984 through 1988,
                           averaged 80.6 million bales (38.7 billion pounds) per year. The United
                           States is the largest cotton exporter. It produces about 16 percent of the
                           world’s cotton and uses about 8 percent. This means that one-half of the
                           U.S. cotton production is available for export.

                           Since 1929, USDA has administered a cotton program affecting various
                           aspects of U.S. cotton production, prices, and farm income.* The govern-
                           ment costs associated with USDA’S cotton program from fiscal years 1986
                           through 1989 averaged about $1.5 billion a year.

                           USDA’SAgricultural Stabilization and Conservation Service (AS%) is
                           responsible for the day-to-day operations of the cotton program with
                           funds provided through the Commodity Credit Corporation (CCC). CCC is
                           a government-owned corporation created within USLHto stabilize, sup-
                           port, and protect farm prices and producer income for a variety of agri-
                           cultural commodities.


The Objectivesof           cotton supply levels for domestic mill use and export, (2) protecting U.S.
USDA’sCotton               farm income, and (3) maintaining competitive US. cotton prices in world
Program                    markets. Under current U.S. farm policy, USDA relies on four primary
                           tools-acreage reductions, import quotas, target prices/deficiency pay-
                           ments, and nonrecourse loans-to help accomplish these objectives.


Managing Cotton Supplies   As a tool for managing cotton supplies for domestic mill use and
                           exports, the Food Security Act of 1985 provides the Secretary of Agri-
                           culture with discretionary authority to establish an acreage reduction
                           program (ARP). Under this program, producers are required to comply
                           with the Secretary’s directive to remove acreage from production as a
                           condition for participating in USDA’Scotton program. The act specifically
                           provides for the Secretary, to the maximum extent practicable, to utilize



                           ‘This report addresses USDA’s program for upland cotton which represents about 98 percent of all
                           cotton grown in the United States.




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                       chapter 1
                       Introduction




                       an ARP that will result in a U.S. cotton carryover stock level each year of
                       4 million bales.2


Protecting U.S. Farm   To help protect U.S. farm income, an annual cotton import quota of
                       about 125,000 bales (60 million pounds) has been imposed pursuant to
Income                 the Agricultural Adjustment Act of 1933, as amended. This quota was
                       imposed to prevent U.S. textile mills from purchasing unlimited supplies
                       of cotton from foreign sources. In addition to this annual quota, the
                       Food Security Act of 1985 provides for a special import quota that is
                       equal to 21 days of U.S. mill use. This special quota is to be implemented
                       during go-day periods when the current U.S. spot price3 for cotton
                       exceeds historical price averages by specific amounts.

                       To further help protect U.S. farm income, the 1985 act continues the use
                       of a deficiency payment program that provides direct government pay-
                       ments to cotton producers when market prices are low. Under this pro-
                       gram a minimum target price is legislatively set each crop year, and
                       deficiency payments are made to support producers’ incomes whenever
                       the calendar year national average price received by producers for their
                       cotton falls below the target price.

                       In conjunction with the target price/deficiency payment program, the
                       1985 act also continues the use of nonrecourse loans to cotton pro-
                       ducers. CCCmakes these loans at an established loan rate,4 and pro-
                       ducers, in turn, pledge their stored cotton as collateral. Essentially,
                       these loans establish a floor price for cotton, which guarantees pro-
                       ducers a minimum price. The loans are nonrecourse because producers
                       may forfeit their stored cotton to ccc as payment of their loan in full,
                       regardless of the current market value of the cotton.

                       Nonrecourse loans for cotton mature 10 months from the first day of the
                       month in which they were made. At the end of the lo-month loan
                       period, producers can elect to (1) repay the loan, (2) forfeit their


                       ‘U S carryover stocks are defmed as the amount of cotton on hand at farms, warehouses, and mills
                       or itransit at the end of each crop year. A cotton crop year begins August 1 and ends July 31 of thi
                       following calendar year.

                       3U.S. spot price represents the average of quoted prices for cotton in seven U.S. geographical areas,
                       as designated by the Secretary of Agriculture.

                       4The nomm          loan rate is calculated by USDA following a statutory formula that is based on
                       historical market prices. This rate is expressed in cents per pound of cotton and, under the 1986 act,
                       cannot be less than 60 cents for any given crop year.



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                          Chapter 1
                          Introduction




                          pledged cotton as full loan repayment, or (3) request that the loan
                          maturity date be extended for 8 months. The criterion in the act for
                          allowing producers to extend their loan for 8 months has proven to be so
                          lenient that availability of this option is practically assured. Thus, pro-
                          ducers routinely have an 18-month period available in which they can
                          hold their cotton under loan and keep it off the market5


Maintaining Competitive   To help maintain competitive U.S. cotton prices in world markets, the
                          1985 act introduced a new repayment tool-the marketing loan-as
U.S. Cotton Prices        part of USDA’S nonrecourse loan program. It is critical that U.S. prices
                          remain competitive in relation to world prices because about one-half of
                          all domestic cotton production is available for export. Under the mar-
                          keting loan concept, whenever the adjusted world price (AWP)‘j for cotton
                          falls below the nonrecourse loan rate established by USDA, producers
                          may repay their loans at the AWP.


                          At the time of legislative debate leading to the 1985 act, the U.S. cotton
Why the Marketing         market was characterized by falling domestic mill use, sharply lower
Loan Was Established,     exports, rising domestic stocks, growing textile imports, and low farm
and How It Works          prices. The sluggish market for U.S. cotton was aggravated by a world-
                          wide record supply of cotton in crop year 1984 of nearly 88 million
                          bales, which exceeded worldwide use by about 18 million bales. This sit-
                          uation caused a worldwide buildup of inventories that year to a record
                          42 million bales and a sharp drop in world market prices. As a result of
                          those conditions, the marketing loan was devised in an attempt to retain
                          the government’s cotton loan program for producers while keeping IJS.
                          cotton prices competitive in world markets. The marketing loan was
                          expected to provide producers an incentive to market the cotton they
                          used as loan collateral rather than to forfeit it and add to the federal
                          government’s costs and accumulation of cotton stocks.

                          As mandated by the 1985 act, if the ASP for cotton is below the USDA-
                          established nonrecourse loan rate, the Secretary must implement the
                          marketing loan repayment provisions to make U.S. cotton prices compet-
                          itive in world markets. In doing this, the Secretary is to implement either

                           “Technically, while U.S. cotton under loan is frequently held by merchants, we use the term “pro
                           ducers” throughout this report to refer to both merchants and producers.

                           ‘The adjusted world price (AWP) represents the prevailing world price-the average of the five
                           lowest quoted prices for cotton from various countries in the Northern European market-as calcu-
                           lated weekly and adjusted to U.S. quality and location by the Secretary of Agriculture.



                           Page 10                                                         GAO/RCED-90-170     Cotton   Program
                       chapter1
                       Introduction




                       of two loan repayment plans- Plan A or B-that he must announce by
                       November 1 of each year for the upcoming cotton crop. Once announced,
                       the repayment plan cannot be changed during the entire period that the
                       crop is under loan, which, as discussed earlier, can be for as long as 18
                       months.

