BABCOCK INSTITUTE DISCUSSION PAPER No. 99-1

Transcription

1 BABCOCK INSTITUTE DISCUSSION PAPER No CANADA'S CLASS 5 PRICING SYSTEM, THE EU's DAIRY EXPORT RESTITUTION PROGRAM, AND THE U.S.'s DEIP AN UPDATE ON IMPACTS OF DAIRY EXPORT SUBSIDY PROGRAMS. W.D. Dobson The Babcock Institute for International Dairy Research and Development University of Wisconsin, College of Agricultural and Life Sciences 240 Agriculture Hall, 1450 Linden Drive Madison, Wisconsin

2 BABCOCK INSTITUTE DISCUSSION PAPER No CANADA'S CLASS 5 PRICING SYSTEM, THE EU's DAIRY EXPORT RESTITUTION PROGRAM, AND THE U.S.'s DEIP AN UPDATE ON IMPACTS OF DAIRY EXPORT SUBSIDY PROGRAMS w. D. Dobson The Babcock Institute for International Dairy Research and Development University of Wisconsin, College of Agricultural and Life Sciences 240 Agriculture Hall, 1450 Linden Drive Madison, Wisconsin

3 The Babcock Institute for International Dairy Research and Development is a joint program of the University of Wisconsin-Madison College of Agricultural and Life Sciences University of Wisconsin-Madison School of Veterinary Medicine University of Wisconsin Extension Cooperative Extension Division Funding for this study was provided by CSRS USDA Special Grant The views expressed in Babcock Institute Discussion Papers are those of the authors; they do not necessarily represent those of the Institute, nor of the University. The Babcock Institute College of Agricultural and Life Sciences 240 Agriculture Hall, 1450 Linden Drive Madison, Wisconsin Phone: ; Fax: babcock@calshp.cals.wisc.edu Internet: wisc.edu University of Wisconsin 1999

4 Table of Contents Executive Summary... &I II 0'11' 1 Introduction What Are Export Subsidies and How lli They WOlk?... 1 ll. Canada's Class 5 Pricing System, t:re EU' s Ex{X>rt Restitution Program, and the U.S.'s DEIP... 2 ill. Impacts of the Uruguay Round GATT Agreement on Dairy Export Subsidy Program;... 3 IV. Implications of the WTO Panel's Decision for Canadian, U. S. and F1J Dairy Export Expansion Prognuns... 3 Introduction... II" II II 5 Purp~es of the Paper I. What Are Dairy Export Subsidies and How Do They Work?... 6 What Are Dairy Export Subsidies?... 6 How lli Dairy Export Subsidy Program; Work? II. Canada's Class 5 (Special Milk Classes) Pricing System, the EU's Export Restitution Program, and the U.S.'s DEIP... 9 Canada's Class 5 (Special Milk Classes) Pricing System... 9 The ElJ' s ExportRestitution System The U. S. ' s Dairy Export Incentive Program How the Current DEIP Program Works How the DEIP has Evolved Export Subsidies under the DEIP The Transparency of DEIP Export Subsidies How Effectively Would the DEIP Support U.S. Farm Milk Prices in the Absence of Dairy Price Supports Based on Product Purchases? Alternative Scenario No Alternative Scenario No Alternative Scenario No III. Impacts of the Uruguay Round GATT Agreement on Dairy Export Subsidy Programs... II 21 IV. Implications of the WTO Panel's Decision Regarding Canada's Class 5 Pricing System for Canadian, U.S., and EU Dairy Export Expansion Programs Implications of the WTO Panel's Decis ion for Canada's (and other Countries') Dairy Export Expansion Efforts Implications for U. S. Dairy Export Expansion Efforts Implications for EU Dairy Policies of Developments Regarding EU Thiry Subsidies References... 27

5 Table 1. Tables and Figures Canada's Commitments Regarding Subsidized Dairy Exports Under the Uruguay Round GA'IT Agreement and Subsidized Dairy Exports Generated Under Classes 5(d) and 5(e) Table 2. Quantities of U.S. Dairy Products Eligible for DEIP Export Subsidies, July 1, 1998 Through June 30, , Table 3. Table 4. Table 5. Selected Export Subsidies (Bid Acceptances) Received by Exporters of U.S. Dairy Products, October 1998-March A verage of Monthly DEIP Export Subsidies for NOM, October 1998 through March 1999, Ranked by Destination Base Quantities of Canadian, EU, and U.S. Dairy Exports and Maximum Quantities that can be Exported with Subsidy Under the GATT Agreement Table 6. Export Market Shares of Major Dairy Exporting Countries, Appendix Table 1. DEIP Export Subsidy Data, October 1998-March Figure 1. Prices and Quantities with Price Supports and an Export Subsidy... 7 Figure 2. Movements of German Wholesale Prices, EU Export Refunds, and Indicative International Prices for NOM... 8 Figure 3. Model of a Typical Common Agricultural Policy System Figure 4. Prices, Exports, and Excess Supply with Different Nonfat Dry Milk Prices... 20

6 CANADA'S CLASS 5 PRICING SYSTEM, THE EU's DAIRY EXPORT RESTITUTION PROGRAM, AND THE U.S. 's DEIP-AN UPDATE ON IMPACTS OF DAIRY EXPORT SUBSIDY PROGRAMS W. D. Dobson* Executive Summary Introduction Dairy export subsidy programs figured prominently in the dairy trade news in early 1999 after a World Trade Organization (WTO) panel ruled that Canada's Class 5 milk pricing scheme represented an export subsidy, and that Canada was not complying with dairy export subsidy reduction commitments it made under the Uruguay Round GATT agreement. The WTO panel ruled that Canada's Class 5 pricing system-based on end use pricing and pooling of lower returns from dairy export sales-constituted an export subsidy under Article 9.1(a) and Article 9.1(c) of the WTO's Agreement on Agriculture. The WTO panel's decision-if it withstands Canada's appeal-regarding Canada's Class 5 pricing system has important implications for U.S. and European Union (EU) dairy export subsidy programs. I. What Are Export Subsidies and How Do They Work? Dairy export subsidies are payments, fund transfers or concessions made by a government to private firms to help the firms compete in international dairy markets. A country sometimes will employ export subsidies because border protection, price support programs, and/or production quotas raise the country's dairy product prices above world prices making it difficult (or impossible) for the country's finns to compete in foreign markets without export subsidies. Article 9.1 of the WTO Agreement on Agriculture specifies six export subsidies that are subject to reduction commitments under the Agreement on Agriculture. These items served as the basis for establishing reductions in agricultural export subsidies under the Uruguay Round GATT agreement. Export subsidies help to raise domestic dairy product prices by off-loading surpluses onto international markets. A given quantity of surplus dairy products generally can be removed from the domestic market more cheaply with export subsidies than through price support purchases. Export subsidies employed by "large country" exporters can depress prices in "thin" international dairy markets. Especially before the Uruguay Round GATT agreement led to reduced EU use of dairy export subsidies, prices for certain bulk dairy products in international markets tended to equal the EU supported prices minus the EUexport subsidies. While Canada is not a "large country" dairy exporter and not a price setter in international markets comparable to the EU, Canadian firms-aided by the Class 5 pricing system-have captured market share from U.S. fmns in certain foreign markets. * W.D. Dobson is Distinguished Professor in the Department of Agricultural and Applied Economics and Co-Director of the Babcock Institute for International Dairy Research and Development arthe University of Wisconsin-Madison. Mr. Daniel Vosberg, an MBA in Agribusiness student at the University of Wisconsin-Madison, assembled and interpreted material for this Discussion Paper. Babcock Institute Discussion Paper No. 99-1

7 II. Canada's Class 5 Pricing System, the EU's Export Restitution Program, and the U.S.'s DEIP Canada's Class 5 pricing system-based on end use pricing and pooling-replaced a schedule of producer levies that had been employed prior to August Canada maintains that the Class 5 system is not an export subsidy as defined by Article 9.1 of the WTO Agreement on Agriculture. The U.S. and New Zealand disputed this claim through a WTO challenge. The U.S. and New Zealand were primarily concerned with the impacts of Canada's Class 5(d) and 5(e) prices. Accordingly, the WTO panel's decision related almost exclusively to assessing whether Canada's Class 5(d) and 5(e) pricing arrangements represented dairy export subsidies. Canada's Class 5(d) milk is used to produce "specific negotiated exports including cheese under quota destined for the U.S. and UK markets, evaporated milk, whole milk powder and niche markets." Class 5(e) milk is "surplus removal." The WTO panel reported, "We found earlier that the provision of lower priced milk to processors for export under Classes 5(d) and (e) constitutes a payment in kind to processors/exporters contingent upon export performance. We also found that this milk is provided by Canada's government or its agencies. On these grounds, we find that the making available of milk under Classes 5(d) and (e) constitutes an export subsidy within the meaning of Article 9.1(a)." The WTO panel continued, "We found earlier that the provision of lower priced milk to processors for export under Classes 5(d) and (e) constitutes a 'payment' to these processors/exporters 'on the export of an agricultural product.' We also found that this 'payment' is 'financed by virtue of government action.' On these grounds, we find that the making available of milk under Classes 5(d) and (e) constitutes an export subsidy within the meaning of Article 9.1(c)." Canada argued that government intervention in the country's pricing and pooling system does not approach the level required under Article 9.1(a). After noting the pervasive involvement of Canada's government in the Class 5 pricing system, the WTO panel rejected this argument. The ED's export subsidy system for dairy products is so transparent that it allows exporters from other countries to undercut EU prices in export markets. The EU has employed an "inward processing" system in an effort to circumvent GATTIWTO limits on subsidized cheese exports. U.S. organizations allege that the EU has circumvented its GA TTIWTO commitments on cheese by exporting with subsidy processed cheese while counting these exports against other (non-binding) export subsidy commitments relating to processed cheese components--especially butter and nonfat dry milk (NDM). There has been no resolution of this issue. The U.S.'s DEIP export subsidies are approximately as transparent as those employed by the EU. This transparency is a valuable source of competitor intelligence for finns interested in gaining market share at the expense of exporters of U.S. dairy products. The DEIP is not likely to be fully effective for supporting U.S. farm milk prices in the absence of a dairy price support program based on product purchases. A producer-financed export subsidy program for NDM might be WTO-compatible if there was no government involvement in the program and producer participation was voluntary, conditions that could be difficult to achieve. Moreover, because such a program would represent an extension of, or partial replacement for, DEIP exports, the initiative could attract challenges under the WTO. 2 Babcock Institute Discussion Paper No. 99-1

