CCP 05/13

Table of Contents

I. INTRODUCTION

II. WHAT IS COMMODITY RISK MANAGEMENT AND WHAT ARE THE MECHANISMS FOR IMPLEMENTING IT?

III. MARKET BASED INSURANCE SYSTEMS TO ASSIST LOW INCOME COMMODITY DEPENDENT COUNTRIES TO COPE WITH WORLD PRICE INSTABILITY

IV. A FOOD IMPORTING FINANCING FACILITY (FIFF) TO IMPLEMENT THE “MARRAKESH DECISION”

V. CONCLUSIONS AND ISSUES FOR DISCUSSION

I. INTRODUCTION

1. During the 64th Session of the CCP it was noted that “many countries are seeking to cope with continued low and variable prices in commodity markets, particularly for specific commodities that are crucial to their economies. The strategies to be developed include appropriate mechanisms for coping with risk resulting from unstable prices, and diversification of their agricultural sectors. Several delegations expressed the need for increased information, analysis and assistance in developing and implementing such strategies”. Along similar and parallel lines, in the World Trade Organization (WTO) implementation of the Uruguay Round (UR) so-called Marrakesh Decision, namely the “Decision on measures concerning the possible negative effects of the reform programme on least-developed and net-food-importing developing countries” is long overdue. In that Decision WTO member country ministers recognized “that as a result of the Uruguay Round certain developing countries may experience short-term difficulties in financing normal levels of commercial imports”. Subsequent FAO and UNCTAD analysis showed that these risks and short term difficulties arise largely from unexpected price developments in international commodity markets or adverse domestic production developments. It also showed that the major constraint facing low income food import developing countries is credit ceilings imposed by developed country on import financing for such countries.

2. This paper reviews the issues arising from international commodity price instability and actions that may be taken to manage the resulting market risks. There has been a long history of discussions, research, proposals, and actions concerning measures to alleviate the adverse consequences of such risks. Despite, however, the long standing concerns and discussions, and several actions aimed at dealing with the problem, the risks faced by developing countries seem to be as large today as they were 50 years ago. There are more than 50 developing countries that depend on three or fewer commodities for more than half of their export earnings. All Highly Indebted Poor Countries (HIPCs) depend for a large share (often more than half) of their merchandise export earnings on commodities. Many of the commodity export dependent countries are also food insecure. There have been two main ways through which commodity dependent countries, as well as the international community, have attempted to deal with commodity market instability. The first concerns attempts at direct intervention in the commodity markets with the purpose of altering the price distribution of the relevant commodities. These efforts include all the various international commodity agreements, national and international buffer stock schemes, and various other mainly national efforts aimed at production control. While most of the international commodity agreements have failed and are currently not in the international agenda, there are still many national policies that attempt to control domestic agricultural commodity markets in many developing as well as developed economies.

3. The second way that has been employed to deal with commodity market instability is through ex-post compensation to those countries whose export earnings or import bills were adversely affected by commodity market fluctuations. Prominent among these are the European Union’s (EU) STABEX and SYSMIN instruments aimed at the ACP countries. The other such existing scheme is the International Monetary Fund’s (IMF) Compensatory and Contingency Financing Facility (CCFF). All these arrangements, however, have not dealt with the ex-ante risks faced by low income commodity dependent (LICDCs).

II. WHAT IS COMMODITY RISK MANAGEMENT AND WHAT ARE THE MECHANISMS FOR IMPLEMENTING IT?

4. Risk is generated by actions whose outcomes are subject to unpredictability. It is unpredictability that defines uncertainty, and it is the actions that have uncertain outcomes that create the attendant risks. The detrimental effects of commodity unpredictability have been the object of discussion and research for a long time. Keynes¹ (1942), argued that commodity price fluctuations led to unnecessary waste of resources, had a detrimental effect on investment in new productive capacity, and tended to perpetuate a cycle of dependence on commodities. Recent literature has refined and extended this argument. The basic new insight is that the presence of uncertainty when there is inability to borrow to smooth negative income shocks, leads agents to accumulate liquid precautionary reserves (which can be in the form of cash or kind). In poor country environments, these reserves must be liquid enough, in order to be readily accessible in times of need. This positive and liquid level of reserves implies that the resources devoted to buffer stocks or what has been termed “consumption smoothing” cannot be used for productive but illiquid investments, and it is this that leads to the negative impact on overall growth².