                       Under Plan A, the marketing loan repayment rate is fixed by the Secre-
                       tary at a level that cannot be less than 80 percent of the established loan
                       rate. Under Plan B, the marketing loan repayment rate equals the AWP or
                       the loan rate, whichever is lower. The Secretary selected Plan A for the
                       1986 crop and set the marketing loan repayment rate at 80 percent of
                       the USDA-establishednonrecourse loan rate.’ He subsequently selected
                       Plan B for the 1987 through 1990 crops.


                       For crop year 1986, the intended effect of the marketing loan program
The Marketing Loan’s   was achieved. U.S. spot prices, which had previously been above the
Effect on USDA’s       nonrecourse loan rate, dropped dramatically below that loan rate in line
Cotton Program         with the newly established AMT. Consequently, U.S. cotton-which      had
                       previously been noncompetitive in world markets-became competitive.
                       As a result, cotton exports rebounded to 6.6 million bales and U.S. carry-
                       over stocks were reduced sharply from 9.3 million bales at the beginning
                       of the crop year (August 1, 1986) to 4.9 million bales by the crop year’s
                       end (July 31, 1987).

                       These developments were initially taken as evidence by USDA and the
                       cotton industry that the marketing loan program was accomplishing its
                       objective. It is important to point out, however, that during part of the
                       period that the 1986 crop under loan could be redeemed, favorable
                       market conditions caused the U.S. spot price and the AWP to reach a high
                       of about 74 cents per pound. Nevertheless, because Plan A of the mar-
                       keting loan program was in effect, producers were allowed to redeem
                       their loans at 44 cents per pound (i.e., 80 percent of the established loan
                       rate of 55 cents). Thus, producers could have received a price of up to
                       30 cents per pound above the loan repayment rate-l 1 cents from the
                       government and 19 cents from the marketplace.

                       According to the Assistant Secretary for Economics and the Director,
                       Economics Analysis Staff, USDA, the favorable market conditions in crop

                       7The nonrecourse loan rate for the 1986 cotton crop was 55 cents per pound. Thus, the marketing
                       loan repayment rate, which under Plan A was 80 percent of the loan rate, was set at 44 cents per
                       pound.



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                          Chapter 1
                          Introduction




                           year 1986 were the primary reason that U.S. producers redeemed their
                           loans and sold their cotton. The director told us that the Plan A repay-
                           ment feature of the marketing loan program had little to do with the
                           movement of U.S. cotton at that time, although the use of Plan A as
                           opposed to Plan B had resulted in producers receiving an additional sub-
                           sidy payment (i.e., 11 cents per pound) from the government that was
                           not warranted.

                           Because USDAwas locked into a lower nonrecourse loan repayment rate
                           under Plan A even after market conditions and cotton prices improved
                           during crop year 1986, USDA has opted not to use Plan A since that time.
                           The potential for high government costs and the lack of flexibility to
                           adjust the repayment rate when warranted by market conditions made
                           Plan A an undesirable marketing loan program feature, according to the
                           USDA Economics Analysis Staff Director.

                           In February 1988, after many months of U.S. cotton prices rising and
                           falling in line with the AWP, the two prices diverged, and U.S. cotton was
                           no longer competitive in world markets. Even after the AWP dropped
                           below the loan rate in July 1988 and loans could be redeemed at the
                           lower AWP under Plan B of the marketing loan program, U.S. cotton
                           remained noncompetitive as evidenced by US. spot prices staying above
                           the Aw by as much as 10 cents per pound. During that price divergence
                           period, producers had no incentive to sell their cotton at the AWP. As a
                           result, cotton exports dropped, and USDA projected in February 1989
                           that the U.S. carryover stock level for crop year 1988 would be above 9
                           million bales, more than double the 4-million bale level targeted by the
                           act.6 This projection caused USDA, the cotton industry, and the Congress
                           to express concern about the effectiveness of the marketing loan.


                           On March 20,1989, the Chairman, Subcommittee on Agricultural Pro-
Objectives, Scope, and     duction and Stabilization of Prices, Senate Committee on Agriculture,
Methodology                Nutrition and Forestry, requested that we analyze the cotton marketing
                           loan program and identify options for improving its effectiveness. Spe-
                           cifically, on the basis of the Chairman’s letter and subsequent discus-
                           sions with his office, we addressed the following questions:

                         . As currently implemented, is the marketing loan for cotton meeting its
                           objective? If not, why?


                           %ubsequent to this projection, the actual crop year 1933 carryover stock level was 7.03 million bales.



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                Chapter 1
                Introduction




            l Has the Secretary of Agriculture fully used his authority to make U.S.
              cotton competitive?
            l Has the Secretary fully used his authority to maintain stocks at approxi-
              mately 4 m illion bales?
            s Are there any options available to improve the program ’s effectiveness?

                In addressing these questions, we examined Title V of the Food Security
                Act of 1985, which covers all aspects of USDA'S cotton program , as well
                as earlier legislation governing the program . We researched pertinent
                literature and documentation on the cotton program , including legisla-
                tive history files, congressional hearings, USDAcotton reports on
                domestic and foreign market conditions, and economic studies per-
                formed by USDA and the cotton industry. In addition, we obtained infor-
                mation and documentation from USDA officials and industry
                organizations to aid in evaluating the marketing loan program ’s effec-
                tiveness. We did not verify the accuracy of the information obtained
                from these sources.

                We interviewed pertinent USDA officials and cotton industry representa-
                tives, including the National Cotton Council, which represents all seg-
                ments of the U.S. cotton industry. Our primary USDA contacts in
                Washington, DC., were with officials of the ASCSFibers Group who are
                responsible for managing the policy and regulatory aspects of the cotton
                program . Other ASCScontacts included county office representatives in
                Marion, Arkansas; Lubbock, Texas; and Bakersfield, California-all      are
                located in major cotton-producing states. We also contacted USDA offi-
                cials from the Economic Analysis Staff and the Economic Research Ser-
                vice, Washington, DC.; the National Agricultural Statistics Service,
                Washington, D.C., and Austin, Texas; and officials in the Kansas City
                Commodity and Management Offices, Kansas City, M issouri, who are
                responsible for maintaining summary data on cotton placed under USDA'S
                loan program .

                We obtained an overall industry view of the cotton loan program from
                the National Cotton Council and also met with representatives of indi-
                vidual segments of the cotton industry to obtain their views on the mar-
                keting loan and to discuss options available for improving the program .
                The individual industry segments included the American Cotton Ship-
                pers Association in Washington, D.C., whose members handle 80 percent
                of the cotton sold to domestic textile m ills (excluding cotton bought
                directly by the m ills) and 90 percent of all U.S. cotton exports; cotton
                merchants in Memphis, Tennessee, and Bakersfield, California, two
                prominent U.S. geographic cotton marketing locations; the American


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Chapter 1
Introduction




Textile Manufacturers Institute, Inc., Washington, D.C., whose members
account for about 85 percent of all textile production in the United
States; the Southern Cotton Ginners Association, Memphis, Tennessee,
which represents ginners in the U.S. Delta cotton-producing region;
Calcot, Ltd., Bakersfield, California, which is the nation’s largest cotton
marketing cooperative; the Texas Association of Cotton Producer Orga-
nizations and the Plains Cotton Cooperative Association, both of Lub-
bock, Texas, which together account for over 50 percent of the cotton
produced in Texas; Staple Cotton Cooperative Association, Greenwood,
Mississippi, a Mid-South regional cooperative that reportedly markets
about one-eighth of all U.S. cotton; and five producers from two geo-
graphically disbursed cotton-producing regions-Critten       County,
Arkansas, and Kern County, California.

In our efforts to address the questions pertaining to the Secretary’s use
of his full authority to make the cotton program work, we did not ana-
lyze all of the multitude of options available to him. Rather, we identi-
fied those actions taken by the Secretary and determined whether they
were reasonable and prudent.

We performed our own economic analysis to determine if the marketing
loan for cotton was meeting its objective of making U.S. cotton competi-
tive. We did this by analyzing price relationships from the start of the
marketing loan program in August 1986 (crop year 1986) through
March 1990 (the latest data available at the time of the analysis). As a
result of this price analysis, we identified a 14-month period within crop
years 1987 and 1988 (from February 1988 through March 1989) as a
period of sustained and generally large differences between U.S. prices
overseas and world prices during which time U.S. cotton was not com-
petitive in the world market. Therefore, our detailed analysis as
presented in this report focuses on crop years 1987 and 1988, with spe-
cific emphasis on the 14-month period of greatest price divergence.

In performing our analysis, we reviewed the formulas used by the ASCS
Fibers Group to determine the AWP and its components and used ASCS’S
data on the AWP and domestic and world market cotton prices to measure
U.S. prices in relation to other countries’ prices. We also reviewed USDA
and ASCSdocuments that provided the rationale for the components used
in the AWP formula and interviewed cotton experts in USDA, the ASCS
Fibers Group, and the Economic Research Service, Commodity Eco-
nomics Division, to obtain information and data on the marketing of
cotton, cotton stocks, storage charges, and other cotton marketing costs.



Page 14                                        GAO/WED-90-170   Cotton Program
Chapter 1
Introduction




Chapter 2 is our analysis of whether the marketing loan is meeting its
objective. To a large degree, our analysis is based on the interrelation-
ships of four prices that come into play in marketing U.S. cotton. These
four prices have very precise, technical meanings. Consequently, to fully
understand the analysis presented in chapter 2, it is critical to under-
stand the price terminology used throughout the chapter. To facilitate
this understanding, the definition of each price follows:

1. World price, as used by USDA and the cotton industry, is the average of
the five lowest quoted prices for cotton delivered to Northern Europe
from various exporting countries.

2. U.S. price overseas is the average quoted price for U.S.-grown cotton
delivered to overseas markets, specifically Northern Europe.

3. Adjusted world price (AW) is the prevailing world price for cotton-
the average of the five lowest quoted prices from various countries in
the Northern European market-as calculated weekly and adjusted to
U.S. quality and location by the Secretary of Agriculture. The AWP is
unique to the U.S. cotton marketing loan program.

4. U.S. spot price is the average quoted price for cotton in seven US.
geographical areas, as designated by the Secretary of Agriculture.

We discussed the information contained in this report with USDA officials
and have included their comments where appropriate. As agreed with
the Chairman’s office, we did not obtain formal agency comments on a
draft of the report.

We conducted our work between April 1989 and March 1990 in accor-
dance with generally accepted government auditing standards.




Page 16                                        GAO/RCElMO-170   Cotton   Program
                                                                                                                                     J




T h e M a rke tin g L o a n H a s N o t K e p t U .S .C o tto n
C o m p e titivein W o rld M a rke ts

                      O u r analysis s h o w s th a t, since e n a c tm e n t o f th e F o o d Security A c t o f
                      1 9 8 5 ,th e m a r k e tin g l o a n h a s n o t a c h i e v e d its objective o f k e e p i n g U .S .
                      cotton prices c o m p e titive in world m a r k e ts. D u r i n g crop years 1 9 8 7 a n d
                      1 9 8 8 ,U .S . cotton prices o v e r s e a s w e r e significantly a b o v e world prices
                      for 1 4 consecutive m o n ths. A t th e s a m e tim e , U .S . s p o t prices w e r e
                      a b o v e th e A W . A s a result, U .S . cotton exports d e c l i n e d a n d carryover
                      stocks g r e w b e y o n d th e 4-million b a l e ta r g e t level.’

                      D u r i n g th e 1 4 - m o n th p e r i o d w h e n th e price d i v e r g e n c e occurred, U .S .
                      p r o d u c e r s lacked incentive to r e d e e m their l o a n s a n d to m a r k e t their
                      cotton a t prices n e a r th e world price, or a t th e A W w h e n th e m a r k e tin g
                      l o a n w a s in e ffect. P roducers lacked incentive to r e d e e m their l o a n s
                      b e c a u s eth e y w o u l d h a v e m a d e th e s a m e m o n e y b y k e e p i n g their cotton
                      u n d e r l o a n a n d ultim a tely forfeiting it to th e g o v e r n m e n t. M o r e o v e r , th e
                      fact th a t U S . s p o t prices stayed significantly a b o v e th e costs o f
                      r e d e e m i n gcotton d u r i n g th e e n tire p e r i o d s u g g e s tsth a t U .S . p r o d u c e r s
                      w e r e speculating o n h i g h e r prices in th e fu ture. S u c h speculation w o u l d
                      likely h a v e i n d u c e d th e m to k e e p their cotton u n d e r l o a n a n d o ff th e
                      m a r k e t in a n a tte m p t to m a k e m o r e m o n e y .

                      T w o a d d i tio n a l factors m a k e it difficult for th e m a r k e tin g l o a n p r o g r a m
                      to b e e ffective. O n e ,import q u o ta s o n cotton insulate U .S . p r o d u c e r s
                      from world c o m p e titio n w h i c h m a y h a v e m a d e th e s e p r o d u c e r s m o r e
                      reluctant to sell their cotton a t lower prices. T w o , th e 8 - m o n th extension
                      to th e basic l o - m o n th n o n r e c o u r s el o a n allows p r o d u c e r s to h o l d their
                      cotton o ff th e m a r k e t for p e r i o d s o f u p to 1 8 m o n th s in a n ticipation o f
                      h i g h e r prices. P e r m i ttin g p r o d u c e r s to h o l d cotton o ff th e m a r k e t for u p
                      to 1 8 m o n th s is in direct c o n flict with th e m a r k e tin g l o a n p r o g r a m ’s
                      intent to r e l e a s ecotton into th e m a r k e tplace.

                      S ince 1 9 8 6 ,th e S e c r e tary o f Agriculture h a s u s e d his discretionary
                      a u thority to m a k e r e a s o n a b l ea n d p r u d e n t c h a n g e sto th e cotton l o a n
                      p r o g r a m in a n e ffort to k e e p U .S . cotton prices c o m p e titive in world
                      m a r k e ts. T h e c h a n g e sh e m a d e th r o u g h crop year 1 9 8 8 d i d n o t fully
                      a c h i e v e this objective, a n d a d d i tio n a l c h a n g e sm a d e in O c to b e r 1 9 8 9
                      h a v e n o t yet b e e n fully tested. Nevertheless, w e believe th a t legislative
                      c h a n g e sa r e also n e e d e dto k e e p U S . cotton c o m p e titive in world
                      m a r k e ts.