8 III. Impacts of the Uruguay Round GATT Agreement on Dairy Export Subsidy Programs Canada, the EU, and U.S. all have agreed to reduce the quantity of butter, NDM, and cheese exported with subsidies in 2000/01 by 21 % from base period quantities. Because the U.S. employed limited dairy export subsidies--compared to Canada and the EU-during the base period, the U.S. fmds itself more tightly constrained than Canada and the EU by the Uruguay Round GAIT agreement limits on subsidized dairy exports. Canada, for example, which produces 11% to 12% as much milk as the U.S., will be permitted to export with subsidy two-thirds as much NDM and three times as much cheese as the U.S. in 2000/01 under the GAITIWTO. Maximum U.S. subsidized exports ofndm in 2000/01 will be equivalent to about 12% of U.S. production of this item. The constraint on export subsidies that has had the greatest impact on EU dairy exports and world cheese prices is the GA TTIWTO constraint on subsidized cheese exports.., The EU's share of cheese exports of major exporting countries declined from 56.7% in 1995 to 45.6% in New Zealand's 5.9 point gain in market share, Australia's 3.5 point gain, and the small gains in market share recorded by the U.S. and Canada approximately equal the loss of market share recorded by the EU during 1995 to Agra Europe reports that "Even the de facto operation of a two-tier exporting system, through discrimination against the high value product in the allocation of export subsidies, will not solve the problem when the Union gets to the point of having more than 1.5 million tons of milk equivalent export availability above the GAIT limit." IV. Implications of the WTO Panel's Decision for Canadian, U.S. and EU Dairy Export Expansion Programs Absent a wro challenge, Canada's Class 5 pricing system would have provided that country with a mechanism for making essentially unlimited exports of subsidized dairy products. The system would have invited imitation by other countries and undermined the effectiveness of Uruguay Round GATT agreement limits on dairy export subsidies. A Class 5 pricing and pooling arrangement-if it survived a wro challenge-would be particularly beneficial to Canada as a "small country" exporter. For example, under the Class 5 pricing scheme, Canada could make essentially uillimited subsidized dairy exports without sharply depressing world prices for dairy products. If the U.S. or EU used a similar system, this would depress prices in "thin" international dairy product markets and eliminate a portion of the benefits for U.S. or EU farmers. It apparently would not be feasible for the U.S. to employ a "Class IV" export class under which the proceeds from the export sales would be pooled under federal milk orders. The wro panel decision regarding Canada's Class 5 system suggests that such sales would have to be counted against the limited subsidized export sales permitted the U.S. under the GAITIWTO. Even if large quantities of U.S. dairy products could be exported with subsidy under a "Class IV" arrangement, it might not be prudent to make such sales. Large additions to exports from a "large country" exporter such as the U.S. would depress world dairy commodity prices and limit the benefits to U.S. producers from the initiative. The U.S. dairy industry will have incentives to push for elimination of dairy export subsidies under the wro negotiating round that begins in late Stringent limits exist on DEIP exports available to the U.S. (relative to comparable limits facing Canada and the EU) and any "Class IV" dairy exports based on a new end use pricing and pooling system would have to be counted against limits on subsidized dairy exports the U.S. agreed to under the Uruguay Round GATT agreement. These and other considerations put the U. S. Babcock Institute Discussion Paper No

9 dairy industry in a position where it likely would be better off if dairy export subsidy programs throughout the world were eliminated. Will the WTO panel's ruling survive Canada's challenge? There is probably not much point in speculating on this issue since the outcome of the appeal will be known in a few months. However, many U.S. dairy organizations believe that the WTO panel's decision is based on a strong rationale. 4 Babcock Institute Discussion Paper No. 99-1

10 CANADA's CLASS 5 PRICING SYSTEM, THE EU's DAIRY EXPORT RESTITUTION PROGRAM, AND THE U.S.'s DEIP-AN UPDATE ON IMPACTS OF DAIRY EXPORT SUBSIDY PROGRAMS Introduction W. D. Dobson This paper describes how dairy export subsidy programs work and discusses implications of recent developments regarding these controversial programs for U.S. dairy export expansion efforts. Controversy surrounding export subsidy programs reflects, in part, beliefs that the programs depress prices in "thin" international dairy markets (only the equivalent of about 6% of world milk production enters global markets in the form of internationally traded dairy products) and cause exporters from nonsubsidizing countries or exporters from countries that adhere to GA TTIWTO export subsidy reduction commitments to lose market share. In addition, the export subsidies create distortions, inefficiencies, and welfare losses in international markets. Attention here focuses mainly on Canada's Class 5 pricing system, the European Union's (EU) export restitution system, and the U.S.'s Dairy Export Incentive Program (DEIP). Dairy export subsidy programs figured prominently in the dairy trade news in early 1999 after a World Trade Organization (WTO) panel ruled that Canada's Class 5 milk pricing scheme represented an export subsidy, and that Canada was not in compliance with the dairy export subsidy reduction commitments made under the Uruguay Round GATT agreement. (Canada reportedly will appeal the WTO panel's decision [10]). The U.S. Trade Representative has requested consultations with the EU under the auspices of the WTO to consider whether the EU's internal processing system for cheese has circumvented the Union's Uruguay Round GATT agreement commitments with regard to subsidized cheese exports. U.S. organizations allege that the EU has circumvented its commitments on cheese by exporting processed cheese under subsidy while counting these exports against other (non-binding) export subsidy commitments relating to processed cheese components~specially butter and powdered milk. The WTO panel's ruling on Canada's Class 5 pricing system will influence the nature of the programs that it will be feasible for U.S. organizations to implement as they attempt to expand dairy exports. Finally, the Dairy Farmers of America, American Farm Bureau Federation, New Zealand Dairy Board and other organizations have indicated that they favor instituting WTO rules to further reduce foreign dairy export subsidies. Such support for change will likely make export subsidy practices an important item on the agricultural trade agenda for the WTO negotiations that begin in Seattle, Washington late in The above considerations make analysis of impacts of dairy export subsidy programs worthwhile items of inquiry. Purposes of the Paper The purposes of the paper are to: 1. Describe dairy export subsidy programs and discuss in general terms how they work. II. Describe Canada's Class 5 (Special Milk Classes) pricing system, the EU's export restitution program, and the U.S.'s Dairy Export Incentive Program (DEIP). III. Analyze the impact of the Uruguay Round GATT agreement on dairy export subsidy programs. IV. Discuss implications of the WTO panel's ruling regarding Canada's Class 5 pricing system for Canadian, U.S. and EU dairy export expansion programs. Babcock Institute Discussion Paper No

11 I. What Are Dairy Export Subsidies and How Do They Work? What Are Dairy Export Subsidies? In non-technical language, dairy export subsidies are payments, fund transfers, or concessions made by a government to private firms to help the finns compete in international dairy markets. A country will sometimes employ dairy export subsidies because border protection, price support programs, and/or production quotas raise the country's dairy product prices above world prices, making it difficult (or impossible) for the country's finns to compete in foreign markets without export subsidies. In straightforward cases, the government provides a per unit subsidy to the exporter approximately equal to the difference between the domestic price and the world price for the exported dairy product to pennit the exporter to compete in world markets on the basis of price. Of course, the language of trade agreements regarding export subsidies is more complicated than the non-technical description. Article 9.1 of the WTO Agreement on Agriculture specifies the export subsidies that are subject to reduction commitments under the Agreement on Agriculture, as follows [22, p. 171]: (a) The provision by governments or their agencies of direct subsidies, including payments-inkind, to a fum, to an industry, to producers of an agricultural product, to a co-operative or other association of such producers, or to a marketing board, contingent on export perfonnance; (b) The sale or disposal for export by governments or their agencies of non-commercial stocks of agricultural products at a price lower than the comparable price charged for the like product to buyers in the domestic market; (c) Payments on the export of an agricultural product that are financed by virtue of governmental action, whether or not a charge on the public account is involved, including payments that are financed from the proceeds of a levy imposed on the agricultural product from which the exported product is derived; (d) The provision of subsidies to reduce the cost of marketing exports of agricultural products (other than widely available export promotion and advisory services) including handling, upgrading and other processing costs, and the costs of international transport and freight; (e) Internal transport and freight charges on export shipments, provided or mandated by governments, on tenus more favorable than for domestic shipments; (f) Subsidies on agricultural products contingent on their incorporation in exported products. It is noteworthy that Canada's government has argued before the WTO that Canada's Class 5 pricing system-based on end use pricing and the pooling of lower returns from dairy export sales--d.oes not constitute an export subsidy as defmed by Article 9.1. Canada's argument is based partly on the fact that there is no explicit reference to end use pricing and pooling as being an export subsidy in Article 9.1. The WTO panel that considered the challenge from the U.S. and New Zealand to Canada's Class 5 pricing system rejected Canada's argument. The panel found with respect to Class 5 (d) and (e) pricing, that Canada"... has acted inconsistently with its obligations under Article 3.3 and Article 8 of the Agreement on Agriculture by providing export subsidies as listed in Article 9.1 (a) and Article 9.1 (c) of that Agreement in excess of the quantity commitment levels specified in Canada's Schedule... [22, p. 207]." (See Section II for more on this issue.) How Do Dairy Export Subsidy Programs Work? The answer to this question depends on a number of factors, including how large a market share the subsidized exporter has, whether the export subsidies are targeted toward particular country markets, and the products for which the subsidies apply. 6 Babcock Institute Discussion Paper No. 99-1

