UNIVERSITI PUTRA MALAYSIA

BONHEE CHUNG

IKDPM 2015 1

IMPACTS OF LIBERALIZING RICE MILLING SECTOR IN MALAYSIA USING SYSTEM DYNAMICS FRAMEWORK

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IMPACTS OF LIBERALIZING RICE MILLING SECTOR IN MALAYSIA USING SYSTEM DYNAMICS FRAMEWORK

By

BONHEE CHUNG

Thesis Submitted to the School of Graduate Studies, Universiti Putra Malaysia, in Fulfilment of the Requirements for the

Degree of Doctor of Philosophy

February 2015

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All material contained within the thesis, including without limitation text, logos, icons, photographs and all other artwork, is copyright material of Universiti Putra Malaysia unless otherwise stated. Use may be made of any material contained within the thesis for non-commercial purposes from the copyright holder. Commercial use of material may only be made with the express, prior, written permission of Universiti Putra Malaysia.

Copyright © Universiti Putra Malaysia

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Abstract of thesis presented to the Senate of Universiti Putra Malaysia in fulfilment of the requirement for the degree of Doctor of Philosophy

IMPACTS OF LIBERALIZING RICE MILLING SECTOR IN MALAYSIA USING SYSTEM DYNAMIC FRAMEWORK

By

BONHEE CHUNG

February 2015

Chair: Datin Paduka Prof., Fatimah Mohamed Arshad, PhD

Faculty: Institute of Agricultural and Food Policy Studies

The Malaysian government has regulated the rice industry through price controls, provision of various subsidies and monopoly on rice importation among other policies. The government’s main objectives are to achieve rice self-sufficiency, improve paddy farmers’ income and keep rice affordable for low income households in particular. By means of price fixation, the government imposes the guaranteed minimum price at farm level and ceiling price at retail level. As a consequence, the government has effectively restricted the profitability of rice millers who play an important role by purchasing rough paddy from farmers and then producing white rice for consumers. The government has also directly intervened in the rice milling sector by establishing public mills and provided them a rice miller subsidy as well as an electricity subsidy for producing affordable rice, known as ST15 in local market.

For many years, there have been concerns over market liberalization in many countries around the world. The Malaysian government is expected to comply with the WTO’s demand for market liberalization, which translates into removals of the protectionist policies. Some important questions arise over how the liberalized market would cope with structural changes and more importantly whether it can stabilize rice prices in Malaysia. The change in market structure are most likely to have sequential effects on key variables such as rice prices, production, consumption, import, rice millers’ capacity utilization and capital investments, milling efficiency represented by the head rice recovery ratio and the rice self-sufficiency level.

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Using a system dynamics approach to modeling the rice industry in Malaysia, the author developed a system dynamics model in an attempt to illustrate the behavioral patterns of the rice milling sector in the context of whole rice industry in Malaysia. And then the author ran simulations of policy change such as removals of price controls and the subsidies, and examined their impacts on the key variables. The author also ran simulations of policy alternatives that can stabilize rice prices and again examined their impacts on the other key variables.

The simulation results of policy changes show that the removal of price controls has considerable impacts on the key variables, while the removal of rice miller and electricity subsidies has little impacts on the key variables. The simulation results of policy alternatives suggest that terminating the monopoly on rice importation is the most effective way to stabilize rice prices, even though Malaysia’s rice self-sufficiency stays at the minimum level. Malaysia is able to stabilize rice prices and achieve the 100% self-sufficiency goal through land conversion from non-granary areas to granary areas; however, there are financial, physical and technical constraints to initiate the land development. Malaysia can also stabilize rice prices and achieve the goal by permitting paddy importation into Malaysia at the expense of local paddy farmers.

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Abstrak tesis yang dikemukakan kepada Senat Universiti Putra Malaysia sebagai memenuhi keperluan untuk ijazah Doktor Falsafah

KESAN LIBERASASI SEKTOR PENGILANGAN BERAS DI MALAYSIA DENGAN MENGGUNAKAN RANGKA KERJA SISTEM DINAMIKS

Oleh

BONHEE CHUNG

Februari 2015

Pengerusi: Datin Paduka Prof., Fatimah Mohamed Arshad, PhD Fakulti: Institut Kajian Dasar dan Pertanian Makanan

Kerajaan Malaysia telah mengawal industry beras di Malaysia melalui harga kawalan, pemberian pelbagai subsidi dan monopoli mengenai pengimportan beras antara dasar-dasar lain. Matlamat utama kerajaan adalah untuk mencapai tahap bekalan beras yang mencukupi, meningkatkan pendapatan petani padi serta dapat memberikan harga beras yang berpatutan terutamanya bagi isi rumah berpendapatan rendah. Dengan cara penetapan harga, kerajaan mengenakan jaminan harga minimum di peringkat lading dan harga maksimum di peringkat runcit. Dengan itu, kerajaan berkesan menghadkan pengilang beras dalam pembelian padi mentah daripada mengambil keuntungan daripada petani dan kemudian menghasilkan beras putih kepada pengguna. Kerajaan terus campur tangan dalam sector pengilangan beras dengan menubuhkan kilang-kilang awam dan memperuntukkan mereka dengan subsidi pengilangan beras serta subsidi elektrik untuk menghasilkan beras dengan harga yang berpatutan yang dikenali sebagai beras ST15 di pasaran tempatan. Selama bertahun-tahun, tidak ada kebimbangan terhadap liberalisasi pasaran di banyak Negara seluruh dunia. Kerajaan Malaysia dijangka akan mematuhi permintaan oleh WTO untuk liberalisasi pasaran, yang bermaksud menghapuskan dasar-dasar perlindungan yang ada. Beberapa soalan yang penting timbul ke atas bagaimana pasaran liberal akan menghadapi perubahan-perubahan struktur dan lebih penting sama ada ia boleh menstabilkan harga beras di Malaysia. Perubahan dalam struktur pasaran mungkin mempunyai kesan yang berturutan terutamanya

