The World Bank JANUARY PREMNko@$ 9 NUMBEER 13 ECONOMIHC POLICY Ussagmarkets d .alwith commodity price volatility What can govemments and donors do to develop markets that ameliorate commodity price volatility? Commodities provide raw materials for commodity agreements, or government processors, food and jobs for families and intervention in commodity markets. Such communities, and export earnings for gov- schemes have failed to stabilize commodity ernments. Commodities are often at the heart prices. Buffer funds have gone bankrupt, of local and sometimes national economies. as in Australia and Papua New Guinea. Buffer Market-based According to UNCTAD, in 1995, 57 devel- stocks have proven ineffective, as with the oping countries depended on three com- largeaccumulationsunderU.S.andEUfarm commodIty rosk modities for more than half of their exports. programs in the late 1980s. International Fuels, grains, and oilseeds are also important commodity agreements have lapsed, as with management imports for some developing countries. those for coffee, cocoa, tin, and sugar. And Commodityprices are notoriouslyvolatile, government intervention has been costly, instruments creating instability and uncertainty for com- with unintended consequences. Today aca- modity-dependentdeveloping countries. Com- demics and policymakers emphasize the dis- have become modity price volatility affects governments, tinction between programs that attempt to producers, processors, traders, and localfinan- alter the distribution of prices, domestically more popular9 cial institutions. Moreover, commodity price or internationally, and programs that deal instability undermines economic growth and with uncertainty using market instruments. but barrie rs remain skews the distribution of income. As a result Market-based commodity risk man- nearly every government has tried to man- agement instruments have become more age commodity price risks. popular, aided by the globalization of com- One set of commodity pricing policies modity markets, market liberalization, and relates to how central banks and treasuries lower trade and capital barriers. Several handle fluctuating foreign exchange needs private sector participants, state-owned and changing fiscal conditions. To protect companies, and developing country gov- consumers, producers, processors, and ernments use commodity derivatives mar- traders, another set of policies deals with gov- kets to hedge their commodity price risks. ernment intervention in commodity mar- Still, important barriers to these markets kets. Related is government policy toward remain. Among these are counterparty private markets for commodity risk man- risk, problems of scale (as with small farm- agement (table 1). ers), basis risk (or lack of correlation between local and international prices), Ni1e1ng0 eo ik th a Z'Ema t$ lack of transparent local reference prices, Most early attempts to deal with commod- limited know-how, and the absence of liq- itypricevolatilitytriedtostabilizepriceswith uid derivatives markets for certain com- buffer funds, buffer stocks, international modities (table 2). FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY AND POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK Public support for private risk farmers, traders, processors, and govern- markets ments and on the failures of policies The literature on commodity risk man- designed to ameliorate those risks. Less agement focuses on the risks facing discussed are the numerous efforts by gov- Table i Commodity risk management problems and policies Short-term policy Long-term policy Sector Problems instruments and objectives instruments and objectives Economywide * Macroeconomic mismanagement * Policy advice and adjustment lending • Counterparty and sovereign risk * Sovereign risk guarantees and better contract laws and enforcement • Severe limits on brokerage and * Financial reform supporting banking services * Lack of, legal and regulatory * Technical assistance infrastructure * Limited or nonexistent markets *Potential multilateral role in facilitating global for some financial instruments markets for some instruments Private *Inefficient local commodity markets - R emo6ve policy-based impediments - Improve market access and to underlying physical markets market information for local *Counterparty risk and small-scale * Government- or association commodity markets activity based transitional intermediary * Improve financial and other agency supporting services ..Basis risk, poor or missing credit, * Government-sponsored instruments * Deliver risk management and insurance markets and safety nets instruments through private *Lack of know-how * Technical assistance intermediaries: brokers, warehouses, and so on Improve regulatory, oversight, and enforcement capacity- PbIC* Fluctuating central bank reserves * Include commodity-based * Diversification through growth instruments in central bank * Improve asset management operations capacity in treasury and central *Fluctuating government revenues * Hedge government budget against bank and expenses commodity price declines *Related short-term and long-term * Include commodity-based debt management problems instruments in debt portfolio *Agent problems related to objectives, * Develop independent reporting, management, reporting, and auditing, and trading groups, or corruption access risk management services through intermediaries Quasi-public * Oversight and reporting of risk * Outsource risk management * Improve regulatory, oversight, parastatals management activities functions and enforcement capacity * Perverse incentives may preclude a Develop administrative capacity * Privatization appropriate risk management and technical know-how to handle hedging and independent reporting, auditing, and trading groups Table 2 Barriers to commodity price risk management in developing countries Limited Count erparty Low Intermediation Basis Lack of local Commodity know-how risk liquidity issues risk price discovery Petroleum In some cases In few cases No No No No Precious metals In some cases In few cases No No No No Base metals In some cases In few cases In general, no No In general, no No Agriculture for export Moderate Yes Low to moderate Yes Moderate Moderate Agriculture for local Yes Yes Moderate Yes Yes Yes markets ernments and donors to support the devel- gin requirements or to directly purchase opment of private risk management mar- options, avoiding local market constraints. kets and developments in the markets Similarly, importers can often take advantage themselves. of guarantee programs when purchasing exports from industrial countries. But many Lack of know-how exporters in many developing countries (espe- Technical skills for risk management are often cially exporters of agricultural commodities) lacking, especially in newly liberalized mar- must relyon indirectrisk management. Where kets. As with markets for physical commodi- financial institutions are weak, exporters often ties, markets for risk management instruments enter into pre-financing arrangements with involve anumberofactorswithvaryingneeds importers to limit exchange rate risks. But Risk management and levels of understanding. Several inter- pre-financing credit and risk management nationalorganizations-InternationalTrade arrangements tend to be short term and services are rarely Center, Common Fund