12 Blayney and Fallert in Figure 1 show how one dairy export subsidy works in the abstract using a "two-country" partial equilibrium analysis where Country A is a net exporter of dairy products to the world market [4]. ES and ED are the excess supply curves and excess demand curves, respectively, in the world market for dairy products. Figure 1. Prices and Quantities with Price Supports and an Export Subsidy p P s T pi ---+ I I I I I I -/ I I I I o Foe E Country A * Source: Blayney and Fallert [56]. q ED o X* X World Market Blayney and Fallert describe the situation as follows: In the absence of price supports, the price established in the international market, P', would be the price in Country A. At the price P', consumption in Country A would be OD, production OC, and exports DC. What would happen if Country A established a price support program where the support price was T, above P'? At T, the government would be required to purchase quantity EF, the difference between a higher quantity produced (OE) and lower quantity consumed (OF). An export subsidy could be used to export the accwnulated stocks rather than store the product, give it away or otherwise isolate the product from the domestic market. Exporting quantity FE=OX would lower the world price to P" and the subsidy on each unit exported by Country A would be the difference between T and P". In summary, Country A's support price and export subsidy program would raise the price, reduce conswnption, and increase exports of that country. What are the practical implications of this simple example? Country A's consumers would prefer the lower prices that existed before price supports and the export subsidy program were introduced. Country A's export subsidy depresses world prices for dairy products. (World prices were reduced from P' to P" in the simple example). Consumers in the world market purchase dairy products at lower prices while milk producers in the world market receive lower prices for their products. The government of Country A finds it cheaper to subsidize the exports of dairy products rather than purchase the entire quantity of dairy products produced at the support price, T. The export subsidy program costs the government of Country A the difference between T and P" times the quantity exported with subsidy in the example while a purchase prog.(am would cost Country A's government the amount T times the quantity FE. As noted earlier, the impact of export subsidies depends partly on the importance-measured mainly by export market share--of the subsidizing exporter. N. Mitchell, representing the New Babcock Institute Discussion Paper No

13 Zealand Dairy Board, a non-subsidizing exporter, characterized the impact of competing EU and DEIP dairy export subsidies as follows in a 1994 statement [12, pp ]: Virtually every kilogram of its (EU) exports are subsidized so now, it is the level of European subsidies which, more than any other single factor, sets international dairy product price levels... More recently the United States has joined the fray. The way the U.S. government operates its Dairy Export Incentive Program has produced a very close replica of the European Community's export restitution system. The result is that subsidies are competing with subsidies. Price and trade bear less and less relationship to the underlying economies of milk and dairy products production. Mitchell's concerns and those of the New Zealand Dairy Board can be illustrated by the impact of EU actions on nonfat dry milk (NDM) prices. EU actions contributed to a sharp run-up of international NDM prices in 1988 and 1989 that was followed by a collapse in world NDM prices. This volatility is traceable partly to tightening and subsequent loosening of EU milk supplies under the Union's quota system and associated changes in EU subsidized NDM exports. Figure 2, developed by the Australian Dairy Corrunission, suggests how EU export subsidies affected world prices for NDM during 1989 to EU firms, which collectively had about a 34% market share of major country exports of NDM during this period, caused the indicative world price to closely approximate the German wholesale price minus the EU export refund (subsidy). Figure 2. Movements of German Wholesale Prices, EU Export Refunds, and Indicative International Prices for NDM* US $/tonne 3,500 3,000 German Wholesale Price 2,500 r-...-",,",,- 2,000 1,500 1, Plus EU Export Refund Indicative World Price O +---~~---r--~--~--.---~-.--~---r~ Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 * Source: Australian Dairy Corporation, 1994 Dairy Compendium [72]. In a 1992 publication, the Australian Dairy Board generalized regarding the impact of EU dairy export subsidies on prices of bulk dairy products in international markets as follows [2, p. 71]: Owing to its dominant position in terms of the supply of most major products, the EC tends to set traded prices in those international markets which are not subject to quota restrictions. Typically export prices in non-quota markets tend to equate to the internal supported price in the EC less the available export refund. While prices in actual markets do not behave precisely as this comment suggests, the claim has some plausibility if the subsidizing exporter--as is the case with the EU--has a large market share and the ability to serve as a price leader and market mover. The ED's market shares and presumably the influence of EU export subsidies on world prices of certain dairy products will decline as GATIIWTO limits on subsidized exports and other developments reduce the Union's subsidized dairy exports. 8 Babcock Institute Discussion Paper No. 99-1

14 Canadian finns clearly do not possess the large export market shares enjoyed by EU finns. However, the success of Canadian exporters aided by the Class 5 (Special Milk Classes) program was described by the National Milk Producers Federation, the U.S. Dairy Export Council, and the International Dairy Foods Association in a petition to the U.S. Trade Representative in 1997 as follows [14, pp ]: ". Canada has increased its exports of natural cheese (to Japan) by 717% in the past six months. Canada is under pricing the United States by as much as US$500 per metric ton in this market, which is the major market for U.S. cheese. In Korea, Canada took business from a U.S. firm by offering mozzarella cheese at a constant price of US$3,250 per metric ton C&F for one year. Thus, a nearly 600 metric ton customer was lost. A similar lost account occurred in early August of Another purchaser of mozzarella cheese in Korea switched from its U.S. supplier to Agropur, a Canadian company, which again underbid the U.S. supplier. Perhaps the clearest example of the injury caused by Canada's dairy price pooling system comes from the worldwide sales of Baskin Robbins ice cream. The Baskin Robbins plant near Toronto now has taken over much of the manufacturing for worldwide supplies with the exception of the U.S. market. The subsidy provided by Canada is approximately 70 cents per gallon. This is such a significant amount that Baskin Robbins was able to move its manufacturing to Canada. Thus, while Canada is a not a price setter in international markets comparable to the EU, Canadian finns--<>perating with the aid of the Class 5 pricing system-have succeeded in capturing market share from U.S. finns in certain foreign markets. II. Canada's Class 5 (Special Milk Classes) Pricing System, the EU's Export Restitution Program, and the U.S.'s DEIP Canada's Class 5 (Special Milk Classes) Pricing System Canada employs a two-tiered pricing and pooling system for milk that is operated by the Canadian Dairy Commission (CDC), The Canadian Milk Supply Management Committee (CMSMC), and provincial milk marketing boards. Class prices are established by the CDC, CMSMC, and provincial boards using fonnulas and other mechanisms. The Canadian milk pricing system is similar in some ways to the classified pricing system used in U.S. federal milk orders. However, it differs from the U.S. system in that Canada uses special class prices for milk used to produce dairy products destined for export markets and products that compete with dairy imports. The U.S. makes no distinction in the federal order classes regarding whether the milk is used to produce dairy products sold domestically, sold domestically in competition with imports, or exported. Under the Canadian classified pricing system, Classes 1 through 4 are defined as milk used to produce the following items [22, p. 9]: Class 1: Fluid milk and cream for the domestic market. Class 2: Industrial milk for the domestic market: ice cream, yogurt, and sour cream. Class 3: Industrial milk for the domestic market: cheese. Class 4: Industrial milk for the domestic market: butter, condensed milk, evaporated milk, milk powder and other products. The Class 5 (Special Milk Classes) items under the Canadian system are defined as milk used to produce the items appearing below [22, pp. 9-10]: Class 5(a) Cheese ingredients for further processing for the domestic and export markets. Class 5(b) All other dairy products for further processing for the domestic and export markets. Babcock Institute Discussion Paper No

