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Risk Management Instruments for Countries Vulnerable to Exogenous Shocks: The Case for Food & Risk Management Instruments for Countries Vulnerable to Exogenous Shocks: The Case for Food & Agriculture Cyril Muller Director Banking and Debt Management

Risk Management Challenges Facing Governments § Understand & Quantify risks in order to evaluate Risk Management Challenges Facing Governments § Understand & Quantify risks in order to evaluate vulnerabilities under different scenarios § Take a broad view of fiscal risks beyond traditional financial risks (exchange rate/currency) to food, energy, fertilizer prices, but also exposure to natural disasters § Create a culture of risk management that strengthens capacity, is linked to sector policies & strengthens inter-ministerial cooperation § Bridge the gap to market solutions when & where they are appropriate through training & capacity building § Develop country-driven, customized approaches § