Hedging Food Price Risks in a World of Uncertainty
The sudden 2008 global food price crisis—which pushed 105 million people into poverty and sparked riots around the world—showed that designing risk management strategies at the national level may prove to be a sound investment. In fact, this is one of the key messages of the 2014 World Development Report on risks and opportunities. With excessive volatility in food prices expected to persist in coming years, net food-importing countries in the developing world need to develop appropriate solutions to address the food price risks and unexpected fiscal impacts ok they may face.
Are hedging instruments appropriate to address these risks?
Hedging food price risks essentially refers to the purchase of insurance against sharp food price fluctuations, transferring the risk to financial institutions or traders. The government of Malawi is a notable example of an importing country which successfully used hedging instruments to mitigate food security risks, resulting in significant import cost savings. In September 2005, Malawi purchased physical call options* for maize, which offered both price protection and the actual delivery of 60,000 metric tons of maize. These instruments thus allowed Malawi not only to effectively manage price risks, but also to deal with physical availability risks, which are critical in many food-importing countries.
In Egypt, between 5 and 24 percent of the approximately US$2.7 billion spent on wheat imports could have been saved from November 2007 to October 2008 through the use of hedging products. Hedging instruments are candidates to substitute for the costly, often ineffective, and market unfriendly traditional price stabilization policies (such as food subsidies, price controls and stock releases) which conflict with long-term transitions from state-run to market-run food systems.
So why have we not seen more cases?
Although ubiquitous in developed countries, developing countries have rarely used hedging instruments. This is likely due to challenges related to technical capacity, financial knowledge, and resources as well as the institutional and legal frameworks of developing countries attempting to implement effective hedging solutions. In the case of Malawi, the World Bank provided technical support during the process, and the United Kingdom’s Department of International Development paid the option premium as an incentive for the government to pilot this new strategy. This type of collaboration has yet to catch on more broadly, but it points to a niche area where the international community can provide leadership.
It is worth noting that futures markets do not yet exist for some basic food commodities (such as sorghum and cassava); and that, depending on the extent of basis risk**, hedging solutions may not always be appropriate. Nonetheless, hedging food price uncertainty may be useful for both public and private supply chain players—governments, local producers, food processors and consumers— to better manage their revenue and spending. Governments may also assist local actors with limited resources by hedging contracts on their behalf (as in Mexico in 2010) or acting as intermediaries.
Malawi’s successful experience suggests that the use of hedging instruments to deal with food price risks and alleviate the consequences of unstable prices is promising—when applied to the right context at the right time. We need to learn more. Hopefully other countries and their development partners will feel inspired to follow suit.
*Hedging instruments that provide the right, but not the obligation, to buy physical assets at a pre-agreed price and at a given time in the future
**The risk of relative price movements, between cash prices and futures prices
The blog is cross-posted from Let's talk Development