15 Class 5(c) Domestic and export activities of the confectionery sector. Class 5(d) Specific negotiated exports including cheese under quota destined for the U.S. and UK markets, evaporated milk, whole milk powder, and niche markets. Class 5(e) Surplus removal. Class 5(e) milk is made up of both in-quota and over-quota milk. The over quota portion of Class 5(e) represents the milk produced that is in excess of the market sharing quota [22, p. 10]. The in-quota portion of Class 5(e) represents the milk production that is surplus to domestic and planned export needs. Class 5 milk is pooled nationally under a pool operated by the CDC [17, p. 53]. The pooling of returns for Class 5 milk includes the revenues from the sale of Class 5 components, plus a share of the returns from sales in other classes. The USDA explained in a July 1997 article how the system operated under rules operating at that time, as follows [17, p. 54]:... The CDC uses the province with the highest percentage of milk in Class 5 as the standard and pools that percentage for the whole country. Thus, if Province A sells 20 percent of its MSQ (Market Sharing Quota) milk into Class 5 while the other provinces are in the 4 to 5 percent range, then 20 percent of all MSQ milk will be in the national pool for Class 5 milk. The pooling of returns in this fashion results in a "sharing of the burden" of the lower prices for Class 5 milk among all Canadian producers and does not cause producers in provinces where a larger than average percentage of the milk is used to produce dairy products destined for export to receive lower than average milk prices. J. Schildroth, Director of the Trade Competition Branch for the British Columbia Ministry of Agriculture, Fisheries and Food, described the need for this type of pooling as follows in a 1996 paper [16, p. 202]: Nine provinces have agreed to pool special classes, which collectively fall into Class 5 in the new, harmonized system. Special classes include export classes and ingredient classes to provide competitive dairy inputs to domestic further processors. Returns are pooled nationally, with each province required to contri bute a minimum amount of Class 5 milk to this pool, from higher classes if necessary. Pooling was done to ensure all provinces paid for structural surplus exports, whether or not a province was generating any such surplus, or benefiting form the export or import-replacing activities of the CDC. Canadian dairy processors purchase designated categories of Class 5 milk at prices negotiated by the CDC that will allow the processors to be competitive in export markets or with imported dairy products. To obtain milk that will be used to produce Class 5 export items, a processor/exporter must secure a permit from the CDC. A permit holder then presents the permit to a provincial marketing board, which provides the milk used to produce dairy products for export. Among other things, the issuing of permits prevent processor/exporters from purchasing milk at export class prices and selling the product domestically, gaining an advantage over processors paying Class 1 to Class 4 prices. The Class 5 pricing system replaced a schedule of producer levies that had been employed prior to August Prior to August 1, 1995 Canada imposed a levy to pay for the export subsidy granted by the CDC to dairy exporters [14, p. 15]. The levy was subtracted from each producer's milk check for the sale of milk in classes 1 through 4. The levies were used to pay a direct subsidy to Canadian dairy product exporters to allow these finns to compete on the world market. This system was used until the GATTIWTO limits agreed to by Canada in the Uruguay Round GATT Agreement limited the amount and value of subsidized dairy exports that Canada could make using the producer levies. 10 Babcock Institute Discussion Paper No. 99-1

16 As noted earlier, Canada has argued that the Class 5 (Special Milk Classes) system does not represent an export subsidy. U.S. and New Zealand dairy organizations disagreed-claiming that the Canadians failed to adhere to GAITIWTO commitments on subsidized dairy exports- and described Canada's Class 5 (Special Milk Classes) system, as follows [14, pp ]: Under this system, known as Class 5, the CDC arranged for the processor to purchase milk, not at the domestic price charged in Classes 1 through 4 as before, but at a lower price that would allow the processor to manufacture the product at a competitive world price. Thus, the money that was previously collected from the dairy producers, was transferred directly to the processor from the producer in the form of a lower price, administered, negotiated and enforced by CDC. Key points relating to the WTO panel's ruling that the Class 5 pricing system was considered to be an export subsidy-and those that may establish precedents-included the following: The U.S. and New Zealand were primarily concerned with Canada's Class 5 (d) and 5(e) prices, although the U.S. claimed that other parts of the Class 5 price could produce export subsidies. Accordingly, the panel's decision related almost exclusively to assessing whether the Class 5(d) and Class 5 (e) pricing arrangements were export subsidies. Findings of the WTO panel indicating that Canada's Class 5 system constituted export subsidies as defined by Article 9.1 (a) and Article 9.1 (c) of the WTO Agreement on Agriculture formed the basis for much of the panel's ruling. With respect to Article 9.1 (a), the WTO panel said: "We found earlier that the provision of lower priced milk to processors for export under Classes 5(d) and (e) constitutes a payment in kind to processors/exporters contingent upon export performance. We also found that this milk is provided by Canada's governments or its agencies. On these grounds, we find that the making available of milk under Classes 5(d) and (e) constitutes an export subsidy within the meaning of Article 9.1(a) [22, p. 185]." With respect to Article 9.1(c), the WTO panel reported: "We found earlier that the provision of lower priced milk to processors for export under Classes 5(d) and (e) constitutes a 'payment' to these processors/exporters 'on the export of an agricultural product.' We also found that this 'payment' is 'financed by virtue of governmental action.' On these grounds, we find that the making available of milk under Classes 5(d) and (e) constitutes an export subsidy within the meaning of Article 9.1 (c) [22, p. 193]." Canada's position was that its government agencies are not involved in providing milk under Classes 5(d) and (e). Rather, it was argued, government agencies in Canada have only an implementing and oversight role in establishing and maintaining efficient operation of the system. Such government intervention, it was argued, does not approach the level required under Article 9.1 (a). The WTO panel conceded that the government involvement required under Article 9.1(a) to create an export subsidy is one of degree that must be addressed on a case-by-case basis. However, after noting information on the pervasive involvement of Canada's government in the Class 5 pricing system, the panel rejected Canada's argument. The WTO panel found that 5(e) over quota milk sales were to some extent pooled, although the nature of the pooling differs from that of 5(d) milk. For example, the panel noted that the price received by a producer for over quota milk is not the actual return for the transaction made, but a three month moving average of all returns achieved nationally for over-quota milk. This quasipooling was apparently sufficient to cause the panel to lump the 5(e) over quota sales with all pooled milk used to produce dairy products that entered export markets. In summary, the WTO panel's decision stated that "Canada provides export subsidies as listed in Article 9.1 in respect of the three dairy products at issue (butter, cheese, and "other d~ products"), and this for both marketing years in dispute, in excess of the quantity commitment levels specified in its Schedule, contrary to its obligations under Article 3.3 [22, p. 194]." Babcock Institute Discussion Paper No

17 Canada' s Class 5 Pricing System, The EU's Dairy Export Restitution Program, and the U.S.'s DEIP Canada's commitments under the Uruguay Round GATT agreement regarding subsidized exports and exports produced under Classes 5(d) and 5(e) appear in Table 1. Table 1. Canada's Commitments Regarding Subsidized Dairy Exports Under the Uruguay Round GATT Agreement and Subsidized Dairy Exports Generated Under Classes 5(d) and 5(e)* Product and Maximum Subsidized Exports under % by which Marketing Year Exports (Mt) Classes 5(d) and 5(e) (3) Exceeds (2) Under GATTIWTO (Mt) (1) (2) (3) Butter 1995/96 9,464 9, % 1996/97 8,271 10, Cheese 1995/96 12,448 13, % 1996/97 11,773 20, Other Milk Products 1995/96 36,990 37, % 1996/97 35,649 60, * Source: WTO, "Canada-Measures Affecting the Importation of Milk and the Exportation of Dairy Product," Report of the Panel, May 17, 1999, p The increase in exports under Classes 5(d) and 5(e) from 1995/96 to 1996/97 is noteworthy. The increases in the latter marketing year exceeded the GATTIWTO maximums by 250/0 for butter and 730/0 for cheese. The EU's Export Restitution System The ED's export restitution program for dairy products was adopted as a companion piece to other government dairy market interventions. The ED's production quotas established in 1984, border protection measures, and an internal price support program keep Union domestic milk and dairy product prices above world prices. The production generated by the market interventions generates larger amounts of milk and dairy products than will clear the market at supported prices. In order to avoid the need to store and dispose of all the surplus dairy products generated in the domestic market (and the associated budget outlays), the EU employs export subsidies for dairy products. Ritson describes a typical Common Agricultural Policy program and its component export subsidy program using Figure 3 [15, p. 5]. The example is an abstract representation of the actual program, which fails to reflect all features introduced after the Uruguay Round GATT agreement. However, Figure 3 describes essential features of the ED's export subsidy programs. Each year the EU Council of Ministers sets target prices for dairy products and other commodities. The target prices are intended as a guide to producers and a reference point for policy operations. The mechanism that ensures that internal market prices are kept near the target level is a levy on imports (now a tariff rate quota) that generally prevents imported products from undercutting the target prices [15, p. 5]. The initial variable levies (converted to declining tariffs under the Uruguay Round GATT agreement) were calculated by reference to minimum import prices-sometimes known as the threshold prices- and were set a little below the target price to 12 Babcock Institute Discussion Paper No. 99-1