5. Mere variability of outcomes does not constitute uncertainty, and may not be detrimental. For instance if export earnings for a country alternate each year between 100 and 200 million USD, and if this outcome is known to the government of the relevant country with certainty one year before the outcome, then export earnings are perfectly predictable one year ahead, and hence there is no uncertainty about them if examined from the perspective of a one year forecast. How, of course, the government decides to handle this predictable variation in export receipts is another issue, but the point is that it can plan for it one way or another. If, however, the knowledge of the impending variations is not available one year ahead, then there is uncertainty of export earnings, and this makes for a more complicated planning problem. Commodity risk management involves all the strategies and specific policies to deal with ex-ante unpredictable incomes. These strategies depend on the possibilities available to the country. If there is no external safety net available (in the form of the possibility of obtaining funds for free or as a loan or to trade the risk faced), then there three ways to deal with risk. The first has to do with altering the risks, by manipulating directly the markets that create those risks. This attitude to dealing with risks the dominant paradigm for a long time in many countries, and is still practiced widely in several countries (including many developed ones). The experience of international commodity control has been disappointing and is currently not regarded as a viable international option. Domestic price control of commodities through either trade policy or direct market intervention has proven to be very expensive, either financially or from a growth perspective. The reason is that it almost invariably distorts long term market signals, and hence affects the allocation of resources, with likely adverse consequences for growth. It also turns out to be very costly, as many developed countries have found out.

6. The second option to deal with income risks is by adjusting one’s exposure to risk, namely diversification. More export diversification and less import dependence lead to less vulnerability in terms of export earnings fluctuations or import price spikes.

7. The third way to deal with income risk at both the individual, as well as the country level is insurance strategies or what has been termed risk coping. At the micro level these strategies essentially involve either individual insurance through accumulation or decumulation of precautionary stocks (in cash or kind) or mutual insurance networks that can provide transfers in times of need. At the macro level the corresponding strategies would involve accumulation and decumulation of foreign exchange reserves at the individual country level, or reciprocal aid agreements between friendly governments (the cost or premium for such agreements is usually implicit).

8. The above discussion assumed that there are no external insurance systems or safety nets or risk diversification instruments available to the entities (individuals of countries) that are exposed to commodity risks. This, however, is not the case for entities in developed countries. Farmers and agricultural product consumers (such as all agents in the marketing chain) in developed countries have a variety of market based instruments with the help of which they can manage the risks they face. For instance elevators that buy grains from farmers in the USA hedge their purchases from farmers in the futures or options markets. Similarly international buyers of coffee and cocoa manage their exposure to commodity risks in the international future and option markets. Producers and consumers in developed countries have developed sophisticated market based risk management strategies to deal with commodity risks, and the development of a variety of financial instruments in the last two decades (futures, options, swaps, etc.) has enlarged the possibilities for risk management. The consequence is that agents in developed countries can trade for a price the risks they face in organized markets as well as in less organized over the counter (OTC) markets³.

9. While the modern markets for risk management instruments are open to all, entities within developing countries have not been very active in using them. The reasons involve a variety of institutional imperfections and financial constraints⁴. This implies that aid in the form of additional national or domestic targeted commodity linked safety nets is likely to be not only useful, but also conducive to growth and poverty alleviation. Recently the World Bank sponsored International Task Force (ITF) on Commodity Risk Management has tried to improve the accessibility of such risk management instruments to developing country entities⁵.