                      ‘A s m e n t i o n e din c h a p t e r 1, o u r detailed analysis focuseso n the p e r i o d of greatest price divergence,
                      from F e b r u a r y 1 9 8 8t h r o u g h M a r c h 1 9 8 9( c r o p years 1 9 8 7 a n d 1 9 8 8 ) .



                      Page 16                                                                      G A O / R C E D - 9 6 - 1 7 0Cotton P r o g r a m
                                  l

                        Chipter 2
                        The Marketing Loan Has Not Kept U.S.
                        Cotton Competitive in World Markets




                        To ensure that U.S. cotton is competitive in world markets, U.S. prices
U.S. Cotton Was Not     overseas must move in line with world prices. Ideally, the two prices
Competitive When        should be close and increase or decrease simultaneously with little or no
U.S. and World Prices   divergence. However, during 14 consecutive months in crop years 1987
                        and 1988 (from February 1988 through March 1989), the price of U.S.
Diverged                cotton overseas diverged significantly above the world price. This diver-
                        gence also appeared on the domestic cotton market, with U.S. spot
                        prices rising above the AWP. As a result, the U.S. share of the world
                        cotton market fell from 28.45 percent in crop year 1987 to 24.22 percent
                        in crop year 1988. U.S. cotton carryover stocks at the end of those two
                        crop years increased to 5.7 m illion bales and 7.03 m illion bales, respec-
                        tively, which was significantly above the 4.9-m illion bale carryover level
                        of crop year 1986 and the 4million bale level targeted by the 1985 act.

                        Figure 2.1 contrasts the U.S. price overseas with the world price for
                        cotton of comparable quality from the beginning of crop year 1987
                        (August 1987) through the end of crop year 1988 (July 1989). As figure
                        2.1 illustrates, the two prices diverged significantly from February 1988
                        through March 1989.




                        Page 17                                        GAO/RCEDBH70   Cotton   Program
                                                                                                                                                             ’   .


                                                                                           .           .
                                                      Chapter 2                                                                                                      .r
                                                      The Marketing Loan Has Not Kept U.S.
                                                      Cotton Competitive in World Markets




Figure 2.1: Relationships Between the U.S. Cotton Price Overseas and the World Price
Cents/lb.




73

70

67

84

61

58



 8187       9187 10187 11187 12187 1188 2l88   3188    4188 5188   6188   7188   8189   9188   10188   III88   12188   II89    2189   9l89   4189    5189    6189    7189
 Month/Year

        -         World Price
        I I I I   U.S. Price Overseas

                                                      Source: Compiled by GAO based on USDA/ASCS data.


                                                      Similarly, figure 2.2 illustrates price relationships on the domestic
                                                      cotton market. It shows that the price divergence that occurred in the
                                                      world market also appeared in the domestic market. Initially, from the
                                                      beginning of crop year 1987 (August 1987) through January 1988, US.
                                                      spot prices were generally in line with the AWP, with both prices above
                                                      the nonrecourse loan rate. Conversely, during the next 14-month
                                                      period-from     February 1988 through March 1989-U.S. spot prices
                                                      rose above the AWP by as much as 10 cents per pound.




                                                      Page 18                                                                 GAO/RCED90-170        Cotton   Program
         . .
                                                                            .
                                                             Chipter 2
                                                             The Marketing Loan Has Not Kept U.S.
                                                             Cotton Competitive in World Markets




Figure 2.2: Relationships Between U.S. Spot Price, the AWP, and the Nonrecourse Loan Rate in the Domestic Market
28      Cents/lb.




 8187     9187      10187 11107 12187   1180   2188   3180    4188   5188       6168   7108   8188   9108   IO/88   11188   12’88   II89   2189   3109   4189   5189   6189   7109
 Month/Year

        -           AWP
        m-11        U.S. Spot Price
        m           Nonrecourse Loan Rate

                                                             Note: The data represent the difference between each pnce and the nonrecourse loan rate. Therefore,
                                                             zero represents the effective nonrecourse loan rate for each crop year
                                                             Source CornplIed by GAO based on USDA/ASCS data


                                                             During the first 5 months of the 14-month price divergence period-
                                                             from February through June 1988-the AWP was above the nonrecourse
                                                             loan rate, so the marketing loan repayment features were not in effect.
                                                             Consequently, during that 5-month period, crop year 1987 cotton under
                                                             loan would have been redeemed at the loan rate. In addition, the
                                                             redeemer of that cotton would have had to reimburse ccc for the car-
                                                             rying charges associated with the loan (i.e., interest and warehouse
                                                             charges).

                                                             During the next 9 months of the 14-month price divergence period-
                                                             from July 1988 through March 1989-the AWP was below the loan rate
                                                             and the marketing loan repayment features were in effect. Therefore,




                                                             Page 19                                                                       GAO/FEED-90-170      Cotton Program
                                                       w
                      Chapter 2
                      The Marketing Loan Has Not Kept U.S.
                      C&ton Competitive  in World Markets




                      cotton under loan would have been redeemed at the AWP.2 If the mar-
                      keting loan program had been effective during this g-month period, it
                      would have caused U.S. spot prices to drop below the loan rate in line
                      with the AWP, and the price divergence would have been eliminated. This
                      price drop did not occur, however, because the repayment features of
                      the marketing loan program did not provide producers the incentive
                      needed to redeem their loans and market their cotton at the AWP.

Producers Lacked      prices and the AWP diverged, the cost of redeeming cotton under loan,
Incentive to Market   including associated carrying charges when applicable, was higher than,
Cotton at the AWP     or equal to, the price producers would have received for their cotton in
                      the world market at the ART. Under such a condition, producers who
                      redeemed their loans and marketed their cotton at the AWP (under Plan
                      B) would have been no better off financially than if they were to have
                      kept their cotton under loan or forfeited it to the government. There-
                      fore, producers lacked incentive to market cotton held under loan unless
                      they could receive a price higher than the AWP.

                      As illustrated in figure 2.3, for the first 5 months of the 14month period
                      when U.S. spot prices were above the Am-from         February 1988
                      through June 1988-the AWP was above the loan rate. Consequently, the
                      marketing loan was not in effect. Producers’ costs for redeeming crop
                      year 1987 cotton under loan during that period equaled the crop year
                      1987 loan rate of 52.25 cents per pound plus accrued carrying charges
                      of 0.75 cents per pound per month (which is the industry’s estimate of
                      the average monthly interest and warehouse charges). Collectively,
                      those costs were greater than the AWP. Each month after February 1988,
                      U.S. spot prices increased to reflect the costs of redeeming cotton under
                      loan. The U.S. spot prices apparently included a price premium
                      demanded by producers, which caused those prices to remain above the
                      AW. While the AWP remained below the cost of redeeming cotton, U.S.
                      spot prices increased each successive month in line with the 0.75 cents-
                      per-pound monthly increase in carrying charges.

                      Subsequent to the initial 5-month period-July    1988 through March
                      1989-U.S. spot prices stayed above the loan rate for 8 of 9 months.
                      (This price divergence was illustrated previously in figure 2.2.) How-
                      ever, the AWP dropped below the loan rate for the entire g-month period,

                      %eginning August 22,1988, USDA required that CCC pay the associated carrying charges for cotton
                      redeemed when the AWP was below the loan rate or above the loan rate by no more than the amount
                      of accumulated carrying charges. This change was made to encourage loan redemption at the AWF’.