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ke atas pembolehubah utama seperti harga beras, pengeluaran, penggunaan, import, pengilang beras, kapasiti pengeluaran pengilang dan pelaburan modal, kecekapan pengilangan yang diwakili oleh nisbah pemulihan beras dan tahap kecukupan beras itu sendiri. Dengan menggunakan pendekatan sistem dinamik untuk pemodelan sector pengilangan beras dalam konteks industry beras di Malaysia, penulis membentuk model sistem dinamik dalam usaha untuk menggambarkan pola tingkahlaku bagi sektor pengilangan beras dalam konteks beras seluruh industri di Malaysia. Kemudian penulis melaksanakan simulasi dasar perubahan seperti menghapuskan kawalan harga dan subsidi serta meneliti kesannya pada pemboleh ubah utama. Penulis juga melaksanakan simulasi alternatif dasar yang boleh menstabilkan harga padi dan turut meneliti kesannya pada lain-lain pemboleh ubah utama. Keputusan simulasi perubahan dasar menunjukkan bahawa harga kawalan mempunyai kesan yang besar kepada pemboleh ubah utama, manakala penarikan subsidi pengilang beras dan elektrik mempunyai kesan yang kecil ke atas pemboleh ubah utama. Keputusan simulasi polisi alternatif mencadangkan bahawa pemansuhan monopoli ke atas perdagangan beras adalah cara yang paling berkesan untuk menstabilkan harga pasaran dan bekalan beras di Malaysia, walaupun tahap kecukupan beras di Malaysia tetap pada tahap minimum. Malaysia mampu untuk menstabilkan harga padi dan mencapai matlamat kecukupan beras 100% melalui penukaran tanah dari kawasan bukan jelapang ke kawasan jelapang.Walau bagaimanapun, terdapat kekangan kewangan, fizikal dan teknikal untuk memulakan pembangunan tanah. Malaysia juga boleh menstabilkan harga padi dan mencapai matlamat dengan membenarkan pengimportan padi ke Malaysia yang akan mengecilkan sector padi tempatan.

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ACKNOWLEDGEMENTS

I thank God my Father and the Lord Jesus Christ for everything. God forgave my sins once and for all through Jesus Christ who sacrificed himself on the cross for the sins of all mankind. He inspired me to pursue a visionary life of Joseph. As a loving father disciplines his beloved son, He brought me into the wilderness to discipline me. He has always given me strength, comfort, wisdom and hopes in times of trouble. He has always listened to my cries and prayers. As a result, I have become a far better and stronger person than I was before. Praise be to the Lord, to God our Savior. I am greatly indebted to Professor Datin Paduka Dr. Fatimah Mohamed Arshad for granting me the opportunity to pursue a doctoral degree under her supervision. I am very grateful for the financial support as well as her kindness and patience towards me. I would also like to express my gratitude to all my colleagues and friends in Malaysia who have shown me genuine humility and gentleness. I thank my mother who has never stopped loving and praying for me. I could not have come this far without her. I also thank all my brothers and sisters in Christ who have supported me through prayers, encouragements and donations. God has caused me to live the life of Joseph. It is my desire and honor to lead a life that is worthy of His calling. I will become a nation changer and a blessing to all people. Let my life be pleasing to His eyes and glorify Him above all names. His love endures forever. I will joyfully worship and praise Him until the last breath.

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I certify that a Thesis Examination Committee has met on 4 February 2015 to conduct the final examination of Bonhee Chung on his thesis entitled “Impacts of Liberalizing Rice Milling Sector in Malaysia using System Dynamics Framework” in accordance with the Universities and University Colleges Act 1971 and the Constitution of the Universiti Putra Malaysia [P.U.(A) 106] 15 March 1998. The Committee recommends that the student be awarded the Doctor of Philosophy.

Members of the Thesis Examination Committee were as follows:

Ahmad Shauib, PhD Principle Research Fellow Bioresource and Environmental Policy Laboratory Universiti Putra Malaysia (Chairman) Khalid Abdul Rahim, PhD Professor Faculty of Economics and Management Universiti Putra Malaysia (Internal Examiner) Mohd Khairol Anuar b. Mohd Ariffin, PhD Associate Professor Faculty of Engineering Universiti Putra Malaysia (Internal Examiner) Muhammad Tasrif, PhD Associate Professor School of Architecture, Planning and Policy Development Institut Teknologi Bandung Indonesia (External Examiner)

________________________ (Insert name of current Deputy Dean) (E.g. XXXXX XXXX, PhD) Professor and Deputy Dean School of Graduate Studies Universiti Putra Malaysia Date:

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This thesis was submitted to the Senate of Universiti Putra Malaysia and has been accepted as fulfilment of the requirement for the degree of Doctor of Philosophy. The members of the Supervisory Committee were as follows:

