The World BankJANUARY

1999

NUMBER 13

ECONOMIC POLICY

Using markets to deal withcommodity price volatilityWhat 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-basedAccording to UNCTAD, in 1995, 57 devel- stocks have proven ineffective, as with theoping countries depended on three com- large accumulations under U.S. and EU farm commodity riskmoditiesfor 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 managementimports for some developing countries. those for coffee, cocoa, tin, and sugar. And

Commodity prices are notoriouslyvolatile, government intervention has been costly, instrumentscreating instability and uncertainty for com- with unintended consequences. Today aca-

modity-dependent developing countries. Com- demics and policymakers emphasize the dis- have becomemodity price volatility affects governments, tinction between programs that attempt to

producers, processors, traders, and local finan- alter the distribution of prices, domestically more popular,cial institutions. Moreover, commodity price or internationally, and programs that deal

instability undermines economic growth and with uncertainty using market instruments. but barriers remainskews 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 ofpolicies 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),Managing risk through markets lack of transparent local reference prices,Most early attempts to deal with commod- limited know-how, and the absence of liq-

ity price volatility tried to stabilize prices with 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

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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 1 Commodity risk management problems and policies

Short-term policy Long-term policySector 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 * Remove policy-based impediments * Improve market access andto underlying physical markets market information for local

* Counterparty risk and small-scale * Government- or association commodity marketsactivity 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-

Public * Fluctuating central bank reserves * Include commodity-based e Diversification through growthinstruments in central bank 9 Improve asset managementoperations capacity in treasury and central

* Fluctuating government revenues * Hedge government budget against bankand expenses commodity price declines

* Related short-term and long-term e Include commodity-baseddebt management problems instruments in debt portfolio

e Agent problems related to objectives, 9 Develop independent reporting,management, reporting, and auditing, and trading groups, orcorruption access risk management services

through intermediaries

Quasi-public 9 Oversight and reporting of risk 9 Outsource risk management * Improve regulatory, oversight,parastatals management activities functions and enforcement capacity

9 Perverse incentives may preclude i Develop administrative capacity Privatizationappropriate 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 Counterparty Low Intermediation Basis Lack of localCommodity know-how risk liquidity nsues risk price discovery

Petroleum In some cases In few cases No No No NoPrecious metals In some cases In few cases No No No NoBase metals In some cases In few cases In general, no No In general, no NoAgriculture for export Moderate Yes Low to moderate Yes Moderate ModerateAgriculture for local Yes Yes Moderate Yes Yes Yes

markets

ernments and donors to support the devel- gin requirements or to directly purchaseopment of private risk management mar- options, avoiding local market constraints.kets and developments in the markets Similarly, importers can often take advantagethemselves. of guarantee programs when purchasing

exports from industrial countries. But manyLack 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 rely on indirect risk management Wherekets. As with markets for physical commodi- financial institutions are weak, exporters oftenties, markets for risk management instruments enter into pre-financing arrangements withinvolve a number of actors with varying needs importers to limit exchange rate risks. But Risk managementand levels of understanding. Several inter- pre-financing credit and risk managementnational organizations-International Trade arrangements tend to be short term and services are rarelyCenter, Common Fund for Commodities, restrict marketing options.World Bank, UNCTAD-offer general tech- Another approach is to use inventories to Offered in poorernical assistance to build the risk management finance trade and bundle risk managementskills ofpolicymakers and market participants. services. Silos and warehouse operators func- countries and inIn addition, several groups offer specialized tion as intermediaries. Sometimes banks willinformation. The International Organization enter into arrangementswith traders or proces- countries whereof Securities Commissions publishes a com- sors to provide a line of credit based on inven-parative review of international regulatory sys- tory levels. The value of the inventories is then markets are newlytems, and the IRIS Center at the University hedged either directly or by lending againstof 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 specialhave 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 governmentples include ASKINDO (the Indonesian cocoa is to provide the legal infrastructure for receipt-association) and ANACAFE (the Guatemalan based trade, regulate and monitor warehousecoffee association). The private sector and operators, and help set standards. In severalgovernment often work together to estab- U.S. states,forexample,agovernmentagencylish local exchanges, and technical informa- manages an indemnity fund to insure receipttion comes from private and public sources. holders. Receipts are also used in spot and

futures markets-for example, in Zimbabwe'sProblems with credit, collateral, and and Argentina's agricultural exchanges.counterparty riskProviders of risk management instruments Problems of scale and aggregationpoint out that producers, traders, and proces- Developing country producers ofmetals andsors in many developing countries cannot energy face fewer hurdles in accessing riskovercome their low credit ratings and lack of markets because of the scale of the firms. Incollateral for hedging transactions. Although addition, multinational firms often have equitythese providers increasingly offer instruments stakes and offer risk management expertise.to middle-income countries in Latin Amer- Butfor agricultural commodities, productionica, Asia, the Middle East, and Eastern Europe, and trade are usually fragmented and diffusedrisk management services are rarely offered in developing countries. Providers ofrisk man-in poorer countries and in countries where agement instruments have to deal with smallermarkets are newly emerging. companies, often with little experience. Local

Large-scale, sophisticated market partici- banks, silos, and warehouse companies canpants 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- ement intervention have established atution. 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

poticies can ducers, and the Options Pilot Programs in markets. Inaddition,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 createdhas 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, betterBasis risk and local markets communications and the Internet haveBasis risk arises when local prices do not increased opportunitiesfor computer-basedmove in line with prices in international trading and price discovery-the Caribbean(derivatives) markets. High basis risk can Commodity Exchange and the Continentalresult 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 consistentfutures or options contract, and local sup- local prices that can be used as a benchmarkply-demand characteristics. High basis risk in commodity risk management transac-can make it impractical to use a futures or tions. Because commodity markets in manyoptions contract for hedging purposes. developing countries have only recently

Basis risk is more ofan issue for agricultural changed from fixed prices to market prices,commodities than for metals and energy. Agri- there is little experience with transparentcultural 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 improvetropical 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 Panosrisk. But over the counter products, if they Varangis (Economist, Development Researchare available for commodities with high basis Group). Ifyou are interested in similar topics,risk, would be expensive, increasing the cost considerjoining the Managing Commodity Boomsof hedging. In dealing with basis risk, some and Busts Thematic Group. Contact Michaeldeveloping countries have established or Lewin, x38684, or click on Thematic Groupsplan to establish commodity derivatives mar- on PREMnet.

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