                      Page 20                                                     GAO/ICED-90-170     Cotton   Program
                                         Chapter 2
                                         The Marketing Loan Haa Not Kept U.S.
                                         Cotton Competitive in World Markets




Figure 2.3: Relationships Between U.S.
Spot Price, the AWP, the Nonrecourse
                                         66   Cants’lb.
Loan Rate, and the Cost of Redeeming
Cotton




                                         60


                                         58


                                         56




                                          10167          11187      12167          1188   za6         3laa        4n6         !v88        6l88
                                          MonthlYear

                                                  -       AWP
                                                  ----    U.S. Spot Prim
                                                  m       Nonrecourse Loan Rate
                                                  ammm    Costof RedeemingCotton

                                         Note: Cost of redeeming cotton equals the nonrecourse loan rate plus carrying charges, assuming that
                                         cotton was placed under loan in October 1987, at which time carrying charges started to accrue.
                                         Source: Compiled by GAO based on USDA/ASCS data.


                                         so the marketing loan repayment features under Plan B were in effect.
                                         Consequently, producers could redeem their loans at the AW without
                                         having to pay carrying charges. Under this condition, producers reacted
                                         in one of two ways. Some redeemed their loans and sold their cotton at
                                         the higher U.S. spot price, while others did not.

                                         The reasons some producers chose not to redeem their loans and to sell
                                         their cotton included (1) insufficient demand for the higher-priced
                                         cotton and/or (2) producers’ expectations for higher prices in the future.
                                         Moreover, producers would have lacked incentive to sell their cotton in
                                         world markets at the AWP because to do so, the net proceeds from such
                                         action would have been the same as if the cotton under loan were u&i-
                                         mately forfeited to the government. For example, if the loan rate was 50
                                         cents, producers would receive that amount if they forfeited their
                                         cotton. If, on the other hand, the AWP was 40 cents and producers
                                         redeemed their loans and sold their cotton at that amount, they would


                                         Page 2 1                                                        GAO/WED-9@170        C.&ton Program
                                                                                        .     - .


                        Chapter 2
                        The Marketing Loan Has Not Kept U.S.
                        Cotton Competitive in World Markets




                        receive 40 cents from the marketplace plus 10 cents from the govern-
                        ment (which is the difference between the loan rate and the AWP). The
                        total of these two amounts equals 50 cents, which is the same proceeds
                        that producers would receive if they forfeited their cotton.

                        One way to encourage producers in the future to redeem their loans and
                        to sell their cotton at the AWP would be to lower the basic nonrecourse
                        loan rate to a level below the market price. For example, the nonre-
                        course loan rate could be set to represent a fraction (e.g., 75 percent) of
                        the current U.S. spot price or world price, whichever is lower at the time
                        cotton is placed under loan. Accordingly, the nonrecourse loan rate
                        would vary with market conditions. For this reason, a maximum nonre-
                        course loan rate should be established to prevent extremely high rates
                        when current market prices are high. Lowering the nonrecourse loan
                        rate would (1) lower producers’ price expectations and encourage them
                        to market rather than to forfeit their cotton and (2) result in producers
                        retaining a greater amount of ownership in the cotton they place under
                        loan, which should reduce their tendency to hold that cotton under loan
                        for extended periods. Furthermore, this approach would put more of the
                        price risk of marketing cotton on producers rather than on the govern-
                        ment. This risk may be offset somewhat, however, by increased income
                        support subsidies that are available under other aspects of the cotton
                        program, such as deficiency payments.

                        We did not assess the potential cost impact of lowering the nonrecourse
                        loan rate. However, according to the Assistant Secretary for Economics,
                        and the Director, Economics Analysis Staff, USDA, this approach would,
                        in the long run, result in reduced program costs to the government.


                        Two other factors make it difficult for the marketing loan program to be
Additional Factors      effective. One, domestic textile mills, for the most part, are prohibited
Make It Difficult for   from importing cotton, so U.S. prices are insulated from world competi-
the Marketing Loan to   tion. Thus, producers in effect have a captive domestic market that may
                        result in their reluctance to sell cotton at lower prices. Two, producers
Be Effective            routinely have available an &month extension to their basic lo-month
                        nonrecourse loan. This extension makes it easier for producers to be
                        selective in the price they will accept for their cotton because it allows
                        them to hold their cotton off the market for up to 18 months. These
                        factors and their potential impact are discussed in the following
                        paragraphs.




                        Page 22                                        GAO/RCJZD-90-170 Cotton Program
                           Chapter 2
                           The Marketing Loan Has Not Kept U.S.
                           Cotton Competitive in World Markets




Import Restrictions        As a result of legal restrictions on importing cotton, only relatively small
                           amounts of foreign cotton can be imported. Consequently, domestic tex-
Hamper the Effectiveness   tile mills are effectively required to purchase their cotton from U.S. pro-
of the Marketing Loan      ducers. For this reason, U.S. spot prices are insulated from declines in
                           the AWP, as was the case from February 1988 through March 1989. With
                           an effective marketing loan program, however, the impact of the import
                           restrictions can be overcome.

                           Pursuant to section 22 of the Agricultural Adjustment Act of 1933, as
                           amended, an annual cotton import quota of about 125,000 bales
                           (60,000,OOOpounds) has been imposed. The Food Security Act of 1985
                           also provides that, under certain conditions, additional cotton equal to
                           21 days of domestic textile mill consumption can be imported. This spe-
                           cial quota is to be implemented only when the current U.S. spot price
                           exceeds historical averages by 130 percent. Furthermore, when imple-
                           mented, it is to remain in effect for a go-day period only. The special
                           quota has been implemented once since 1985, at which time domestic
                           textile mills could have imported approximately an additional 633,000
                           bales (303,894,717 pounds) of cotton.

                           Cotton imports in recent years have averaged about 3,000 bales, signifi-
                           cantly below the annual import quota of 125,000 bales. According to an
                           official of the American Textile Manufacturers Institute, Inc., which
                           represents about 85 percent of all U.S. textile production, domestic tex-
                           tile mills choose not to import cotton because this annual import quota
                           equates to less than one week’s consumption by their mills. This official
                           stated that it is not practical for domestic mills to import such a small
                           quantity of cotton.

                           This official further stated that the provisions of the special import
                           quota provided for in the 1985 act are so restrictive that, during the one
                           time it was triggered, it was not practical to have the imported cotton
                           purchased and delivered within the specified go-day period. According
                           to this official, at least 90 days is needed for the purchase and an addi-
                           tional 180 days is needed to take delivery of imported cotton. So, even
                           when domestic mills could import under these provisions, it was not
                           practical to do so under the go-day time constraint.

                           To demonstrate the effect that import quotas have had on the domestic
                           mills, the American Textile Manufacturers Institute, Inc., estimates that
                           when U.S. spot prices were higher than world prices in 1988 and 1989,
                           U.S. textile mills paid at least $100 million more for their cotton than
                           foreign mills paid. This added cost would likely have been passed on to


                           Page 23                                         GAO/RCED-90470   Cotton   Program
                                                                                                   .     ’   .