Fatimah Mohamed Arshad, PhD. Professor Faculty of Economics and Management Universiti Putra Malaysia (Chairman) Kusairi B Mohd Noh Senior Researcher Fellow Bioresource and Environmental Policy Laboratory Universiti Putra Malaysia (Member) Shaufique Fahmi Bin Ahmad Sidique, PhD. Senior Lecturer Faculty of Economics and Management Universiti Putra Malaysia (Member)

________________________ BUJANG KIM HUAT, PHD Professor and Dean School of Graduate Studies Universiti Putra Malaysia Date:

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Declaration by graduate student

I hereby confirm that:

this thesis is my original work; quotations, illustrations and citations have been duly referenced; this thesis has not been submitted previously or concurrently for any

other degree at any other institutions; intellectual property from the thesis and copyright of thesis are fully-

owned by Universiti Putra Malaysia, as according to the Universiti Putra Malaysia (Research) Rules 2012;

written permission must be obtained from supervisor and the office of Deputy Vice-Chancellor (Research and Innovation) before thesis is published (in the form of written, printed or in electronic form) including books, journals, modules, proceedings, popular writings, seminar papers, manuscripts, posters, reports, lecture notes, learning modules or any other materials as stated in the Universiti Putra Malaysia (Research) Rules 2012;

there is no plagiarism or data falsification/fabrication in the thesis, and scholarly integrity is upheld as according to the Universiti Putra Malaysia (Graduate Studies) Rules 2003 (Revision 2012-2013) and the Universiti Putra Malaysia (Research) Rules 2012. The thesis has undergone plagiarism detection software.

Signature: ________________________ Date: __________________

Name and Matric No.: _________________________________________

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Declaration by Members of Supervisory Committee

This is to confirm that:

the research conducted and the writing of this thesis was under our supervision;

supervision responsibilities as stated in the Universiti Putra Malaysia (Graduate Studies) Rules 2003 (Revision 2012-2013) are adhered to.

Signature: Name of Chairman of Supervisory Committee:

Signature:

Name of Member of Supervisory Committee:

Signature:

Name of Member of Supervisory Committee:

Signature:

Name of Member of Supervisory Committee:

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TABLE OF CONTENTS

Page

ABSTRACT i ABSTRAK iii ACKNOWLEDGEMENTS v APPROVAL vi DECLARATION viii LIST OF TABLES xiii LIST OF FIGURES xiv LIST OF ABBREVIATIONS xix

CHAPTER

1 INTRODUCTION 1 1.1 Background 1 1.2 Problem Statement 2 1.3 Research Objectives 5 1.4 Scope, Relevance and Limitations 6 2 INDUSTRY BACKGROUND 8 2.1 Introduction 8 2.2 Paddy Production 8 2.2.1 Areas Planted 8 2.2.2 Yields 10 2.2.3 Production 12 2.2.4 Granary Areas 14 2.3 Rice Processing 16 2.3.1 Development of Modern Rice Mills 16 2.3.2 Development of Public Rice Mill 18 2.3.3 Distribution of Rice Mills 19 2.3.4 Drying and Milling 22 2.3.5 Paddy Grading and Deduction Schedule 25 2.3.6 Rice Grading and Quality Control 28 2.4 Rice Consumption and Import 30 2.5 Supply Chain and Market Intervention 32 2.6 Energy Supply and Demand 34 2.7 Conclusion 38

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3 LITERATURE REVIEW 39 3.1 Introduction 39 3.2 System Dynamics as a Methodology 39 3.3 Confidence Building in System Dynamics Models 44 3.4 Econometrics vs. System Dynamics 46 3.5 System Dynamics Modelling on Commodity Market 48 3.6 Case Studies of Impacts of Trade Liberalization 53 3.7 Conclusion 55 4 METHODOLOGY 57 4.1 Introduction 57 4.2 Steps of the Modelling Process 58 4.3 Problem Articulation 60 4.4 Model Boundary 61 4.5 Sample Data Collection 62 4.6 Model Assumptions 62 4.7 Reference Modes 63 4.8 Dynamic Hypothesis 65 4.9 Subsystems Diagram 68 4.10 Causal Loop Diagrams 70 4.10.1 Reinforcing Loop 1 71 4.10.2 Reinforcing Loop 2 72 4.10.3 Reinforcing Loop 3 73 4.10.4 Reinforcing Loop 4 74 4.10.5 Balancing Loop 1 75 4.10.6 Balancing Loop 2 76 4.10.7 Balancing Loop 3 77 4.10.8 Balancing Loop 4 78 4.11 Stock and Flow Diagrams 79 4.11.1 Paddy Price and Production 79 4.11.2 Rice Processing 83 4.11.3 Rice Distribution and Import 87 4.11.4 Rice Demand 92 4.11.5 Rice Prices 95 4.11.6 Capacity Utilization 98 4.11.7 Capital Investments 101 4.11.8 Electricity Consumption 106 4.12 Model Validation 108 4.12.1 Structure Verification Test 108 4.12.2 Parameter Verification Test 109 4.12.3 Extreme Conditions Test 110 4.12.4 Behavior Reproduction Test 120 4.12.5 Behavior Sensitivity Test 127 4.13 Conclusion 137

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5 RESULTS AND DISCUSSION 138 5.1 Introduction 138 5.2 Simulation of Policy Changes 138 5.2.1 Price Controls Withdrawal 139 5.2.2 Rice Miller Subsidy Withdrawal 149 5.2.3 Electricity Subsidy Withdrawal 156 5.2.4 Price Controls and Rice Miller Subsidy