18 reflect the cost of transport from port to internal market points. Unlike the variable levies used prior to the Uruguay Round GAIT agreement, the declining tariffs introduced in 1995 may expose some EU dairy products to foreign competition within Europe during the next few years-especially during periods of low world prices. Figure 3. Model of a Typical Common Agricultural Policy System* Target price Target price Minimum import price I Import levy t Export subsidy Intervention price ~ World price World price + * Source: Ritson, [15, p.5]. Imports Exports Ritson notes that a relatively high import tariff will, on its own, keep internal market prices near the target level as long as the EU is less than self-sufficient in the commodity. However if, as has frequently been the case, EU farmers supply more of the commodity than can be sold on domestic markets at or near the target price, internal prices will begin to drop below target levels. To address this eventuality, the second line of defense described below is used to prevent surpluses from depressing producer prices [15, p. 6]: An intervention price is set somewhat below the target price. If the internal market price should now fall to the intervention level, official intervention agencies will buy produce offered to them at the intervention price. The agency will then store the produce and subsequently export it at a loss. Alternatively, private traders receive an export subsidy (known as a refund or restitution) equal to the difference between the intervention price and the world price, and in fact the bulk of surplus produce has been disposed of in this way. For some commodities, other methods are used to dispose of surpluses. For example, both wheat and skimmed milk powder have been subsidised for use as animal feeding-stuffs. Actual EU export subsidies available to exporting finns are adjusted to reflect world prices for dairy products, competitive conditions in target markets, and constraints imposed by the Uruguay Round GAIT agreement on export subsidies, particularly for cheese. For example, the USDA reported in 1998 that the EU had selectively reduced the export subsidies for some destinations, such as other European countries where EU cheese is competitively priced without subsidy [20, p. 14]. In a related adjustment in September 1997, the EU Commission divided the world into the following three zones: Babcock Institute Discussion Paper No

19 Eastern Europe and Russia. USA. Rest of the World (including the Middle East and Japan). Export subsidies for Eastern Europe were reduced by 20%, while those for the "Rest of the World" were increased by 10%. The 10% increase in export subsidies for the portion of the "Rest of the World," comprised of the Middle East and Japan, represented an important measure since EU exporters were encountering strong competition in those markets. The USDA reported that the following average EU export subsidy rates prevailed for exports by Union flnns at the end of 1997 [18, p. 15]. Product Subsidy in US$ Subsidy as % of U.S. Market Per Metric Ton Price for December 1997 NDM $ % WMP 1, Butter 1, Butteroil 2,413 NA Cheddar Cheese 1, EU export subsidies for different times, different competitive situations, and for particular market channels will differ from the averages. For example, the U.S. Department of Commerce reported that following information on EU export subsidies for U.S. within-quota cheese imports for the October I-December 31, 1998 quarter [5]: Countries Austria, Finland France, Germany Belgium, Netherlands, Portugal, Spain, U.K., Luxembourg Italy Greece Export Subsidy Range $.25 to $.30 lib.20 to to As noted in the schedule, the EU export subsidies for within quota cheese destined for the U.S. ranged from zero for Greece to $.25 to $.30 per pound (or about 15% of the U.S. market price) for Austria and Finland during the fourth quarter of EU export subsidies create both advantages and disadvantages for EU exporters. The EU system allows subsidies to be established for up to four months into the future for cheese and up to five months into the future for butterfat and milk powders [18, p. 14]. Exporters regard such advanced "prefixing" of subsidies as an important mechanism for reducing their risks. A potentially important disadvantage of the EU system is that it is so transparent that it allows exporters from other countries to undercut EU prices in export markets. In this connection, the USDA reported the following in December 1998 [19, p. 39]: Given the transparent nature of its (the EU's) export restitution system coupled with its intervention system it has become a simple exercise for competitors to rapidly adjust prices as subsidy levels are increased. As a consequence, in recent months, EU prices have been at the upper end of the acceptable range while NDM from Oceania at $1,275-1,350 per ton FOB, has been closer to the bottom as Australia and New Zealand have vied with each other to capture markets. 14 Babcock Institute Discussion Paper No. 99-1

20 Of course, this phenomenon is no mystery. Similar undercutting frequently takes place in international grain markets when government interventions affecting prices under a transparent system create opportunities for undercutting a competitor's price. For the EU, one of the bigger challenges is dealing with the Union's Uruguay Round GATT commitments to reduce subsidized cheese exports. The inward processing system for cheese mentioned earlier is a response to the binding GAITIWTO constraints on subsidized cheese exports. Because of the base period used to establish limits on subsidized butter exports, subsidized exports of this EU product are not tightly constrained. The U.S.'s Dairy Export Incentive Program The DEIP is a program administered by the Foreign Agricultural Service (FAS) and Commodity Credit Corporation (CCC) of the USDA, which helps exporters of U.S. dairy products compete on the world market. The help is provided through targeted export subsidies for different regions, which make U.S. dairy products competitive in international markets, especially against subsidized EU dairy exports. Certain milestones in the legislative history for the DEIP are as follows: Section 153 of the 1985 Farm Bill mandated that the DEIP be established and operated by the CCC through September 30, 1989 [20]. The 1990 Farm Bill extended the DEIP through December 31,1995. The 1996 Farm Bill extended the DEIP through December 31, 2002 [13, p. 1]. Under the 1985 Farm Bill and for a limited time under the 1990 Farm Bill, DEIP export subsidies consisted of generic certificates that could be exchanged for commodities in CCC inventories. But, beginning on November 6, 1991, the use of generic certificates for paying DEIP subsidies was discontinued and replaced with cash subsidies [6]. In the late 1980s and in 1990, relatively little use was made of the DEIP, partly because international prices of NDM-the principal export item under the DEIP-rose above U.S. market prices in 1989 and 1990, fostering U.S. commercial exports of the product. The DEIP was reactivated on March 1, 1991 after world prices for NDM fell below the U.S. support price. In fiscal 1991,30,470 metric tons of milk powder, butteroil, butter, and cheese were exported with DEIP subsidies totaling $39.3 million [21]. DEIP subsidies for dairy products rose to over $140 million for both 1992 and Algeria (long a major EU market) and Mexico became major destinations for DEIP exports of NDM in 1992 and How the Current DEIP Program Works Under the current DEIP, the commodities eligible for export subsidies are NDM, whole milk powder, butterfat (butter and butteroil), and cheddar, mozzarella, Gouda, Feta, cream, and processed American cheeses. The quantities of U.S. dairy products eligible for DEIP subsidies for July 1,1998 through June 30,1999 appear in Table 2 and reflect the U.S.'s commitment to reduce subsidized exports under the Uruguay Round GAIT agreement. NDM is the major DEIP export item. (The item described as "Reinstated Nonfat Dry Milk" in Table 2 consists of DEIP allocations for a previous period that were not used and that were carried forward to 1998/99.) Butter is a distant second in terms of the tonnage eligible for DEIP export subsidies in All DEIP sales are made by private finns. Once an invitation for bids is issued by the USDA, it is the responsibility of exporters to contact prospective buyers in countries eligible for subsidies and negotiate a sales contract covering price, quantity, quality, delivery and other terms. The.sale may be contingent upon getting USDA's approval of a bonus (subsidy). Each prospective exporter submits a bid to USDA requesting a subsidy that would allow the sale to take place at the agreed upon price. Babcock Institute Discussion Paper No

21 Table 2. Quantities of U.S. Dairy Products Eligible for DEIP Export Subsidies, July 1, 1998 Through June 30, 1999* Commodity Quantity (Metric tons) % of 1999 U.S. Production Nonfat Dry Milk 84, % Reinstated Nonfat Dry Milk 26, Whole Milk Powder 5, Cheese 3, Butter 29, * Sources: International Dairy Foods Association," News Update," May 1999 and USDA, "Dairy: World Markets and Trade," FD 3-98, December An exporter interested in participating in the DEIP must provide the following information to the USDA: The name and address of an agent for service of legal process in the U.S. A description and documented proof of business structure, including how and where the business is incorporated. A certified statement describing participation, if any, during the past three years in U. S. government programs, contracts or agreements. A certified statement that the exporter is not debarred, suspended, or proposed for debarment from any federally administered program. In addition, exporters must post a performance security before submitting a request to the USDA for an export subsidy. How the DEIP Has Evolved Kiendl describes the early years of the DEIP and evolution of the program as follows [11]: In the early days, the emphasis was on battling European subsidized exports and getting rid of surplus stocks of u.s. butter and nonfat dry milk. But with the signing of the Uruguay Round Agreement and the implementation of the Federal Agricultural Improvement Act of 1996, there has been a growing recognition in the U.S. dairy industry that the role of government in international and domestic markets is set to decline. Now the industry is entering a period of uncertainty as it moves towards a more market-oriented environment where the traditional government support net will be much lower. Kiendl describes program changes that, he argues, have made the DEIP more effective for expanding sales of U.S. dairy products, as follows [11]: While traditionally the bulk of NDM was exported to Mexico and North Africa, the program has been expanded to cover a number of Asian countries that continue to offer long-term market potential, despite recent economic problems in the region. Registration qualifications have been changed to allow broader participation in the program. Program allocations are no longer country-specific but regional, giving exporters incentives to pursue the most attractive markets. Noting that the DEIP's role as simply a market clearing device is diminishing, Kiendl forecasts the DEIP sales will be increasingly made to markets where the "U.S. dairy industry ultimately holds a competitive edge in the absence of subsidies [11, p. 2]." While, as claimed by Kiendl, the Asian markets undoubtedly will be growth markets, making them eligible for DEIP subsidies represents a departure from earlier practice. In early years under the DEIP, markets served primarily by nonsubsidizing exporters such as the New Zealand Dairy 16 Babcock Institute Discussion Paper No. 99-1