                              chapter 2
                              The Marketing Loan Has Not Kept U.S.
                              Cotton Competitive in World Marketa




                              some extent to consumers and would have reduced the competitiveness
                              of U.S. cotton textile products. The Institute believes that U.S. textile
                              m ills should be allowed to import cotton during periods when U.S. spot
                              prices are higher than world prices.

                              W h ile we did not assessthe appropriateness of the cotton import quotas,
                              we recognize that cotton import quotas can play an important role in
                              causing U.S. spot prices to diverge above world prices. W e believe, how-
                              ever, that, if the marketing loan program is made to work effectively so
                              that U.S. spot and overseas prices are competitive in world markets,
                              then U.S. textile m ills would have accessto cotton on the domestic
                              market at prices competitive with world prices.


Routine Availability of the   The routine availability of the 8-month nonrecourse loan extension
                              allows U.S. producers to keep cotton under loan and off the market
8-Month Loan Extension        beyond the basic lo-month loan period, even when cotton prices are
Hampers the Effectiveness     above the loan rate. W ith the 8-month loan extension, producers are
of the Marketing Loan         provided additional tim e to hold their cotton under loan and speculate
                              on receiving higher prices. W e believe that if the 8-month loan extension
                              were available at the discretion of the Secretary of Agriculture based on
                              current market conditions, producers would market their cotton in a
                              more timely manner and forfeitures could be reduced.

                              USDA officials have expressed concern that a lo-month loan period with
                              an 8-month extension undermines the marketing loan’s objective. On
                              February 22,1989, for example, the USDA Assistant Secretary For Eco-
                              nomics, in testimony before the House Committee on Agriculture, Sub-
                              committee On Cotton, Rice and Sugar, made the following statement:

                              “On the one hand, we have a marketing loan which is supposed to release cotton to
                              the market and make US. cotton competitive. On the other hand, we have an 1 %
                              month loan and a practice of paying price premiums . . . which encourages the storage
                              of cotton. W e cannot have it both ways. If we want to market cotton, it does not
                              make sense to isolate it from the market in storage.”

                              Similar concerns regarding the availability of the 8-month loan exten-
                              sion have been expressed by industry officials, including the American
                              Cotton Shippers Association, whose members handle nearly all of the
                              domestic and exported cotton sold, and the American Textile Manufac-
                              turers Institute, Inc.




                               Page 24                                             GAO/RCED-9&170 CottonProgram
    .   l




                                 Chapter 2
                                 T h e Marketing L o a n H a s Not K e p t US.
                                 Cotton Competitive in W o r l d Marketa




                                 U n d e r th e 1 9 8 5 act, th e 8 - m o n th extension is a p p r o v e d , u p o n r e q u e s t b y
                                 th e producer, unless th e a v e r a g e U .S . s p o t price in th e p r e c e d i n g m o n th
                                 e x c e e d s 1 3 0 p e r c e n t o f th e a v e r a g e U .S . s p o t price for th e p r e c e d i n g 3 6 -
                                 m o n th period. This criterion h a s p r o v e n to b e s o lenient th a t p r o d u c e r s
                                 a r e virtually a s s u r e d th e availability o f th e 8 - m o n th l o a n extension e v e n
                                 w h e n cotton prices a r e a b o v e th e l o a n rate. W e believe th a t th e criterion
                                 s h o u l d b e c h a n g e dto eliminate th e routine availability o f th e l o a n exten-
                                 sion d u r i n g s u c h periods. In o u r opinion, a b e tter a p p r o a c h w o u l d b e to
                                 p r o v i d e th e S e c r e tary with discretionary a u thority to u s e th e 8 - m o n th
                                 l o a n extension only w h e n n e e d e dto m inimize cotton forfeitures to th e
                                 g o v e r n m e n t a t th e e n d o f th e basic l o - m o n th l o a n period. This a p p r o a c h
                                 w o u l d e n c o u r a g ep r o d u c e r s to m a r k e t their cotton a n d w o u l d b e m o r e
                                 consistent with th e objective o f th e cotton m a r k e tin g l o a n p r o g r a m .


                                 In A u g u s t 1 9 8 8 th e S e c r e tary m a d e several administrative c h a n g e sto
A d m in istra tive              th e cotton l o a n p r o g r a m to a d d r e s s th e c o n c e r n s discussedin this
C h a n g e sto th e C o tto n   c h a p ter. T h e s e c h a n g e s ,w h i c h w e r e r e a s o n a b l ea n d p r u d e n t, primarily
Loan P rogram Have               a ffected th e calculation o f th e A W P a n d th e p a y m e n t o f storage a n d
                                 interest costs.
N o t B e e n F u lly
E ffe c tive                     O n e c h a n g e adjusted th e transportation factor in th e A W P fo r m u l a to
                                 m o r e accurately reflect th e cost o f transporting cotton from th e United
                                 S ta te s to Northern E u r o p e . This adjustment w a s e x p e c te d to m a k e th e
                                 A W P m o r e closely reflect th e world price, th u s increasing th e c o m p e ti-
                                 tiveness o f U .S . cotton in world m a r k e ts. A n o th e r c h a n g e revised th e
                                 l o a n r e p a y m e n t fe a tures b y providing th a t w h e n l o a n s a r e r e d e e m e da t
                                 a tim e w h e n th e A W P e x c e e d sth e l o a n rate, U S D A will p a y th a t portion o f
                                 th e carrying c h a r g e snecessaryto permit th e l o a n to b e r e d e e m e da t n o
                                 m o r e th a n th e A W P .

                                 A lth o u g h th e s e administrative c h a n g e sw e r e steps in th e right direction,
                                 th e y d i d n o t h a v e th e d e s i r e d e ffect o f eliminating th e d i v e r g e n c e
                                 b e t w e e n U .S . s p o t prices a n d th e A W P . C o n s e q u e n tly,U .S . cotton
                                 r e m a i n e d n o n c o m p e titive a fter th e s e c h a n g e sw e r e i m p l e m e n te d .

                                 In O c to b e r 1 9 8 9 th e S e c r e tary a n n o u n c e dfurther c h a n g e sin th e m a r -
                                 keting l o a n p r o g r a m to h e l p k e e p U .S . cotton c o m p e titive a n d to
                                 e n c o u r a g eth e tim e l y m o v e m e n t o f cotton into th e m a r k e t. T h e s e
                                 c h a n g e sw e r e twofold. O n e c h a n g e allows th e S e c r e tary to m a k e discre-
                                 tio n a r y adjustments to th e A W P a t tim e s w h e n U .S . cotton b e c o m e sn o n -
                                 c o m p e titive, a s it w a s in 1 9 8 8 a n d 1 9 8 9 .U S D A believes th a t s u c h
                                 adjustments will permit U .S . cotton prices to react m o r e quickly to


                                 Page 26                                                              G A O /‘R C F D 9 @ 1 7 0 Cotton P r o g r a m
              Chapter 2
              The Marketing Loan Has Not Kept U.S.
              Cotton Competitive in World Markets




              changes in the world price. USDAexpects this change to result in larger
              exports and lower prices to domestic textile mills.

              The other change requires producers, beginning with crop year 1989, to
              pay interest and storage costs on loans redeemed during the 8-month
              loan extension, regardless of whether the Aw is above or below the loan
              rate. In addition, if producers decide to forfeit their cotton rather than
              to redeem their loans during the 8-month loan extension, they must pay
              storage costs for the entire extension period and a handling fee of $1 per
              bale. USL)Aexpects this change to promote timely loan repayments and to
              discourage both loan extensions and forfeitures.

