By Jeevan Kelum
Ceylon Tea is a globally recognised brand, and Sri Lanka’s tea sector remains an important source of employment and foreign exchange. The sector has survived for 200 years since its establishment under colonial rule. However, it appears to be on the decline in recent years, eclipsed by more dynamic players around the world.
According to the Sri Lanka Tea Board, the tea industry comprises 719 manufacturers, 340 exporters, and eight brokers. On average, the annual earnings of the tea industry are about $ 1.2 billion. According to data from the Tea Board and Ceylon Tea Brokers, 64% of export revenue goes to direct producers (planters, manufactures, warehouse providers), while 35% goes to exporters. The remaining 0.7% is shared between eight competing brokerage firms (Fig 1).
Tea brokers or financial intermediaries?
Given the low amount of revenue absorbed by eight brokerage firms – essentially middlemen in the auction system – it is worthwhile interrogating their role in the tea industry and what value they add as a whole. As we have argued previously (https://www.themorning.lk/is-ceylon-tea-auctioning-away-sri-lankas-development/), the auctions are a colonial system that ensures a steady supply of cheap raw tea to firms in foreign countries which process and sell finished products at a higher profit margin.
Three out of the eight tea brokerage firms are listed in the Colombo Stock Exchange (CSE), and therefore have publicly available financial reports. For the purpose of this study, we have combined the data of two of these brokerage firms which together represent 25% of the volume of tea sold in the Colombo Tea Auction.
According to the aggregate data of these two brokerage firms, commissions on auction sales are the main source of revenue. However, the second largest source of income is from interest, averaging about 40% of total revenue from 2011 to 2020 (Fig 2). This relatively high reliance on interest earnings indicates that tea brokerage firms are deviating from their core business and slowly transforming into financial intermediaries.
Based on the total outstanding loans and advances from the two brokerage firms under study, we estimate that the total loans and advances by all brokerage firms may be around Rs. 4-5 billion as at 31 March 2021. The two tea brokerage firms under study have a high debt ratio of more than 74% (Fig 3). These two companies have somehow borrowed more than three times the value of their total non-current (Fig 4).
How these brokerage firms manage to borrow so much money while many SMEs (small and medium-scale enterprises) struggle to acquire credit for production should be investigated.
Squeezing manufacturers through interest arbitrage
In terms of production, more than 70% of tea volumes come from smallholders, with the remaining 30% produced by the regional plantation companies (RPCs). However, in terms of land utilisation, smallholders cultivate about 60% of tea lands, while RPCs cultivate 40%. This demonstrates a significant gap in yield between smallholders and RPCs, with the former being significantly more efficient.
Raw tea from RPCs and smallholders is processed by manufacturers. These manufacturers rely on brokers for working capital due to the relative reluctance of commercial banks to provide financing to SMEs. Manufacturers securitise their stocks of tea to acquire loans from brokers. In turn, brokers securitise these same stocks pledged to them, in order to acquire loans from commercial banks. This process is called “back-to-back securitisation”.
In effect, brokerage firms are leveraging based on the stocks of producers, which enables them to extract intermediary financial gain by borrowing from banks at low interest rates and lending to manufacturers at higher interest rates. Data from 2012 to 2020 shows that the two brokerage firms under study had an average effective interest income of 20%, and an average effective interest cost of 15% (Fig 5).
Clearly, such a business model does not add value to the tea industry, and is in fact parasitic as it is based on extracting intermediary rents through interest rate arbitrage. The end result most severely affects the manufacturers and the smallholders they buy from, who bear some of the highest costs in the value chain.
The cost of working capital for manufacturers can be significantly reduced if the parasitic financial intermediary role played by brokerage firms is replaced by dedicated development banks. Lower financing costs will enable manufacturers to make and retain higher profits, allowing more breathing room to invest in technical improvements.
Multinational monopsonies behind ‘competitive’ auctions
The tea auctions are generally portrayed as a textbook example of how supply and demand interact to produce prices. Firstly, this theory of how price is determined is flawed as it ignores the role of technological innovation and marketing gimmicks which can manipulate supply and demand. Moreover, it ignores the determining role of cost of production in price setting.
Secondly, a handful of multinational companies like Unilever (Lipton), James Finlay, TATA (Tetley), Twinings, and McLeod Russel control around 85% of tea trade, according to research by Sanne van der Wal. These companies strive to keep their costs down, and some auction buyers supply multiple multinational companies. This is a form of monopsony which undermines the theoretical role of demand and supply in determining price.
For example, Sanne van der Wal notes that Unilever bought 70% of the tea auctioned at the Jakarta auction and 12% of the world’s black tea in 2008. Sanne’s research concludes that Sri Lanka earns a mere 30 cents for every dollar that consumers spend on Sri Lankan tea.
In 2005, the Kenyan National Chamber of Commerce took steps to eliminate the auction system after revelations of alleged collusion by big buyers sharing out lots among themselves instead of bidding against each other competitively. India’s Ministry of Commerce has detected similar problems, with “proxy buyers” buying tea on behalf of numerous multinational companies, thereby stifling competition.
Therefore, the idea that auctions allow for efficient price setting via competition is inconsistent with the actually existing reality of monopsony in the purchase of raw tea. Based on the above data regarding the role of brokers as financial intermediaries and the hidden monopsonies in auction, we question the need for having an auction system at all, as it has not helped the country develop from a raw materials supplier to a value-added manufacturer.
A blue ocean for Ceylon Tea
Tea smallholder firms are exposed to significant business risks. For example, annual tea production has declined 18% from 337 million kg in 2013 to 276 million kg in 2020, despite continuous use of fertiliser. While the current chemical fertiliser ban is a challenge, it should be contextualised in the long-term decline in yield caused by soil acidity from excess use of fertilisers, lack of replanting, and climate change.
Few tea producers have taken serious steps to address these problems prior to the ban on chemical fertilisers. This long-term decline in production volumes will seriously impact the commission and interest income of brokering firms while smallholder tea firms will be adversely impacted unless bulk tea fetches significantly higher prices. This currently seems very remote, looking at the historic average prices. Therefore, smallholder tea firms will eventually need to consolidate and change their outdated business model.
Sri Lanka’s old colonial model of exporting raw bulk black tea via auctions to developed countries is increasingly unsustainable and also serves as an impediment for the tea industry’s take off. The tea sector is also plagued with environmental issues such as climate change and soil acidity caused by excess use of fertiliser, which is dropping yields. Therefore, the industry needs a fresh outlook to respond to these new challenges and how best to capture a larger global market share from its current narrow focus.
In all likelihood, there are numerous master plans and strategies prepared by industry veterans, which are locked away in the file cabinets of various departments and ministries. What is needed at this crucial juncture is action and implementation to finally break away from the mindset of colonial raw material production model and put Sri Lanka on a path of tea value-added industrialisation.
Tea companies must be made to produce innovative products for the new global consumers and thirst-oriented global market, rather than competing for domestic market share with low-quality black tea. There remains a “blue ocean of opportunity” for Ceylon Tea in a diverse range of industries including hot and cold beverages, fizz tea, tea confectioneries, tea cosmetics, and nutraceuticals.
(The writer holds a BSc. in Accountancy [Sp], FCA, ACMA, and MBA-PIM [SJP], and is Vice President of Finance, Research, and Strategic Development at Econsult Asia, an economic research and management consultancy firm with an alternative development outlook)