Withdrawals 157

5.2.5 Price Controls and Electricity Subsidy Withdrawals

164

5.2.6 Price Controls and All Subsidies Withdrawals

165

5.3 Simulation of Policy Alternatives 171 5.3.1 Converting Non Granary Areas into

Granary Areas 172

5.3.2 Importing Paddy for Local Rice Processing 181 5.3.3 Terminating Import Monopoly License 189 5.4 Conclusion 198 6 SUMMARY, CONCLUSION AND RECOMMENDATIONS 200 6.1 Summary 200 6.2 Conclusion 201 6.3 Recommendations for Policy Makers and Industry

Stakeholders 202

6.4 Recommendations for Future Research 203 REFERENCES/BIBLIOGRAPHY 205 APPENDICES 211 BIODATA OF STUDENT 249

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LIST OF TABLES

Table Page 2.1 Planted Areas, Paddy Production and Average Paddy Yields

in Granary Areas, Peninsular Malaysia, 2010 16

2.2 Distribution of Licensed Rice Mills in Malaysia 20 2.3 Distribution of Registered Rice Mills in MADA 20 2.4 Effects of the Moisture Content on Milling Yield and Broken

Kernels 23

2.5 Modern Rice Milling Processes 23 2.6 Paddy Deduction Schedule 26 2.7 Import Volume and Values of Rice by Exporting Country, 2010 32 2.8 Total Amounts of Paddy and Rice Subsidies 33 4.1 Model Boundary Chart 61 4.2 List of Key Parameter, Value, Unit and Source 109 4.3 List of Extreme Conditions Test 111 4.4 Summary Statistics of Behavior Reproduction 122 4.5 List of Parameters for the Sensitivity Analysis of the Retail

Price of ST15 129

4.6 List of Parameters for the Sensitivity Analysis of the Retail Price of SST5

131

4.7 List of Parameters for the Sensitivity Analysis of Rice Production

133

4.8 List of Parameters for the Sensitivity Analysis of Paddy Production

135

5.1 List of Policy Simulations and their Corresponding Key Variables

139

5.2 Comparison of Percentage Changes (%) in the Key Variables between PCW and PCW&ESW in 2025

165

5.3 Comparison of Percentage Changes (%) in the Key Variables between PCW&RMSW and PCW&RMSW&ESW in 2025

166

5.4 Comparison of Percentage Changes (%) in the Key Variables in 2025 after the Policy Changes

167

5.5 Comparison of Percentage Changes (%) in the Key Variables in 2017, 2020 and 2025 after the Policy Changes

169

5.6 Comparison of Percentage Changes (%) in the Key Variables in 2035 after the Policy Alternatives

198

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LIST OF FIGURES

Figure Page

1.1 Paddy Price, Rice Prices and Profit Margins in Malaysia, 1980 –

2010 2

1.2 Head and Broken Rice & Rice Recovery Ratio in Malaysia, 2002 – 2010

4

1.3 Rice Production and Estimated Electricity Cost in Malaysia, 1980 – 2010

5

2.1 Area Planted to Paddy in Malaysia, 1961 – 2012 (Hectare) 9 2.2 Area Planted to Paddy by Region in Malaysia, 1985 – 2011

(Hectare) 9

2.3 Area Planted to Paddy by State in Malaysia, 2011 (Hectare) 10 2.4 Average Paddy Yields in Malaysia, 1961 – 2012 (kg/ha) 11 2.5 Average Paddy Yields by Region in Malaysia, 1987 – 2011

(kg/ha) 11

2.6 Paddy Production in Malaysia, 1961 – 2012 12 2.7 Paddy Production by Region in Malaysia, 1985 – 2011 (Tonnes) 13 2.8 Paddy Production by State in Malaysia, 2011 (Tonnes) 13 2.9 Paddy Production by State in Malaysia, 2011 (Tonnes) 14 2.10 Paddy Areas and Average Yields in Malaysia, 1980 – 2010 15 2.11 Proportion of Rice Mills by State and Ownership in Malaysia,

2013 21

2.12 Proportion of Ethnic Ownership in Kedah, Perlis, Perak, and Kelantan, 2013

21

2.13 Flow Diagram of the Modern Rice Milling Process 25 2.14 Per Capita Consumption of Rice in Malaysia, 1980 – 2010 (kg

per capita) 31

2.15 Rice Consumption and Import in Malaysia, 1980 – 2010 (Tonnes)

31

2.16 Retail Price of Rice in Malaysia and World Price of Rice, 1980 – 2010 (RM/MT)

31

2.17 Subsidy Distributions for Paddy and Rice in Malaysia, 2010 34 2.18 Energy Demand by Sector in Malaysia, 1990 – 2011 (KTOE) 35 2.19 Primary Energy Supply in Malaysia, 1980 – 2010 (KTOE) 35 2.20 Market Prices of Major Petroleum Products and Natural Gas,

1990 – 2010 36

2.21 Electricity Consumption in Malaysia, 1980 – 2010 (KTOE) 36 2.22 Energy Input for Power Station in Malaysia, 1980 – 2010

(KTOE) 37

2.23 Electricity Tariff for the Industry Sector in Malaysia, 1980 – 2012 (RM/KWH)

38

4.1 Steps of the Modelling Process 59 4.2 Modelling Process in an Iterative Cycle 60

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4.3 Historical Behaviors of Key Variables (Paddy Production, Rice Production, Rice Consumption, Paddy Price and Rice Price)