III. MARKET BASED INSURANCE SYSTEMS TO ASSIST LOW INCOME COMMODITY DEPENDENT COUNTRIES TO COPE WITH WORLD PRICE INSTABILITY

10. The major international export and import commodity risks that LICDCs face is the possibility of abnormally low commodity prices and quantities exported or high import quantities and prices of imported staple foods, and hence low export incomes or high import expenditures. The type of international insurance that LICDCs would need relates to the possibility of covering some of the shortfall in export earnings or import expenditures. Given that the prices of most agricultural commodities both food and non-food are characterised by infrequent spikes, and long periods of slumps, the type of insurance that would be appropriate for them resembles the purchase of put or call options.

11. A put option on a commodity gives the buyer of the option the possibility to sell a given quantity of the commodity at a prespecified price (the strike price), within a given period. If the actual price of the commodity at the time the seller of the commodity wishes to sell is higher than the strike price, the seller does not exercise the option and just loses the option premium. If, on the other hand, the actual price is lower than the strike price, then the buyer of the option “exercises” the option and gains the difference between the strike price and the actual cash price. A call option gives the buyer the possibility to buy a futures contract at a pre-specified strike price, within a given period. If the futures price is lower, the buyer of the call option does not exercise the option and loses the premium. If the actual price is higher than the strike price, then the buyer of the option exercises the option and gains the difference between the cash and strike price.

12. For planning purposes it would help the governments of many LICDCs to have such option like insurance available to them. The problem is that although such options are available in organised commercial exchanges in developed countries there are several problems that make the use of such instruments difficult to use for LICDCs. These include the unavailability of desired commodity options for periods longer than one year, the potentially high “basis” risk, problems related to credit and counter-party risk for developing country entities, lack of relevant expertise, weakness in the financial and regulatory environments, small volumes of potential trade, and the potentially high cost of participation in organized futures and options⁶.

13. Although it may make sense for some LICDCs to manage their export or food import commodity risk through direct involvement in developed country future and option markets, the costs both monetary, but also related to the absence of certain types of infrastructure and institutions, can be large. Hence one international policy option that may be appropriate is to create some type of intermediation mechanism or facility between the LICDCs and the well-organised markets of developed countries. The idea of such a facility could be to provide the governments of LICDCs with the possibility to purchase single year or multiyear put or call like options for agricultural commodity exports and imports. This could be done directly by LICDCs or through some type of fund or other financing facility, which would provide possibilities to LICDCs for purchasing option like contracts of the type discussed above.

14. A feature that would be attractive to LICDCs is that the contracts could be made tailor made to each country, or entity within a country, among those deemed eligible. The more the desired contract departs from terms and conditions existing in organised commodity exchanges, the more difficult will be for the facility or any commercial OTC operator to re-insure its own risk, and hence the more expensive will be the contract. For instance, if a country desires a multiyear commodity export price guarantee or put option at a given strike price, and since the organised exchanges offer put options for periods not longer than one-two years in the future, then the premium for such a multi-year option like contracts may be considerably larger than standard premiums for commercially available put options.

15. The main advantage of a system of this type would be first that it could make available to LICDCs commodity insurance contracts that may not be available to them through the market. Second it would achieve economies of scale both for financial intermediation, and also for risk pooling from the various LICDCs. This risk pooling would decrease the overall cost of providing the insurance contracts. It should not be too expensive, as most of the risk could be hedged in commercial exchanges.

16. The FAO secretariat has done several empirical analyses of the implications of a system of commodity risk management for basic food imports and commodity exports. Tables 1-3 present the results of three simulations for wheat, maize, and robusta coffee, respectively. The simulations address the question of what would have been the cost for a food importing country, or a robusta coffee exporting country, if it had consistently over the recent past (the simulations involve the period of 1986-2004) hedged the excess cost of food imports due to price spikes with call options, or the excess decline in export earnings with put options. The simulations assume that the individual countries would have paid the full commercial cost of the options.