22 Board were off limits for DEIP subsidies. Of course, making the Asian markets eligible for DEIP export subsidies was not welcomed by nonsubsidizing exporters. The regionalization of program allocations has doubtless made the DEIP more flexible and attractive to users. Indeed, the regionalization of allocations expanded in early 1999 to the point that all remaining allocations of NDM were "globalized," meaning that those allocations could be sold to any previously eligible regions [9, p. 7]. Export Subsidies Under the DEIP Figures showing the average subsidies (bid acceptances) received by exporters of selected U.S. dairy products during October 1998 through March 1999 appear in Table 3. The individual bid acceptance figures used to compute the averages appearing in Table 3 are listed in Appendix Table 1. Table 3. Selected Export Subsidies (Bid Acceptances) Received by Exporters of U.S. Dairy Products, October 1998-March 1999* Product Export Subsidy Export Subsidy as (U.S. $lmetric Ton) % of U.S. Market Price Nonfat Dry Milk October 1998 $ 1, % November , December , January February , March , Whole Milk Powder September 1998 $ 1, % December , January , February , Processed American Cheese September 1998 $ 1, % October , November , December , January , Mozzarella Cheese October 1998 $ 1, % December , Varietal Cheese February 1999 $ 1,000 NA * Sources: USDA, FAS Press Releases Summarized in Appendix Table 1, USDA, "World Markets and Trade," FD 3-98, December 1998, and USDA, "Dairy Market News," various issues, Babcock Institute Discussion Paper No

23 The monthly average DEIP subsidies for NDM-the largest DEIP export item-ranged from $979 per ton ($.44/lb) in January 1999 to $1,072 per ton ($.49Ilb) during November 1998, and averaged more than 40% of the U.S. market price. DEIP whole milk powder export subsidies were equivalent to about a third of the U.S. market price for the product during September 1998 through February DEIP export subsidies for processed American cheese ranged from $1,192 per ton ($.54/lb) in September 1998 to $1,525 per ton ($.69/lb) in October and December 1998, averaging about one-third of the market price for this product. The figures in Table 3 indicate export subsidies equivalent to 30% to 40% of the market price are needed to make U.S. bulk milk powder and cheese products competitive in world markets. However, the export subsidies for NDM-the item for which price support purchases are still needed-were less than a half the support price for the product. Hence, from the standpoint of budget outlays, DEIP export subsidies are less costly than NDM product purchases under the price support program. DEIP export subsidies (bid acceptances) were similar for sales to different foreign destinations. The average export subsidies for NDM for October 1998 through March 1999 are shown in Table 4 for three regions. The DEIP export subsidies for NDM sales to Africa and the Middle East differed from those for the Caribbean, Central & South America-the lowest subsidy destination-by $36 per ton (3.5%). The difference was smaller ($17 per ton, l.7%) for exports to Asia and the Former Soviet Union as compared to those for the Caribbean, Central and South America. Differences in costs of shipping products to the various destinations are reflected in the export subsidy figures. Competitive conditions in these regions apparently permit similar export subsidies. Table 4. Average of Monthly DEIP Export Subsidies for NDM, October 1998 Through March 1999, Ranked by Destination* Destination Average Export Subsidy % of Lowest Subsidy (U.S. $ per Metric Ton) Caribbean, Central & South America $1, % Africa & Middle East 1, Asia & Former Soviet Union 1, * Source: USDA, FAS Press Releases Summarized in Appendix Table' \. The Transparency ofdeip Export Subsidies The same transparency that exists with respect to EU dairy export subsidies prevails with regard to the DEIP. Recent information on DEIP bids accepted is available on the internet, together with the names of finns that were successful bidders, the amount of product that successful bidders would export, the sales region to which the product would be sold, and the delivery period. This information is a potentially valuable source of competitor intelligence for firms interested in gaining market share at the expense of exporters of U.S. dairy products. How Effectively Would the DEIP Support u.s. Farm Milk Prices in the Absence of Dairy Price Supports Based on Product Purchases? As is well known, the USDA's dairy price support program is scheduled to end after Under the current dairy price support program, the USDA purchases NDM, butter, and cheese at prices needed to support U.S. farm milk prices at designated levels-$9.90 per hundredweight in Butter and cheese prices have remained above support levels in recent periods, causing many in the U.S. dairy industry to conclude that a price support program is not needed for these products. However, the National Milk Producers Federation indicates that a structural surplus of NDM equivalent to about 400 million pounds of NDM-about one-third of recent annual U. S. NDM production-exists in the U.S.[13]. This plausible claim means that there are about 400 million pounds ofndm that will not clear the market at U.S. NDM prices of $l.00 to $l.05 per 18 Babcock Institute Discussion Paper No, 99-1

24 pound (prices that prevailed in the U.S. early in 1999). This structural surplus is currently dealt with through USDA price support purchases, DEIP exports, and USDA purchases of NDM for donations. Certain U.S. dairy industry groups have lobbied the Congress to continue the dairy price support program until If this effort is successful, the impact of the structural surplus of NDM will be of limited concern to the U.S. dairy industry until after However, successful lobbying for an extension of dairy price supports might only delay until 2002 (not eliminate) the need to address the following question: How effective will the DEIP be as a mechanism for supporting U.S. farm milk prices in the absence of a dairy price support program based on product purchases? While no claim is made that the structural surplus of NDM is precisely 400 million pounds, this number and related information developed by the National Milk Producers Federation (appearing below) can be used to analyze how effectively the DEIP might work in the absence of the current price support program [13]. StructuralSuf21us 400 DEIP Usage 100% 150 CCC Donations 85 Total Use 235 Residual to Market 165 Thus, the above schedule shows that: Each year 150 million pounds of NDM can be exported with subsidy under the DEIP-the maximum amount that can be exported with subsidy under the Uruguay Round GAIT agreement. The CCC can acquire another 85 million pounds of NDM and distribute the product as food aid. This leaves 165 million pounds of NDM (about 14% of 1999 U.S. NDM production) that must be isolated from the domestic market if prices are to be maintained near $1.00 per pound. Under current programs involving USDA dairy product purchases, DEIP exports, and CCC donations, there is no problem in isolating price-depressing surpluses from the domestic market. While obviously not drawn to scale, Figure 4 illustrates this point. In the figure, there is a domestic demand curve (DD), a total demand curve (TD), and a supply curve (S). The difference between the total demand and the domestic demand is the amount of NDM exports. At the assumed world price of $.65 per pound, markets clear and there are commercial exports equal to Qt -Qd. However, with a $1.00 per pound price, there is an excess supply. In order to maintain the $1.00 per pound price, the government must isolate the quantity AB of NDM (the excess supply) from the domestic market. This can be done through purchase and storage programs and purchases for donations. In addition, part of the excess supply can be exported with DEIP export subsidies by giving exporters a subsidy equal to the difference between the domestic price of $1.00 per pound and the world price of $.65 per pound. Complications arise when the USDA no longer purchases dairy products to support U.S. milk and dairy product purchases. The DEIP program currently works, in part, because NDM purchases by the USDA and border protection provided by U.S. tariff rate quotas for NDM create a wedge between domestic prices and world prices for the product. But what if there is no longer a USDA price support program based on product purchases? - Babcock Institute Discussion Paper No

25 Figure 4. Prices, Exports, and Excess Supply with Various Nonfat Dry Milk Prices* $1.00/Ib. r :B~ s Q) u '': Il.. $.65/Ib. I-----Ir-----~ TD o t Quantity * Source: Modified version of diagrams appearing in R. Knutson, J.B. Penn, and B. Flinchbaugh, Agricultural and Food Policy, International trade theory and experience tell us that relatively small imports of an agricultural commodity will tend to push domestic prices of the commodity in question toward world price levels. But, it might be argued, this will not be the situation in the U.S. because the nation's tariff rate quotas will keep all but small quantities of foreign NDM out of the U.S. However, there is still the troublesome matter of the 165 million pounds of NDM (14% of NDM production) that will not be isolated from the domestic market. While this is not an imported product, its presence will have a similar impact. This 14% of domestic NDM production is likely to depress prices of all U.S. NDM to near world levels. If this happens, the DEIP-which provides export subsidies to make up the gap between the domestic price and world price- will have little function. There will be little or no price gap to fill with an export subsidy and the DEIP will find little use. The price impact described is a modest overstatement since the CCC donations in the schedule presented earlier will shift the domestic demand curve to the right and keep U.S. prices from falling all the way to world price levels. However, the amount of price support provided by the CCC donations is likely to be small and U.S. prices for the product will fall to near world levels. Alternative scenarios describing different outcomes can, of course, be constructed. Alternative Scenario No.1 One alternative scenario calls for the U.S. industry to produce sharply lower quantities of NDM in response to any substantial drop in the market price for the product. If this action eliminated most or all the structural surplus of NDM, then of course the problem just described would diminish in importance. However, limits exist to the amount of milk that can be channeled away from NDM without causing potentially objectionable increases in output and reductions in prices in other affected segments of the U.S. dairy industry. In particular, the impact of such an 20 Babcock Institute Discussion Paper No. 99-1