64

4.4 Historical Behaviors of Other Key Variables (Gross Margin, Paddy Price, Rice Price, Production Costs and Head Rice Recovery Ratio)

65

4.5 Expected Behaviors of Key Variables (Production, Consumption, Import and Price)

66

4.6 Expected Behaviors of Other Key Variables (Rice Price, Gross Margin, Capacity Utilization, Capital and Head Rice Recovery Ratio)

67

4.7 Subsystems Diagram of the Rice Milling Sector in Malaysia 69 4.8 Causal Loop Diagram of the Rice Milling Sector in Malaysia 70 4.9 Reinforcing Loop 1: Capacity Utilization 71 4.10 Reinforcing Loop 2: Technical Progress 72 4.11 Reinforcing Loop 3: Capacity Expansion 73 4.12 Reinforcing Loop 4: Cost Effects on Price and Production 74 4.13 Balancing Loop 1: Costs of Production 75 4.14 Balancing Loop 2: Inventory Effect on Price 76 4.15 Balancing Loop 3: Price Effect on Consumption 77 4.16 Balancing Loop 4: Price Effect on Production 78 4.17 Sub Model 1: Paddy Price and Production 82 4.18 Sub Model 2: Rice Processing 86 4.19 Sub Model 3a: Rice Distribution 90 4.20 Sub Model 3b: Rice Import 91 4.21 Sub Model 4: Rice Demand 94 4.22 Sub Model 5: Price Setting 97 4.23 Sub Model 6: Capacity Utilization 100 4.24 Sub Model 7: Capital Investment 105 4.25 Sub Model 8: Electricity Consumption 107 4.26 Reality Check on Rice and Paddy Price 112 4.27 Reality Check on Paddy Price and Areas 113 4.28 Reality Check on Rice Recovery Ratio and Production 114 4.29 Reality Check on Rice Import and the Retail Price of ST15 115 4.30 Reality Check on Rice Import and the Retail Price of SST5 116 4.31 Reality Check on Population and Rice Consumption 117 4.32 Reality Check on Profit and Capacity Utilization 117 4.33 Reality Check on Profit and Capital 118 4.34 Reality Check on Profit and the Head Rice Recovery Ratio 119 4.35 Comparison between Simulated and Actual Outputs of Rice

Production 123

4.36 Comparison between Simulated and Actual Outputs of Rice Consumption

123

4.37 Comparison between Simulated and Actual Outputs of Rice Import

124

4.38 Comparison between Simulated and Actual Outputs of Paddy Production

125

4.39 Comparison between Simulated and Actual Outputs of Paddy 126

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Price 4.40 Comparison of Simulated and Actual Outputs of the Wholesale

Price of ST15 126

4.41 Comparison between Simulated and Actual Outputs of the Retail Price of ST15

127

4.42 Sensitivity Graph and Confidence Bounds for the Retail Price of ST15

129

4.43 Correlation Coefficients of ST15 Price and its Parameters 130 4.44 Sensitivity Graph and Confidence Bounds for the Retail Price of

SST5 131

4.45 Correlation Coefficients of SST5 Price and its Parameters 132 4.46 Sensitivity Graph and Confidence Bounds for Rice Production 133 4.47 Correlation Coefficients of Rice Production and its Parameters 134 4.48 Sensitivity Graph and Confidence Bounds for Paddy Production 136 4.49 Correlation Coefficients of Paddy Production and its Parameters 136 5.1 Effects of Removing Price Controls on the Wholesale & Retail

Prices of ST15 140

5.2 Effects of Removing Price Controls on the Wholesale & Retail Prices of SST5

141

5.3 Effects of Removing Price Controls on the Wholesale & Retail Prices of SST5

142

5.4 Effects of Removing Price Controls on Paddy Areas and Production

143

5.5 Effect of Removing Price Controls on Rice Production 144 5.6 Effects of Removing Price Controls on Rice Consumption and

Import 145

5.7 Effect of Removing Price Controls on the Rice Self Sufficiency Level

145

5.8 Effect of Removing Price Controls on Capacity Utilization 146 5.9 Effects of Removing Price Controls on Capital and Head Rice

Recovery Ratio 147

5.10 Dynamic Behaviors of Key Variables after PCW 148 5.11 Dynamic Behaviors of Other Key Variables after PCW 148 5.12 Effects of Removing the Rice Miller Subsidy on the Wholesale &

Retail Prices of ST15 150

5.13 Effects of Removing the Rice Miller Subsidy on the Wholesale and Retail Prices of SST5

150

5.14 Effects of Removing the Rice Miller Subsidy on Paddy Price and Areas

151

5.15 Effects of Removing the Rice Miller Subsidy on Paddy and Rice Production

152

5.16 Effects of Removing the Rice Miller Subsidy on Rice Consumption and Import

152

5.17 Effects of Removing the Rice Miller Subsidy on SST5 and ST15 Consumption

153

5.18 Effects of Removing Rice Miller Subsidy on SST5 and ST15 Consumption

154

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5.19 Dynamic Behaviors of Key Variables after RMSW 155 5.20 Dynamic Behaviors of Other Key Variables after RMSW 155 5.21 Effects of Removing the Electricity Subsidy on the Wholesale