              Whether these October 1989 changes will meet USDA'S expectations and
              help keep U.S. cotton competitive is still uncertain, as they have not yet
              been fully tested. As of March 1990, when our review work ended, the
              Secretary had not needed to make any additional adjustments to the AWP
              because favorable market conditions, resulting from decreased supplies
              of foreign cotton, had kept U.S. cotton competitive in world markets.
              Furthermore, the change regarding the payment of interest and storage
              costs during the 8-month extension will not be applicable until crop year
              1989’s initial lo-month loan period expires, which will not occur until
              about July 1990.

              In addition to the above-mentioned changes, the Secretary could have
              implemented Plan A rather than Plan B repayment features during crop
              years 1987 and 1988 in his attempt to improve the effectiveness of the
              marketing loan program. However, as we discussed in chapter 1, the
              Secretary opted not to use Plan A in those crop years because, even
              under conditions of very high market prices, the government would
              have been required to pay high subsidies to producers. Because of the
              implications of these additional subsidies on the federal budget, we
              believe the Secretary’s decision not to use Plan A is appropriate.


              The marketing loan program has not achieved its objective of keeping
Conclusions   U.S. cotton prices competitive in world markets. Our analysis shows
              that, from February 1988 through March 1989, the price of U.S. cotton
              overseas diverged above the world price. Similarly, U.S. spot prices
              diverged above the Aw, and although the marketing loan was in effect
              during most of that period, it did not correct this price divergence. As a
              result, U.S. cotton was not competitive in world markets, and cotton
              exports decreased while U.S. carryover stocks grew.



              Page 26                                        GAO/RCEB90-170   Cotton Program
Chapter 2
The Marketing Loan Has Not Kept U.S.
Cotton Competitive in World Markets




During the time when U.S. cotton was not competitive, the marketing
loan did not provide producers the incentive needed to redeem their
loans and to market their cotton at the AWP. We believe that a way to
provide producers this needed incentive would be to lower the nonre-
course loan rate to a level below the U.S. spot price and the world price.
This approach would increase the producers’ ownership in their pledged
cotton and reduce their tendency to hold cotton under loan for extended
periods. This approach would also help to make the cotton program
more market-oriented by better assuring that producers react to prices
established in the marketplace rather than to USDA'S price support pro-
gram. For these reasons, we believe that the Congress could better
achieve its objective of keeping U.S. cotton prices competitive in world
markets by lowering the nonrecourse loan rate. According to USDA offi-
cials, lowering the nonrecourse loan rate would, in the long run, result in
reduced program costs to the government.

The routine availability of an 8-month loan extension to the basic lo-
month nonrecourse loan makes it easier for producers to be selective in
the price they will accept for their cotton because it allows them to keep
their cotton under loan longer while they speculate on higher prices. We
believe that the 8-month loan extension should be available to producers
only when the Secretary of Agriculture determines that it is needed to
minimize cotton forfeitures to the government at the end of the basic lo-
month loan period. This approach would encourage producers to market
their cotton and would be more consistent with the objective of the
cotton marketing loan program.

The Secretary made several administrative changes in August 1988 to
help keep U.S. cotton competitive. These changes were not fully suc-
cessful, however. In October 1989 the Secretary made additional
changes to help keep U.S. cotton competitive and to encourage the
timely movement of cotton into the market. Although these changes
may help to improve the marketing loan program’s effectiveness, we
believe that the lack of incentive for producers to redeem their nonre-
course loans and to sell their cotton at the AWP, as well as the virtually
automatic 8-month loan extension, will continue to inhibit the marketing
loan from working as intended. Addressing these factors will require
congressional action.




Page 27                                        GAO/ICED-9@170   Cotton Program
                                                                                      .        - .

                       Chapter 2
                       The Marketing Loan Has Not Kept U.S.
                       Cotton Competitive in World Markets




                       To help achieve the objective of keeping U.S. cotton prices competitive
Matters for            in world markets, the Congress should consider including provisions in
Consideration by the   the 1990 farm legislation to increase the effectiveness of the cotton pro-
Congress               gram. Specifically, the Congress should consider doing two things.

                       First, the Congress should consider lowering the nonrecourse loan rate
                       to a level that represents a fraction of the current U.S. spot price or
                       world price, whichever is lower at the time cotton is placed under loan.
                       Because the nonrecourse loan rate would vary with market conditions, a
                       maximum rate should be established. Lowering the nonrecourse loan                   1
                       rate would (1) lower producers’ price expectations and encourage pro-
                       ducers to market their cotton rather than forfeit it to the government
                       and (2) reduce producers’ tendency to hold cotton under loan for
                       extended periods.

                       Second, the Congress should consider providing the Secretary of Agri-
                       culture the authority to make available the 8-month loan extension to
                       the basic lo-month nonrecourse loan only when it is needed to minimize
                       cotton forfeitures to the government. This provision would eliminate the
                       existing situation where producers are virtually assured availability of
                       the 8-month loan extension, which allows them to keep cotton under
                       loan whether or not justified by current market conditions.




                       Page 28                                        GAO/RCED9&170       Cotton Program
            c


Chapter 3

The Secretary’s Discretionary Actions Have Not
Achieved the Annual Target Carryover
Stock Level
                          The Secretary of Agriculture considered options available to him and,
                          utilizing his discretionary authority, took reasonable and prudent
                          actions to maintain carryover stocks at the 4million bale level targeted
                          by the Food Security Act of 1985. In doing so, the Secretary used his
                          primary tool-the ARP. However, carryover stock levels have exceeded
                          the target each year since 1985. To help achieve the target carryover
                          stock level, the Secretary needs additional time beyond the mandated
                          November 1 announcement date to obtain more complete cotton crop
                          production data before determining the ARP rate each year. Providing
                          the additional time will require congressional action.


                          The Food Security Act of 1985 requires that the Secretary utilize the
Basis for the $-Million   ARP,   to the maximum extent practicable, to achieve a carryover stock
Bale Carryover Stock      level of 4 million bales of cotton each year. Carryover stocks refer to the
Level                     amount of cotton on hand in the United States at the end of a crop year
                          (i.e., July 31).

                          According to legislative history, at the time the 1985 act was being
                          debated, the 4million bale carryover stock level represented one-third
                          of the approximate 12 million bales of U.S. cotton that was being con-
                          sumed domestically and exported each year. A 4-month supply of cotton
                          is considered necessary by USDA and the industry to provide adequate
                          stocks between crop year harvests.

                          The act directs the Secretary to achieve the target carryover stock level
                          through an ARP by applying a uniform percentage reduction-not       to
                          exceed 25 percent-to the cotton crop acreage base for each farm. As a
                          condition for participating in USDA'S cotton program, producers must
                          reduce their cotton acreage by the specified rate. The Secretary is
                          required to announce the ARP rate no later than November 1 of the cal-
                          endar year preceding the year in which the crop is harvested.