26 action on U.S. cheese production and cheese prices could be substantial. Moreover, NDM is a joint product (admittedly not a peifect example of a joint product), the production of which cannot be changed without modifying the output of butter and other products, again necessitating adjustments that would not necessarily be welcomed by all segments of the U.S. dairy industry. In view of these problems, it may be heroic to assume that the price impacts of the 400 millionpound structural surplus of U.S. NDM can be largely eliminated by altering the U.S. dairy product mix to reduce NDM production. Alternative Scenario No.2 A second alternative scenario would have private firms develop an import substitution plan to use some of the milk components that have created the structural surplus of NDM to produce casein. Such an import substitution plan would require an internal subsidy-possibly collected through producer levies-to make it feasible, since casein is less profitable to produce than NDM. Alternative Scenario No.3 A third scenario would have cooperatives use funds collected from milk producers to finance exports of part of the NDM structural surplus. There might be wro-compatible ways to make such producer-financed subsidized exports without having the exports count against the subsidy limits agreed to by the U.S. under the Uruguay Round GATT agreement. This is possible because such an arrangement could be structured so that it did not involve the government, and producer assessments to finance the program could be voluntary. However, both arrangements would be difficult to achieve. Moreover, because it would represent an extension of, or partial replacement for, DEIPexports, such an initiative could attract challenges under the wro. III. Impacts of the Uruguay Round GATT Agreement on Dairy Export Subsidy Programs The Uruguay Round GATT agreement required countries to limit the amount and value of subsidized agricultural exports by 21 % and 36%, respectively, from base period amounts. Commitments made under the agreement by Canada, the EU and the U.S. to reduce dairy export subsidies are described below in Table 5 followed by an analysis of the impacts of such commitments. Noteworthy points emerge from Table 5 and comments that appeared earlier in the paper regarding the Uruguay Round GATT agreement: Canada, the EU, and U.S. all have agreed to reduce the quantity of subsidized exports of butter, NDM, and cheese in by 21 % from the base period quantities. While Canada agreed to the reduction in export subsidies shown in Table 5, the Canadian government, as noted earlier, disagreed with the U.S. and New Zealand regarding what constituted an export subsidy. However, if the WTO panel's decision is not overturned on appeal, Canada will be required to adhere to the subsidy totals shown in Table 5. Because the U.S. employed limited dairy export subsidies (compared to Canada and the EU) during the base period, the U.S. finds itself more tightly constrained than Canada and the EU by the Uruguay Round GATT agreement on subsidized exports of dairy products. Canada, for example, which produces 11 % to 12% as much milk as the U. S., will be permitted to export with subsidy two-thirds as much NDM as the U.S. and will be permitted to export with subsidy three times as much cheese as the U.S. in under the GATT agreement. U.S. subsidized exports of butter and cheese in 2000/01 will be equivalent to 4.1 % and 0.1%, respectively, of 1999 U.S. production of these products. Maximum U.S. subsidized exports of NDM in will be larger-equivalent to about 12% of U.S. NDM production in However, maximum U.S. subsidized exports of NDM in will be only about 60% as large as the actual DEIP exports of NDM in 1992 and Babcock Institute Discussion Paper No

27 Table 5. Base Quantities of Canadian, EU, and U.S. Dairy Exports and Maximum Quantities that can be Exported with Subsidy Under the GATT Agreement* Country and Year Base Period Quantities and Maximum Quantities that can be Exported with Subsidies under GATT r r... Butter NDM Cheese Canada (l,000 metric tons) Base Quantity ( ) GATT Agreement 1995/ / / / / / European Union Base Quantity ( ) GA TT Agreement 1995/ / United States Base Quantity ( ) GA TT Agreement 1995/ / / / / / * Sources: USDA, FAS, Dairy Annual Report For Canada, 1997, and USDA FAS, "Dairy: World Markets and Trade," FD 1-94, March While the EU agreed to make relatively large reductions in the tonnage of butter, NDM, and cheese that would be exported with subsidy by 2000/01, the constraints on butter exports will not likely be binding on EU exports. This is so because in the 1990s, the EU has exported with subsidy quantities of butter that are substantially smaller than the maximums agreed to under the Uruguay Round GATT agreement. For example, in 1992 and 1993 the EU exported with subsidy an average of only 202 thousand metric tons of butter, which was only 55% of the maximum quantity permitted under the GATT agreement for 2000/0l. The EU is more likely to bump up against the constraints on NDM exports late in the 2000 or 2001 period since the GATT maximums for 2000/01 are 27% less than actual subsidized 22 Babcock Institute Discussion Paper No. 99-1

28 exports of the product during However, EU dairy finns have expressed fewer concerns about the GAIT constraints on subsidized exports of NDM than they have for those on cheese. The constraint on EU exports that has had the greatest impact on EU dairy exporters and on world cheese prices is the GAITIWTO constraint on subsidized cheese exports. The maximum amount of cheese that the EU can export with subsidy in 2000/01 is 305 thousand tons, which is 34% less than the average annual EU exports of subsidized cheese in The impact of the constraint on subsidized cheese exports within the ED is exacerbated by the requirement that the EU open 5 % of the market to cheese imports by 2000/01. The impact of the GAITIWTO-mandated reduction in the EU's subsidized exports of cheese can be seen in Table 6. The EU's share of cheese exports of major exporting countries declined from 56.7% in 1995 to 45.6% in A decline in EU cheese exports of 96 thousand metric tons was associated with this 11.1 point reduction in market share [19]. New Zealand apparently was a main beneficiary, gaining 5.9 points of market share during the period. New Zealand's 5.9 point gain in market share, Australia's 3.5 point gain, and the small gains in market share by the U.S. and Canada are approximately equal to the loss of market share recorded by the EU during 1995 to The limits on EU exports of subsidized cheese forced ED firms to make strategic adjustments to shift cheese sales from third country markets to the EU. For example, Jens Bigum, Group Managing Director of MD Foods of Denmark (Denmark's dominant dairy firm), in a 1994 comment forecasting the probable impact of the Uruguay Round GATT agreement on his finn said, "... before the year 2000, MD Foods must switch exports of 32,000 tons of cheese from markets outside the EU to those within the EU [3, p. 6]." MD Foods proved capable of making this adjustment, exceeding the target identified by Bigum [7, p. 12]. Ireland's Dairy Board indicated the need to make similar adjustments [8]. The EU recorded a decline in market share for NDM from 34.9% in 1995 to 27.4% in New Zealand gained over four points of NDM market share during the period from 1995 to 1998 (Table 6). While EU finns have been required to reduce subsidized exports of dairy products under the GA IT agreement, the EU will remain a much larger exporter of subsidized dairy products than the U.S. The EU can satisfy the constraints of the GATT agreement for 2000/01 while exporting with subsidy 3.5 times as much NDM and 100 times as much cheese as the U.S. The constraint on budget outlays for dairy export subsidies (a 36% reduction from the base period expenditures) presumably has given countries incentives to achieve economies in the use of the export subsidies. For example, the budget constraint apparently causes governments to channel export subsidies to products and markets requiring the smallest outlay to move a given quantity of product. In the EU, the budget constraint has contributed to reduced expenditures for export subsidies for products and markets where finns have a chance to compete without subsidies. Early assessments of the impact of the Uruguay Round GATT agreement predicted dire consequences for the EU as a result of the dairy export subsidy reductions required by the agreement. For example, a 1996 article in Agra Europe entitled, "EU dairy sector approaching policy crunch" trumpeted [1, p. PIl]: Despite the leeway built into the early stages of the GAIT Agreement, the EU is facing an inevitable collision between the level of dairy production and the limits on subsidized exports in the period.... Even the de facto operation of a two-tier exporting system, through discrimination against the high value product in the allocation of export subsidies, will not solve the problem when the Union gets to the point of having more than 1.5 million tons of milk equivalent export availability above the GAIT limit. Babcock Institute Discussion Paper No

29 Canada's Class 5 Pricing System, The EU's Dairy Export Restitution Program, and the U.S.'s DEW This quotation--especially the reference to operation of a de facto two-tier exporting system-illustrates adjustments that have been made in EU policies in response to the Uruguay Round limits on subsidized exports. Too, if the situation is unfolding as suggested in the article, it should have been no surprise that the EU has implemented measures such as inward processing to deal with the stringent constraints on subsidized cheese exports. However, it is perhaps surprising that the EU has not made greater efforts to reduce Union milk production if EU surpluses are likely to approach the levels suggested by the Ag@ Europe article. Table 6. Export Market Shares of Major Dairy Exporting Countries, * Country and Year Butter Cheese NDM WMP Canada % % % % European Union % % % % United States % % % % New Zealand % % % % * Source: USDA, "Dairy, World Markets and Trade," FD 3-98, Dec., Figures for 1998 are preliminary. Figures for 1999 are forecasts. Exports of minor exporting countries were not taken into account in computing market shares. IV. Implications of the WTO Panel's Decision Regarding Canada's Class 5 Pricing System for Canadian, U.S., and EU Dairy Export Expansion Programs This section is concerned mainly with assessing what can be gleaned from the important WTO decision with respect to Canada's Class 5 pricing system. 24 Babcock Institute Discussion Paper No. 99-1