Prices of ST15 and SST5 156

5.22 Effects of PCW and RMSW on the Wholesale and Retail Prices of ST15

157

5.23 Effects of PCW and RMSW on the Wholesale and Retail Prices of SST5

158

5.24 Effects of PCW and RMSW on Paddy Price and Areas 159 5.25 Effects of PCW and RMSW on Paddy and Rice Production 159 5.26 Effects of PCW and RMSW on Rice Consumption and Import 160 5.27 Effects of PCW and RMSW on the Rice Self Sufficiency Level 161 5.28 Effects of PCW and RMSW on Capacity Utilization 162 5.29 Effects of PCW and RMSW on Capital and Head Rice Recovery

Ratio 162

5.30 Dynamic Behaviors of Key Variables after PCW & RMSW 163 5.31 Dynamic Behaviors of Other Key Variables after PCW and

RMSW 164

5.32 Comparison of Percentage Changes (%) in the Key Variables in 2035 after Policy Changes

168

5.33 Addition of Land Conversion from Non-Granary to Granary Areas

173

5.34 Effects of PPSLC on Granary and Non Granary Areas 174 5.35 Effects of PPSLC on Paddy and Rice Production 174 5.36 Effects of PPSLC on the Wholesale and Retail Prices of SST5 176 5.37 Effects of PPSLC on the Wholesale and Retail Prices of ST15 176 5.38 Effects of PPSLC on Rice Consumption and Import 177 5.39 Effects of PPSLC on the Rice Self Sufficiency Level 178 5.40 Effects of PPSLC on Rice Import 178 5.41 Effects of PPSLC on Capacity Utilization, Capital and the Head

Rice Recovery Ratio 179

5.42 Dynamic Behaviors of Key Variables after PPSLC 180 5.43 Dynamic Behaviors of Other Key Variables after PPSLC 180 5.44 Addition of Importing and Purchasing Dried Paddy 182 5.45 Effects of RPPIM on Rice Production and Consumption 184 5.46 Effects of RPPIM on the Wholesale and Retail Prices of SST5 184 5.47 Effects of RPPIM on the Rice Self-Sufficiency Level 185 5.48 Effects of RPPIM on Importing SST5 186 5.49 Effects of RPPIM on Capacity Utilization, Capital and the Head

Rice Recovery Ratio 187

5.50 Dynamic Behaviors of Key Variables after RPPIM 188 5.51 Dynamic Behaviors of Other Key Variables after RPPIM 188 5.52 Doubling the Parameter Value of Desired Import Inventory

Coverage of Rice 190

5.53 Effects of IMBD on Importing ST15 and SST5 191 5.54 Effects of IMBD on the Wholesale Inventory of SST5 and ST15 191 5.55 Effects of IMBD on the Wholesale Inventory of SST5 and ST15 192

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5.56 Effects of IMBD on the Retail Prices of ST15 and SST5 193 5.57 Effects of IMBD on Rice Consumption and Production 194 5.58 Effects of IMBD on Paddy Price and Production 195 5.59 Effects of IMBD on Capacity Utilization, Capital and the Head

Rice Recovery Ratio 195

5.60 Effects of IMBD on the Rice Self Sufficiency Level 196 5.61 Dynamic Behaviors of Key Variables after IMBD 197 5.62 Dynamic Behaviors of Other Key Variables after IMBD 197

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LIST OF ABBREVIATIONS

ASEAN Association of South East Asian Nations

BERNAS Padiberas Nasional Berhad

ESW Electricity Subsidy Withdrawal

FAOSTAT Food and Agriculture Organization Corporate Statistics

GA Granary Areas

GDP Gross Domestic Product

GMP Guaranteed Minimum Price

IBD Inclined Batch Dryers

IMBD Import Bernas Discontinue

IMF International Monetary Fund

KADA Kemubu Agricultural Development Authority

KTOE Kilo Tonne of Oil Equivalent

MADA Muda Agricultural Development Authority

MSE Mean Square Error

NGA Non Granary Areas

PCW Price Controls Withdrawal

PPSLC Paddy Production Sector Land Conversion

RMS Root Mean Square

RMSPE Root Mean Square Percent Error

RMSW Rice Miller Subsidy Withdrawal

RPPIM Rice Processing Paddy Import

RTP Retail Price

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R&D Research and Development

SST5 Super Special 5%

SST10 Super Special 10%

ST15 Super Tempatan 15%

USA United States of America

USD United States Dollar

WHP Wholesale Price

WTO World Trade Organization

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CHAPTER 1

INTRODUCTION

1.1 Background Rice milling refers to a process of turning rough paddy into white rice. A rice miller plays an important role by purchasing rough paddy from paddy farmers and then producing white rice for consumers. However, the Malaysian government has paid less attention to the rice milling sector because of its tendency to give emphasis to paddy production and consumption sectors. The Malaysian government gives subsidies to paddy farmers to boost local production. The government is also keen on raising paddy farmers’ income and thus provides them a generous package of farm inputs and financial incentives. At the same time, the government desires to assure steady supply of rice at reasonable prices for consumers. By means of price fixation, the government imposes the guaranteed minimum price and ceiling price at farm and retail level, respectively. Price controls leave a little room for rice millers’ profitability. For this reason, the government dispenses a rice miller subsidy to a group of rice millers that supply Super Tempatan 15% of broken rice (ST15), an inferior grade of rice designated for low income households in Malaysia. The government also subsidizes energy such as petroleum products and electricity to support manufacturing activities of all sorts in the country. Rice milling is an energy intensive operation and heavily relies on electricity to run machinery and equipment. Its energy use has an explicit effect on the supply volume of good quality rice and production costs. Hence, improving the milling efficiency through better technology is essential for higher recovery ratios and cost reduction. However, rice millers are often reluctant to make capital investments because of low profitability. Furthermore, Malaysia is expected to comply with the WTO’s demand for market liberalization, which translates into the removal of price controls and the subsidies. Rice millers must go through structural changes in market. In short, the aim of this study is to examine the impacts of market liberalization on the rice milling sector in the context of whole rice industry in Malaysia. Specifically, the author develops a system dynamics model for the Malaysian rice industry, and examines the impacts of removing price controls and the subsidies on rice prices, production, consumption, import, capacity utilization, capital investments, the head rice recovery ratio and the rice self-sufficiency level. The author then proposes policy alternatives that can mitigate the impacts of market liberalization after understanding the market structure and behaviors of the rice milling sector in the context of whole rice industry in Malaysia.

