When I said I was off to a workshop with some well-known City finance firms, my neighbour said: “How can you talk to those terrible hedge fund people?” Fear and distrust of the whole concept of ‘hedging’ has become widespread following the economic downturn. In India, one of the first acts when food prices started to get out of control in 2007-8 was to ban futures markets in staple grains and other key commodities. The US Senate has been equally suspicious of the role of speculators in pushing up world wheat prices.
I don't understand the complexities of high finance. But hedging in its simplest form makes sense to me - it is just a kind of insurance. Farming is a terribly risky business, and tools like forward contracts and options help both farmers and buyers (such as flour millers) fix prices ahead of time, when they are planning their own investments. This might mean giving up some potential profit, but most people think it is worth it to insure against a massive loss if prices don’t go the way you expected.
In the absence of such insurance mechanisms, farmers are reluctant to take risks, and this means they are likely to invest less and produce less. This is a big problem for most developing countries, where farmers have little money to invest and face very high risks. Low food production is one of the reasons that an estimated 1 billion people in developing countries still go hungry. Although pilot risk management schemes such as weather insurance have been started up over the past few years, including by NGOs such as Oxfam, the numbers of people benefiting are still very small. To really have an impact on hunger, the world needs to scale up risk management work drastically (as discussed in ODI’s last annual report).
Over the past few years there have also been moves to introduce hedging tools to governments of developing countries, who have an acute interest in keeping their food import costs down. Better use of hedging during the international food price spike in 2007-8 could have saved poor countries billions of dollars in foreign exchange. For example, Egypt imported an estimated 7 million tonnes of wheat in 2007-8, when international wheat prices were rocketing upwards. According to World Bank calculations the country might have saved over 600 million dollars if they had bought options contracts. The World Bank - together with the UK Government through the Department for International Development (DFID) - supported the Government of Malawi to do just this in 2005, when drought set food prices soaring for the third year in a row. The Government saved several million dollars on maize imports for humanitarian use, over a two month period.
The World Food Programme (WFP) is also taking expert advice from the World Bank and others on how it might use hedging tools in future. If WFP can persuade its big funders to think ahead instead of waiting until pictures of hungry children appear on the telly, it will be able to use tools like forward contracts and options to cut the price of its food purchases. That could mean a lot more hungry people fed for the same money.
So what was I doing with the aforementioned City slickers? I was representing the ODI/DFID High World Food Prices Project at a workshop on Agricultural Risk Management in Developing Countries, organised by the World Bank with the governments of Switzerland (SECO) and the Netherlands (MFA). The workshop brought together experts in hedging and derivatives, insurance companies and banks with farmers’ organisations, NGOs, donors, and lots of other people interested in developing country agriculture. We had lively debates about the spectrum of risks that farmers face (weather, locusts and sudden government policy changes, among others!) and improving ways of tackling them. The organisers are developing a web site to share international experience on this.
It would be great if we could see farmers and governments in developing countries able to manage and insure their risks in the way that rich countries routinely do. Many experts predict increasing uncertainty in international food markets, due to climate change and unpredictable oil prices, among other things. So managing risks will become a vital skill for national food security - and if developing countries don’t have access to the right ‘hedges’ then they will be at a disadvantage.
I look forward to hearing readers’ views - and any examples of risk management being used in agriculture and food security. Do you agree that a hedge can stop us falling into a ditch?
This blog post features the author's personal view and does not represent the view of ODI.
Comments
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re: Can a hedge stop us falling into a ditch? Food security, high food prices and risk management @ Saturday, November 14, 2009 2:20 PM
This is a really interesting topic. Like you rightly noted, hedging makes a lot of sense. It is, however, most applicable to the trade in energy derivatives, which is the most lucrative and also the most volatile of all markets. In the agricultural sector, I would only recommend a seasonalization of hedging plans, as full-time hedging would reduce profits in times of favorable price movements. I do not see the way hedging tools could guarantee food security; this should be left to farming technologies. To reduce the need for hedging, developing countries are managing risks by adopting significantly lower price benchmarks for policy-making purposes. For instance, Nigeria (I cannot think of an agricultural example) uses a $50 benchmark on crude oil prices, and by this morning crude oil traded at $76.54. This significantly low benchmark is a tremendous protective measure, as prices have not dropped below it in decades, leaving the country with enough gains to build on her foreign reserve. Because developing countries do not have strong enough financial institutions in regulating risk management in the agro-trade, I would recommend the use of government policies in order to avoid falling into a ditch.
re: Can a hedge stop us falling into a ditch? Food security, high food prices and risk management @ Saturday, November 14, 2009 9:35 PM
The use of hedging in agro-bussiness seems to be an innovative way of addressing food security in most of the developing world. It is nice to have more tools in the tool box to deal with food security. However, it would have been great if the author of this article would have incorporated the food subsidies that most farmers enjoy from the developed world notably the U.S and EU. What would have been the correlation between hedging and subsidies in regards to securing food security to the most vanulable population.
re: Can a hedge stop us falling into a ditch? Food security, high food prices and risk management @ Sunday, November 15, 2009 2:22 PM
As you said, it will be vital for developing countries to manage risks in regards to food security as experts predict growing agricultural uncertainty.