30 Implications of the WTO Panel's Decision for Canada's (and other Countries') Dairy Export Expansion Efforts If it survives Canada's appeal, the WTO panel's decision regarding Canada's Class 5 pricing system has implications that extend beyond the constraints that it will place on Canada's dairy exporting practices. Canada's transparent transition to end use pricing and pooling in August 1995 produced a system that was, in numerous respects, similar in impact to the producer levies that were subject to explicit reduction commitments under Article 9.1 of the WTO Agreement on Agriculture. When Canada chose not to count dairy exports made with the benefit of its end use pricing and pooling arrangement against the WTO constraints on subsidized exports, it invited a challenge under the WTO. Absent a WTO challenge, Canada's Class 5 pricing system would have provided Canada with a mechanism for making essentially unlimited export subsidies for dairy products. Survival of such a system could have invited imitation by other countries and undermined the effectiveness of Uruguay Round GATT agreement limits on dairy export subsidies. Canada's Class 5 pricing and pooling arrangement is particularly beneficial to a "small country" exporter like Canada. If its Class 5 pricing system had survived the WTO challenge, Canada could have made essentially unlimited exports of subsidized dairy exports without sharply depressing world prices for dairy products. If a similar system were used by the U.S. or EU, it would depress prices in "thin" world markets and eliminate a portion of the benefits for U.S. or EU fanners. Canada will have substantial capacity to make subsidized exports of dairy products while adhering to its GAITIWTO commitments to reduce subsidized dairy exports. Specifically, in Canada will be able to export with subsidy while adhering to GAITIWTO constraints three times as much cheese and two-thirds as much NDM as the U.S. while maintaining a dairy industry (as measured by milk production) that is 11 % to 12% as large as that of the U.S. The WTO panel's decision did not address the issue of the WTO compatibility of end use pricing and pooling for promotion of import substitution programs. Canada's Class 5 pricing gives price discounts to processors who purchase milk used to produce products that compete with dairy imports. This system discourages exports of dairy products to Canada. Implications for U.S. Dairy Export Expansion Efforts Implications that emerge for U.S. dairy export expansion efforts include the following: The WTO panel's decision entitled, "Canada-Measures Affecting the Importation of Milk and the Exportation of Dairy Products" should be required reading for those planning to develop new dairy exporting programs that might attract WTO challenges as export subsidy arrangements. It apparently would not be feasible to employ a "Class IV" export class with the proceeds from the export sales pooled under the federal milk orders. The WTO panel decision regarding Canada's Class 5 system suggests that such sales would have to be counted against the subsidized export sales permitted under the GA ITIWTO agreement. Moreover, the constraints on subsidized U.S. dairy exports under the DEIP are so stringent that relatively small amounts of dairy products could be exported under such a "Class IV" arrangement. Even if large quantities of dairy products could be exported with subsidies under such an arrangement, it might not be prudent to put such a program into operation. Additions to exports from a "large country" exporter such as the U.S. could depress world prices for bulk dairy products substantially and limit the benefits to U.S. producers from such an export subsidy program. Babcock Institute Discussion Paper No

31 It is unclear whether a producer financed export subsidy program for NDM would attract a wro challenge. The National Milk Producers Federation has suggested that a producerfinanced program could be used to subsidize the exports of part of the structural surplus of NDM that cannot be exported with DEIP subsidies or that the USDA does not purchase for food assistance programs [13]. Arguably, a program could be constructed that would be wro-compatible if the govenunent was not involved in operating the program and participation by producers was voluntary, both of which are difficult to achieve. But the program would be a transparent extension of, or replacement for, DEIP subsidized exports that might attract a wro challenge. Implications for EU Dairy Policies of Developments Regarding EU Dairy Subsidies Two issues warrant discussion. First, proposals to employ a two-tier dairy export subsidy program-{)f the type advocated by the Danish Dairy Board, in particular-will be discouraged by the wro panel's decision regarding Canada's program. There was little chance that such a program would be introduced anyway since fears existed that expanded exports by the EU, a "large country" exporter, would sharply depress world dairy product prices. The wro panel's decision regarding Canada's Class 5 pricing system makes it still more unlikely that a two-tiered export subsidy system will be introduced by the EU. There is no recent news regarding the EU's inward processing arrangement for cheese. While this program appears to be a mechanism for circumventing GA TTIWTO limits on subsidized cheese exports, the program has found limited use. While the WTO has been alerted that the U. S. objects to the program, no dispute settlement panel has been appointed to render a decision regarding the EU's inward processing arrangement. 26 Babcock Institute Discussion Paper No. 99-1

32 REFERENCES 1. Agm Europe, "Panorama from Brussels, EU Dairy Sector Approaching Policy Crunch," February 23, 1996, p. PIl. 2. Australian Dairy Corporation, Dairy Compendium. 1992, p Bigum, J., "Eastern Revival, but Denmark Forced to Shift Exports," Dairy Industries International, March 1994, p Blayney, D.P. and R. Fallert, "The World Dairy Market-Goverrunent Intervention and Multilateral Policy Reform," ERS-USDA Staff Report No. AGES 9053, August Cheese Market News, "List of foreign cheese subsidies published," April 9, The Cheese Reporter, "Dairy Export Incentive Program: A Look At Its Operations, Impacts," October 30, 1992, p Dobson, W., "The Evolution and Strategies ofmd Foods of Denmark and the Danish Dairy Board-Implications for the U.S. and World Dairy Industries," Babcock Institute Discussion Paper 98-1, November 1998,29 pages. 8. Dobson, W., "Positioning the Firm to Export Dairy Products in the 21 sl Century-Lessons from the Dairy Boards of Ireland and New Zealand," Babcock Institute Discussion Paper No. 96-3, November 1996,29 pages. 9. International Dairy Foods Association, "DEIP Update," News Update, April 1999, p International Dairy Foods Association, "International Happenings, Canada to Appeal WTO Ruling," News Update, May 1999, p Kiendl, P., "The DEIP-An Important Market Development Tool," FAS-USDA, 1998, Jas.usda.gov/info/agexporterIl Mitchell, N. "GAIT and the Dairy Industry-GAIT: Possibilities and Threats from the Point of View of the New Zealand Dairy Industry," Dairy Industries International, February 1994, pp National Milk Producers Federation, Discussion Paper Developed for Meeting of American Farm Bureau Federation Dairy Advisory Committee, February 20, 1999, Orlando, Florida. 14. National Milk Producers Federation, U.S. Dairy Export Council, and International Dairy Foods Association, "Section 301 Petition for the Office of the United States Trade Representative, Case No. 97," Submitted September 5, Ritson, C. Chapter 1 in The Common Agricultural Policy, edited by C. Ritson and D. Harvey, CAB International, Wallingford, UK, Schildroth, J., "Contemporary Dairy Policy Changes in Canada: A Western Canada Perspective," Exhibit I in National Milk Producers Federation, U.S. Dairy Export Council, and International Dairy Foods Association, "Section 301 Petition for the Office of the United States Trade Representative, Case No. 97," Submitted September 5, U.S. Department of Agriculture, "Dairy: World Markets and Trade," FD 2-97, July U.S. Department of Agriculture, "Dairy: World Markets and Trade," FD 1-98, January U.S. Department of Agriculture, "Dairy: World Markets and Trade," FD 3-98, December U.S. Department of Agriculture, "Dairy Situation and Outlook Report," DS-413, January 1988, p U.S. Department of Agriculture, "World Dairy Situation," FD 2-91, November 1991, p World Trade Organization, "Canada-Measures Mfecting the Importation of Milk and the Exportation of Dairy Products," WTIDS103/R, WTIDS113/R, May 17, 1999,207 pages. Babcock Institute Discussion Paper No

33 APPENDIX Appendix Table 1. DEIP Export Subsidy Data, October 1998-March 1999* Product & Bid Subsidy Amount Destination Acceptance Date ($/mt) (mt) Nonfat Dry Milk Oct. 19, 1998 $1, Caribbean, Central & South America Oct. 19, , Africa & Middle East Oct. 21, , Caribbean, Central & South America Oct. 22, , Africa & Middle East Nov. 2,1998 1, Africa & Middle East Nov. 2,1998 1, Caribbean, Central & South America Nov. 5,1998 1, Caribbean, Central & South America Nov. 6, , Asia & Former Soviet Union Nov. 9, , Caribbean, Central & South America Nov. 10,1998 1, Caribbean, Central & South America Nov. 12,1998 1, Caribbean, Central & South America Nov. 17, , Caribbean, Central & South America Nov. 18, , Africa & Middle East Nov. 19, , Asia & Former Soviet Union Nov. 20, ,080 1,200 Caribbean, Central & South America Nov. 23, ,080 1,213 Caribbean, Central & South America Nov. 23, , Asia & Former Soviet Union Nov. 23, , Africa & Middle East Nov. 24, ,080 3,385 Caribbean, Central & South America Nov. 24, , Africa & Middle East Nov. 25, ,078 2,220 Caribbean, Central & South America Nov. 25,1998 1,080 3,000 Caribbean & Mexico Nov. 25, , Africa & Middle East Nov. 27, ,080 5,173 Asia & Former Soviet Union Nov. 27, ,115 1,108 Africa & Middle East Nov. 27, , Caribbean, Central & South America Dec. 7,1998 1, Caribbean, Central & South America Dec. 8, , Caribbean, Central & South America Dec. 8, ,000 1,000 Caribbean & Mexico Dec. 8, , Africa & Middle East Dec. 14, , Asia & Former Soviet Union Dec. 16, , Caribbean, Central & South America Dec. 17, ,070 Caribbean, Central & South America Dec. 18, , Caribbean, Central & South America Dec. 18, , Africa & Middle East Dec. 21,1998 1, Asia & Former Soviet Union Dec. 22, , Caribbean, Central & South America Dec. 24, , Caribbean, Central & South America Dec. 24, ,000 1,000 Asia & Former Soviet Union 28 Babcock Institute Discussion Paper No. 99-1