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1.2 Problem Statement Market liberalization has aroused public concerns over food security in many countries because it stands to compromise the role of governments in protecting their domestic market. Most governments in Asia have intervened in their rice markets through various policy instruments to ensure sufficient supply of rice at reasonable prices. The most effective means of controlling the market is perhaps price controls. The Malaysian government has fixed the guaranteed minimum price for local paddy at farm level to protect paddy farmers’ income and at the same time imposed ceiling price for rice at retail level to protect consumers. Hence, price controls have restricted rice millers’ profitability. Consequently, it has provided uncertainties and little incentives for rice millers as to making capital investments that are necessary to improve their milling efficiency. Price controls also have detrimental effects on market efficiency and competitiveness of the rice milling sector in general. In January 1993, the Malaysian government concerned with adverse effects of market distortions removed price controls on all rice grades, promptly increasing their wholesale and retail prices as shown in Figure 1.1 (Salman, 2010). See Appendix I for numerical data.

Figure 1.1 Paddy Price, Rice Prices and Profit Margins in Malaysia, 1980 – 2010 Source: Department of Statistics, 2011 The profit margin of rice millers had been stable before 1993, but markedly improved when rice prices increased. Interestingly, rice millers raised the production of head rice since 2005 as shown in Figure 1.2, although the milled rice recovery ratio declined during the same period. In

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retrospect, the head rice recovery ratio is more important than simply the milled or white rice recovery ratio. The more head rice the millers recover, the higher profit margin the millers can obtain as head rice carries a higher commercial value than does broken rice. Figure 1.2 indicates that there were improvements in the head recovery ratio because of technical progress. After the removal of price controls in 1993, the profit margin had improved substantially and capital investments would have followed. Given inherent delays in capital investments and installment, rice millers appear to have reaped higher proportion of head rice since 2005. By the end of 1998, the government imposed price controls again to reign on price increases at retail level, whereas the wholesale price remained floated. The retail price of rice was relatively stable until 2007, when the international food crisis hit the domestic market and caused price shocks. Paddy price also experienced rapid growth since 2005, sharply raising the costs of production as rice millers paid more for paddy. Hence, the profit margin has been falling again at an alarming rate because the ceiling price remains fixed. It is likely to discourage rice millers from making capital investments and inhibit further improvements in the head rice recovery ratio. The Malaysian government gives the rice miller subsidy to a group of rice millers that produce ST15 to relieve their burden on the costs of production, given the poor recovery ratios and price controls. Rice is processed food from rough paddy, which cannot be consumed in its original form. Rice processing removes about 35% ~ 40% of rough paddy in terms of a gross weight. It is a large physical loss because rice millers are able to sell only 60% ~ 65% of what they paid for paddy. For example, ST15 has a fixed price at wholesale and retail level. Rice millers that produce ST15 sell it to wholesalers at RM 1350/MT, while the purchasing price is RM 1050/MT on average. Then, rice millers can sell only 0.60 MT ~ 0.65 MT of rice after processing. This translates into a net loss of RM 170/MT ~ RM 240/MT, exclusive of other production costs. This is why the Malaysian government compensates the rice millers and dispenses the rice miller subsidy of RM 750/MT. In addition, rice millers must deal with poor quality of paddy. The high moisture content as well as the presence of damaged, immature and foreign matters have detrimental effects on the rice recovery ratios. The undesired contents that need to be deducted for payment are estimated at 24% ~ 27% in Malaysia, whereas the actual deduction for them is only 17% ~ 20% (Fredericks and Wells, 1983). Hence, rice millers are facing an extra 6% ~ 7% financial loss for every paddy purchased. Put differently, rice millers make payments for raw materials that cannot be essentially processed or recovered. Therefore, the rice miller subsidy has become an inalienable right if rice millers supply ST15.