for Commodities, restrict marketing options. World Bank, UNCTAD-offer general tech- Another approach is to use inventories to offered in poorer nical assistance to build the risk management finance trade and bundle risk management skills ofpolicymakers and market participants. services. Silos and warehouse operators func- countries and in In addition, several groups offer specialized tion as intermediaries. Sometimes banks will information. The International Organization enter into arrangementswith traders orproces- countries where of Securities Commissions publishes a com- sors to provide aline of credit based on inven- parative review of international regulatory sys- tory levels. The value of the inventories is then markets are newly tems, and the IRIS Center at the University hedged either directly or by lending against of Maryland offers a survey of collateral law. a portion of its value. Unlike other collat- emerging Producers, traders, and processors are most eral, the value of inventories matches mar- interested in the specifics of their commod- ket price changes and capital needs. ity markets and the relevant international mar- On a more sophisticated level, a stan- kets. Several in-country commodity associations dardized warehouse receipt is granted special have been especially effective in offering infor- legal status and serves as a transferable instru- mation and guidance to their members. Exam- ment. In such cases the role of government ples include ASKINDO (the Indonesian cocoa is to provide the legal infrastructure for receipt- association) and ANACAFE (the Guatemalan based trade, regulate and monitor warehouse coffee association). The private sector and operators, and help set standards. In several government often work together to estab- U.S. states, for example, a governmentagency lish local exchanges, and technical informa- manages an indemnity fund to insure receipt tion comes from private and public sources. holders. Receipts are also used in spot and futures markets-for example, in Zimbabwe's Problems with credit, collateral, and and Argentina's agricultural exchanges. counterparty risk Providers of risk management instruments Problems of scale and aggregation point out that producers, traders, and proces- Developing country producers of metals and sors in many developing countries cannot energy face fewer hurdles in accessing risk overcome their low credit ratings and lack of markets because of the scale of the firms. In collateral for hedging transactions. Although addition, multinational firms often have equity these providers increasingly offer instruments stakes and offer risk management expertise. to middle-income countries in Latin Amer- But for agricultural commodities, production ica, Asia, the Middle East, and Eastern Europe, and trade are usually fragmented and diffused risk management services are rarely offered in developing countries. Providers ofrisk man- in poorer countries and in countries where agement instruments have to deal with smaller markets are newly emerging. companies, often with little experience. Local Large-scale, sophisticated market partici- banks, silos, and warehouse companies can pants can use offshore accounts to meet mar- provide a distribution network for risk man- agement products, but supporting financial kets. Argentina, Brazil, China, Hungary, sectors are often weak. Thus making these India, Malaysia, the Philippines, Russia, instruments available to small producers will South Africa, and Zimbabwe have func- require establishing a system that allows the tioning commodity derivatives exchanges, aggregation of price risks from many small and Bulgaria, Indonesia, Poland, Romania, producers so they can be hedged in inter- Thailand, and Turkey are establishing them. national markets. Government policies can be a source of In some cases the government or an asso- basis risk. Countries that have reduced gov- ciation puts in place an aggregating insti- ernment intervention have established a tution. Examples include the government closer link between domestic and interna- Government agency ASERCA in Mexico, which hedges tional prices, allowing commodity deriva- cotton and grains prices on behalf of pro- tives instruments in international derivatives policies can ducers, and the Options Pilot Programs in markets. In addition, manydevelopingcoun- the United States (grains and dairy) and tries have been pursuing commodity mar- be a source Canada (cattle). In Guatemala, ANACAFE ket liberalization, which has created has trained local banks and exporters in opportunities for using risk management of basis risk price risk managementwith the objective of instruments by improving local price dis- guaranteeing loan repayment. covery and more closely linking domestic and international prices. Finally, better Basis risk and local markets communications and the Internet have Basis risk arises when local prices do not increased opportunities for computer-based move in line with prices in international trading and price discovery-the Caribbean (derivatives) markets. High basis risk can Commodity Exchange and the Continental result from a variety of factors, including Commodity Exchange are two examples. transportation costs, local policies, grade or Related to basis risk is the fact that devel- quality differences, characteristics of the oping countries lack reliable and consistent futures or options contract, and local sup- local prices that can be used as a benchmark ply-demand characteristics. High basis risk in commodity risk management transac- can make it impractical to use a futures or tions. Because commodity markets in many options contract for hedging purposes. developing countries have only recently Basis risk is more of an issue for agricultural changed from fixed prices to market prices, commoditiesthanformetalsandenergy.Agri- there is little experience with transparent cultural markets tend to be localized, while and reliable price reporting systems. Devel- energy and metals markets tend to be global. oping countries should put special empha- Within agriculture, markets for exportable sis on establishing such systems to improve tropical commodities (coffee, cocoa) are con- the dissemination of price information. sidered global and basis risk tends to be small. Over the counter markets could over- This note was written by Donald Larson (Econ- come some of the problems related to basis omist, Development Research Group) and Panos risk. But over the counter products, if they Varangis (Economist, Development Research are available for commodities with high basis Group). If you are interested in similar topics, risk, would be expensive, increasing the cost considerjoining theManaging Commodity Boons of hedging. In dealing with basis risk, some and Busts Thematic Group. Contact Michael developing countries have established or Lewin, x38684, or click on Thematic Groups plan to establish commodity derivatives mar- on PREMnet. i This note series is intended to summarize good practice and key policy findings on PREM-related topics. PREMnotes are distributed widely to Bank staff and are also available on the PREM website (http://prem). If you are interested in writing a PREMnote, email your idea to Asieh Kehyari. For additional copies of this PREM- "R*b11W*hw note please contact the PREM Advisory Service at x87736. Prepared for World Bank staff