17. The results suggest that consistently hedging wheat or maize imports with options in the Chicago Board of Trade (CBOT) appears to be a viable individual strategy for many low income food deficit countries (LIFDCs) to engage in, even if they bear the full cost of hedging. The profits that can be made are mostly positive, and in the cases where they are negative, they are usually less than one percent of the value of imports. In the case of coffee the results appear to show that almost all exporting countries could have made substantial profits had they hedged their commercial exports in LIFFE, the major robusta international exchange in London.

18. While the results suggest that each country could profitably engage in hedging individually, it was shown that pooled hedging, shown in the row in the tables labelled “Fund”, has a much higher chance of generating net profits, and this is the advantage of an intermediation facility, which can pool the risks of many countries. Of course the profits considered were purely monetary. There would be additional benefits deriving from the insurance. For instance the overall quantity of imports or exports may increase, thus resulting in higher domestic food supplies, and perhaps better domestic food security, or higher export earnings and hence better incomes for exportable commodity producers.

IV. A FOOD IMPORTING FINANCING FACILITY (FIFF) TO IMPLEMENT THE “MARRAKESH DECISION”

19. Speedily creating an international Food Import Financing Facility (FIFF) according to the terms of the Marrakesh Decision would, at this stage, not only ensure that WTO member countries finally meet their legal obligations, but would also facilitate ongoing negotiations on export credits in WTO by providing, at least under certain conditions, a larger group of exporters with more equitable possibilities to sell food on credit, and importing countries to maintain import levels under adverse domestic and international conditions.

20. Excess food import needs can arise from mainly three factors. The first is higher world market prices for food, which can arise from a variety of reasons that are exogenous to the country concerned. The second is an increased national food deficit, as a result of unforeseen production shortfall, disaster, and other factors, that is not compensated by food aid. The third is a shift within a country’s food imports from food aid or preferential terms to commercial imports. Financing constraint for such excess food imports are due to the imposition, largely by international private financial institutions, of credit or exposure limits for specific countries. These limits can easily be reached during periods of needs for excess imports due to the above factors, thus limiting food imports, and it is this constraint that the facility should be designed to alleviate⁷.

21. Possible options along these lines include an agreement to create a FIFF with the purpose to provide additional commercial financing to the agents of LIFDCs for the cost of excess food import bills, so as to maintain normal levels of quantities of imports, or to make it possible to import extra quantities in excess of normal commercial import requirements. The financing could be provided to the food importing agents via the central and commercial banks in the concerned countries, which normally provide the financing for commercial food imports in forms such as letters of credit (LCs). The financing provided through the FIFF could not only increase the financing capacity of local banks, but also induce the private exporters’ banks to accept the LCs of the importing countries’ banks in hard currency for amounts larger than the credit ceilings imposed by commercial banks for exports to the LIFDCs. Initial technical analysis by FAO has indicated that such an agreement, in the form of a facility that utilizes guarantees to borrow in times of abnormal world market conditions, and onlend to LIFDCs, will be quite cost effective, especially when utilized in conjunction with modern risk management instruments to hedge commodity price, as well as sovereign and foreign exchange convertibility risks, and could provide a valuable additional tool for managing food import risks.

V. CONCLUSIONS AND ISSUES FOR DISCUSSION

22. The major points of the paper can be summarised as follows:

• The risks faced by commodity exporting or food importing developing countries depend on the unpredictability of the underlying international prices and domestic production, as well their degree of trade diversification.
• The commercial risk management instruments available to LICDCs and LIFDCs are fewer than those available to developed country agents.
• Of the various ways available to deal with commodity market risks, interfering with commodity markets is costly and unlikely to succeed. Establishing better predictability seems the best way to insure risk prone LICDCs.
• In developed countries commodity predictability has been enhanced with the proliferation of market based institutions like futures and options markets. Such institutions are generally not available to the agents of LICDCs, and their participation in the markets of developed countries is hampered by a variety of constraints.
• An international intermediation system to provide LICDCs and LIFDCs with option like insurance contracts appears as one viable way to enhance the risk management capabilities of such countries. The costs of operation of such a system are small, and could even be nil, under certain conditions.
• As far as food imports are concerned, a food import financing facility to guarantee LIFDCs the additional finance on commercial terms in times of excess food import needs, could be made compatible with the idea behind the “Marrakesh Decision” of the UR Agreement on Agriculture, and hence contribute to the conclusion of the Doha Round.
• All the institutional options discussed above could be made to operate in a self sustaining manner, with no subsidies or additional funds.