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Figure 1.2 Head and Broken Rice & Rice Recovery Ratio in Malaysia, 2002 – 2010 Source: Department of Statistics, 2011 Rice milling is energy intensive operation, making rice millers as vulnerable as all other industries to rising costs of energy. Malaysia has seen an unprecedented increase in energy prices because of the increasing demand for energy, particularly the crude oil and natural gas, from all sectors of economy (Energy Commission, 2011). Hence, the Malaysian government has subsidized energy such as fuel oil, natural gas and electricity to stimulate economic growth. The rice milling sector is one of the beneficiaries of the energy subsidy. Rice millers would be negatively affected by the energy subsidy withdrawal because it will increase their production costs. Particularly, rice millers heavily rely on electricity. There is a positive relationship between rice production and electricity cost shown in Figure 1.3. Hence, the rising cost of energy in addition to the energy subsidy withdrawal will reduce the profit margin of rice millers. Falling profit margins will slow down capital investments that are necessary for capital acquisition. Old capital has detrimental effects on energy efficiency. Rice millers are likely to spend more on energy despite the diminishing returns to capital. In a nutshell, the Malaysian government provides subsidies for food and energy to enhance the well-being of its citizens and sustain industrial activities including rice milling. The energy and rice miller subsidies amounted to about RM 10 billion and RM 337 million, respectively, in 2010 (Mohd Salim, 2010). Hence, the rising demand for rice as well as the energy to produce rice makes the government subsidies seemingly an indispensable input. However, impending market liberalization adds pressure on Malaysia to remove these subsidies. Rice millers can no longer benefit from financial provisions that help them reduce the costs of production. At the same time, market liberalization requires the removal of

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price controls. It is likely to trigger a proportional increase in rice prices as evidenced by historical data. Hence, rice millers will have to adjust to the changing market structure simultaneously as market liberalization unfolds. In short, it raises some important questions. How will the rice milling sector respond to policy or structural changes in the event of market liberalization in Malaysia? What will be their effects on the level of rice production, consumption, import and prices? Furthermore, how will those changes in the level of rice production, consumption, import and prices affect rice millers when they are making decisions on capacity utilization and capital investments? Furthermore, how will their decisions affect the head rice recovery ratio and the rice self-sufficiency level in Malaysia? The questions will be explored throughout the thesis.

Figure 1.3 Rice Production and Estimated Electricity Cost in Malaysia, 1980 – 2010 Source: Department of Statistics, 2011 1.3 Research Objectives The focus of this research centers on the impacts of market liberalization on the rice milling sector as well as the rice industry as a whole. The Malaysian government has intervened in the rice industry by implementing protectionist policies such as imposition of price controls and provision of the subsidies. However, Malaysia must comply with the WTO’s demand for market liberalization, which translates into the removal of price controls and the subsidies. It has become a central issue for open economies like Malaysia. Should Malaysia comply with the WTO and abandon the protectionist policies, whether the rice milling sector can withstand the shocks and raise its competitiveness is of vital importance to policy makers and industry stakeholders. Questions arise over the readiness of rice milling sector and the stability of market supply and price in Malaysia. The author conducts a research with the following objectives.

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1.3.1 General Objective To examine the impacts of removing price controls and the subsidies from the rice milling sector on the paddy and rice industry in Malaysia. 1.3.2 Specific Objectives To develop a system dynamics model for the rice milling sector in the context of whole rice industry in Malaysia. To simulate the removal of price controls and the subsidies, and examine their impacts on rice prices, production, consumption, import, capacity utilization, capital investments, the head rice recovery ratio and the rice self-sufficiency level in Malaysia. To simulate policy alternatives that can stabilize rice prices after market liberalization in Malaysia and examine their impacts on production, consumption, import, capacity utilization, capital investments, the head rice recovery ratio and the rice self-sufficiency level. 1.4 Scope, Relevance and Limitations The scope of the thesis confines to the business dynamics of Malaysian rice milling sector with relevance to rice production, consumption, price setting, costs of production and profitability. The rice milling sector is closely associated with the paddy production and rice consumption sectors in the context of whole rice industry in Malaysia. Hence, the author looks into structural relationships among different sectors of the rice industry, and then examines how they interact with one another so as to understand their causal or feedback relationships. In addition, the author examines how rice millers behave when they are making decisions on capital investments and capacity utilization in response to structural and policy changes in the event of market liberalization. Their decisions have successive effects on the head rice recovery ratio and the rice self-sufficiency level. The author seeks to understand the structure of rice milling sector in the context of whole rice industry in Malaysia and describe how the interrelationships among the key variables give rise to certain behaviors. The author uses a system dynamics approach to conduct this research. System dynamics is an ideal methodology for studying and managing complex systems like the rice industry in Malaysia. System dynamics gives emphasis to feedback relationships or loops that generate system behaviors arising from an internal structure. In each feedback loop, stock (level) and flow (rate) determine system behaviors. The level accumulates

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as a result of actions, which depend on decision rules and information stemming from the level. The decision rules dictate the flow or rate of change, which in turn causes the level to change in an iterative cycle. Most importantly, system dynamics models must incorporate actual decision rules used by the real actors in the real world. The feedback loops represent causal relations based on information from not only quantitative data or statistical correlations among variables observed in historical data, but also qualitative data that exert great influence on decision rules and system behaviors. System dynamics is a powerful tool for policy analysis because it enables one to simulate different patterns of system behaviors in a computer platform when there are changes in the internal structure or parameter values. Hence, system dynamics as a methodology fits well with the objectives of this study. The limitations include data availability and measurement errors. The quantitative data used for building a system dynamics model are highly aggregated, e.g. rice production, consumption, import and prices. Some important data are not readily available for comparisons between simulated and actual outputs. However, system dynamics models do not seek to provide precise parameter values. Generating plausible patterns of system behaviors may suffice the objective of the study, which is to illustrate feedback relationships and simulate policy changes and alternatives. Given the data availability, the model structure was built on the basis of 30 years from 1980 to 2010. The author runs simulations up to 2025 for a short term analysis and 2035 for a long term analysis of system behaviors. The author deems that the selected time bounds are appropriate for simulations in the case of Malaysian rice industry.

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