An interesting report from ActionAid also provides agricultural insights to the above-mentioned dilemma.
ActionAid published a "Hunger Free Scorecard" in which developing and developed countries are rated based on their progress within the four categories of hunger, legal framework, sustainable agriculture and social protection (Brazil is ranked first overall, followed by China, Ghana and Vietnam). The information from this report points to several reoccurring solutions that have reduced hunger and promoted more sustainable agriculture.
First, in most cases where hunger was reduced, heavy investment was given to support smallholder family farmers. Investment ranged from credit and technology to income or price supports. These countries have also maintained or implemented specific policies to ensure that needed food is retained domestically, and not solely exported by the hands of the profit-seeking elite.
As in the case of Guatemala (Listed #26 on the sustainable farming list), this is still a concern despite government polices(Listed as #2 for for its constitutional and legislative declaration for a right to food). However, even on a low income, Ghana and Malawi have made remarkable strides using similar policies (Listed as #2 and #5 overall, respectively.
Thus, a combination of support to poor farmers and implementation of protective policies makes sense for countries where farmers are burdened with too much risk, or people starve while food is being exported abroad.
re: Can a hedge stop us falling into a ditch? Food security, high food prices and risk management @ Monday, November 16, 2009 11:20 AM
Usi, you make a lot of really interesting points. I’d like to follow up on a couple of them! First, I agree about the need to hedge for other risks than food prices, and in particular for oil prices. The oil price strongly affects food prices (and many others), so oil importing countries often want to keep it low and stable. Nigeria is lucky to be an oil exporter, so the government can base its national budget on a low ‘benchmark’ price for oil – after that, any rise in the international price of oil above the benchmark is a bonus for the government. Importing countries are not so lucky. Buying a call option gives them a chance to fix a price ahead of time, so they at least know what the effect on their budget will be. This might be used for either oil or food imports. Where prices are rising, it could also save them money. Second, about the need for countries to have strong financial institutions. I agree. But even where these do not exist, some large traders and government institutions might be able to take advantage of financial institutions in neighbouring countries – for example in southern Africa, using Safex. What do other readers think? Julia
re: Can a hedge stop us falling into a ditch? Food security, high food prices and risk management @ Monday, November 16, 2009 12:26 PM
Denis - Thanks for raising this. Many developed countries, for example the USA, do subsidise risk management for farmers, for example crop insurance, and also the government can make what are called ‘countercyclical payments’ to farmers when prices fall below a target level. There are arguments in the USA that insurance is a better and more equitable form of support to farmers than traditional subsidies. In terms of broader food security, hedging is only one tool in the toolbox to support production. One very important tool to help the most vulnerable is social protection.
Laura – I agree the Action Aid Hunger Free ScoreCard is a really good idea and I hope it will push countries – including donor governments – in the right direction. Which specific policies to adopt to support agriculture and food security, however, can cause a lot of controversy – the devil is in the detail! Some suggestions are on my colleague Steve’s blog here as this subject is really too big for this blog. Julia
re: Can a hedge stop us falling into a ditch? Food security, high food prices and risk management @ Monday, November 16, 2009 7:56 PM
This debate reminds me of the Stiglitz book excerpt I recently read where he argued that all states should guard against rapid liberalization of financial and capital markets because situations can spiral out of government's control. Governments should make globalization work for them by selectively engaging with it while protecting their own industries. The 1997-98 East Asian crisis was his example and they developed by carefully guarding their economies. It was only when they opened up their markets too fast that the markets got out of their control and the crisis ensued.
Developing countries that have food production problems have to make risk management from globalization their top priority. They can take lessons from the developed world. In your article, you provided the example of India reacting to food price speculation by abolishing their practice for key grain markets and they US Senate discussing doing the same. I think Laura's mention of Action Aid's report validates this thinking. Domestic food production has to come before export production no matter what the IMF or World Bank recommends. And Denis has a great point also that if their were no developed world agricultural subsidies there would be a much larger transfer of wealth from North to South and we may not even be discussing this issue.