23. The Committee may wish to deliberate on the following issues:

• Are current market institutions adequate to provide LICDCs and LIFDCs with the instruments needed for commodity risk management? What new institutions, if any, are desirable?
• How can the international community assist LICDCs and LIFDCs to better manage the risks arising from international commodity market instability?
• The commercial availability of many risk management financial instruments opens many new possibilities for commodity risk management by developing countries. Mechanisms need to be developed to facilitate access to these by all commodity dependent economies.
• Is there a need for further analysis to explore the viability of using better risk management strategies by LICDCs and LIFDCs?

Table 1. Profit/loss from hedging wheat import price risks with Chicago Board of Trade call options for the period 1986-2002. (All figures are expressed as a share of the country’s wheat commercial import bill over the same period. The parameter k denotes the number of months before the actual import purchase, when the call option is bought. The parameter α denotes the proportion above the current future price k months ahead of purchase, that defines the strike price of the call option.)

Table 2 - Profit/loss from hedging maize import price risks with Chicago Board of Trade call options for the period 1986-2004. (All figures are expressed as a share of the country’s maize commercial import bill over the same period. The parameter k denotes the number of months before the actual import purchase, when the call option is bought. The parameter α denotes the proportion above the current future price k months ahead of purchase, that defines the strike price of the call option.)

Table 3 - Profit/loss from hedging robusta coffee export price risks with LIFFE put options for the period 1986-2004. (All figures are expressed as a share of the country’s coffee export revenues over the same period. The parameter k denotes the number of months before the actual export, when the put option is bought. The parameter α denotes the proportion below the current future price k months ahead of the actual export, that defines the strike price of the put option.)

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¹ Keynes, J.M. (1942), “The International Control of Raw Materials”, U.K. Treasury Memorandum, reprinted in Journal of International Economics, vol. 4, 1974.

² See e.g. Fafchamps, M., and J. Pender (1997), “Irreversible Investment: Theory and Evidence from Semiarid India”, Journal of Business and Economic Statistics, vol. 15(2): 180-193..

³ For a review of such risk management possibilities and practices see Harwood, J, R. Heifner, K. Coble, J. Perry, and A. Somwaru (1999), “Managing Risk in Farming: Concepts, Research and Analysis”, US Department of Agriculture, Economic Research Service, Agricultural Economics Report No. 774, Varangis, P., D. Larson, and J.R. Anderson (2002), “Agricultural Markets and Risks: Management of the Latter not the Former”, World Bank, Policy Research Working Paper 2793.

⁴ For a review see Debatisse, M.L., I. Tsakok, D. Umali, S. Claessens, and K. Somel (1993), “Risk Management in Liberalising Economies: Issues of Access to Food and Agricultural Futures and Options Markets”, World Bank, Europe and Central Asia Regional Office, Middle East and North Africa Regional Office, Technical Department Report No. 12220 ECA, November 30.

⁵ International Task Force on Commodity Risk Management in Developing Countries (ITF) (1999), “Dealing with Commodity Price Volatility in Developing Countries: A Proposal for a Market Based Approach”, Discussion Paper for the Roundtable on Commodity Risk Management in Developing Countries (World Bank). Washington DC., September 24, processed.

⁶ For more details see Debatisse, et. al. (op. cit.)

⁷ FAO (2003). Financing Normal Levels of Commercial Imports of Basic Foodstuffs in the context of the Marrakesh Decision on least-developed (LDC) and net food importing developing countries (NFIDC).