                          After considering the objectives of the cotton program and the provi-
The Secretary Has         sions available for achieving those objectives, the Secretary utilized his
Used the ARP in an        authority each year since 1985 by implementing an ARP rate that he
Attempt to Achieve        believed would achieve the target carryover stock level. For crop years
                          1986 and 1987, the Secretary announced the maximum 25-percent ARP
the Target Carryover      rate in an attempt to attain the target carryover stock level of 4 million
Stock Level               bales. Carryover stocks at the end of those years were 4.94 million bales
                          and 5.72 million bales, respectively, down considerably from the 9.3 mil-
                          lion bales in crop year 1985, but still above the target level.


                          Page 29                                        GAO/RCED-9@170   Cotton   Program
                       Chapter 3
                       The Secretary’s Discretionary Actions Have
                       Not Achieved the Annual Target Carryover
                       Stock Level




                       Contrary to what he did in crop years 1986 and 1987, the Secretary
                       implemented an ARP rate of 12.5 percent for crop year 1988. tics statis-
                       tics available at that time indicated that the estimated cotton production
                       and consumption for 1987 and 1988, together with the 12.5-percent ARP
                       rate, would result in a crop year 1988 carryover stock level of 3.9 mil-
                       lion bales. However, unexpected back-to-back large cotton yields in crop
                       years 1987 and 1988, combined with the less-than-maximum ARP rate in
                        1988 and the reduction in exports during the noncompetitive price
                       period discussed in chapter 2, resulted in a crop year 1988 carryover
                       stock level of 7.03 million bales. If the Secretary had not been required
                       to announce the ARP rate so early, he would have had more complete
                       data available for determining a more appropriate ARP rate for crop year
                        1988. We recognize, however, that while delaying the AFIP announcement
                       date would allow USDA to get a better handle on beginning stock levels,
                       the unpredictability of yields and demand in the next year would still
                       make it difficult to achieve the target carryover stock level.


                       As mentioned earlier, the Secretary is required to announce an AFIP rate
Delaying the ARP       no later than November 1 of the calendar year preceding the year in
Announcement Date      which the crop is harvested. For example, the ARP rate for crop year
Could Better Achieve   1988, which began August 1,1988, and ended July 31,1989, was
                       announced by the Secretary on October 29,1987. USDAand industry offi-
the Target Carryover   cials believe that the required ARP announcement date is too early, how-
Stock Level            ever, for two reasons.

                       First, because the ARP rate affects the cotton carryover stock level at the
                       end rather than at the beginning of each crop year, the Secretary’s ARP
                       rate decision is based on estimated ending stock levels that are expected
                       to occur 21 months after the ARP rate is announced. (In other words, a
                       November 1,1987, ARP announcement for the 1988 crop year would
                       have been in effect through July 31, 1989, at which time the ending
                       stock level would have been determined. The time span between
                       November 1,1987, and July 31,1989, was 21 months.) Second, because
                       the Secretary does not have complete information on the current crop
                       year’s harvest at the time he must decide on the ARP rate for the fol-
                       lowing year, his decisions are based on forecasts which could change
                       significantly from month to month, especially during the harvesting
                       period that occurs between November 1 and January 1 each year.

                       Crop year 1988 illustrates why the required ARP announcement date of
                       November 1 is too early. The November 1 deadline for announcing the
                       1988 ARP rate forced the Secretary to announce the rate before having


                       Page 30                                        GAO/RCEJMO-170   Cotton Program
              Chapter 3
              The Secretary’s Discretionary Actions Have
              Not Achieved the ANNULI Target Carryover
              Stock Level




              complete information on the 1987 cotton crop yield. Nonetheless, on the
              basis of the information available at that time, the Secretary announced
              an ARP rate of 12.5 percent for crop year 1988. After the 12.5-percent
              rate had been announced, favorable weather resulted in a record 1987
              cotton crop yield and increased the forecasted US. production by 1.4
              million bales beyond what it was predicted to be at the time the Secre-
              tary made the ARP announcement on October 29,1987. Consequently,
              the higher-than-expected 1987 yield increased the carryover stock level
              which, in turn, resulted in a larger supply of cotton available during
              crop year 1988.

              In hindsight, had the Secretary had information indicating the higher
              cotton yield estimates in 1987, he might have increased the ARP rate for
              1988. If he had increased the ARP rate to 15 or 20 percent, or had he
              used the maximum allowable 25-percent rate, the 7.03~million bale car-
              ryover stock level in 1988 would have been reduced to a level closer to
              the 4million bale target level.

              According to the AXS official in charge of the day-to-day management of
              the cotton program, the Secretary would have announced an ARP rate
              higher than 12.5 percent for crop year 1988 if he had been allowed to
              delay the announcement of the final ARP decision until after the legis-
              lated deadline of November 1. Had the announcement date been delayed
              until the Secretary had obtained U.S. cotton data through December
              1987, for example, he would have known that the 1987 crop yield was
              significantly higher than forecasted at the time he made his decision on
              the 1988 ARP rate. The tics official stated that a 2- to 3-month delay
              would give the Secretary the additional time needed to acquire data on
              nearly all of the current U.S. cotton crop harvest, as well as additional
              information on planting intentions overseas.

              Regarding any adverse effects that a delayed ARP rate announcement
              date might cause, the ASCSofficial stated that only a small number of
              producers in four counties in south Texas would likely be affected.
              These producers typically plant cotton earlier than producers in other
              parts of the country and they need to know by November 1 what the
              ARP rate is going to be for the upcoming year. This official indicated that
              USDA could work with producers who plant early in the season to mini-
              mize any adverse effects from the later announcement date.


              The Secretary of Agriculture’s discretionary actions have not achieved
Conclusions   the annual 4million bale cotton carryover stock level targeted by the


              Page 31                                        GAO/RCED-90-170   Cotton Program
                       Chapter 3
                       The Secretary’s Discretionary Actions Have
                       Not Achieved the Annual Target Carryover
                       Stock Level




                       Food Security Act of 1985. We believe the Secretary could more likely
                       achieve the annual target level if he were to base his ARP rate decisions
                       on the crop year’s harvest data through December each year. To do so,
                       the Congress would have to change the mandated November 1 ARP
                       announcement date to no earlier than sometime in January.


                       If the Congress chooses to maintain a target carryover stock level for
Matter for             cotton, it should consider including provisions in the 1990 farm legisla-
Consideration by the   tion to revise the ARP announcement date to at least January to provide
Congress               the Secretary of Agriculture the time needed to obtain data on the crop
                       year’s harvest through December of each year.




                       Page 32                                        GAO/RCXIH@l70   C&tan   Progmm
Page 33   GAO/lUXD~l70   Cotton Rugram
                                                                                         .      -.
Appendix I                                                                                      Z
Major Contributors to This Report                                                             ’ -


                          Flora H. Milans, Associate Director
Resources,                Clifton W. Fowler, Assistant Director
Community, and            Dennis J. Parker, Assignment Manager
                          Charles W. Bausell, Jr., Senior Economist
Economic                  Cad Es Bray, Econofist
Development   Division,

Washington, D.C.

                          Sherrill H. Johnson, Regional Manager’s Representative
Dallas Regional Office    Seth D. Taylor, Evaluator-in-Charge
                          Kirk D. Menard, Evaluator




                          Page 34                                      GAO/RCED-90-170       Cotton Program
‘,’:5,          .       :

?:       ,          _   1     .
_;                       --

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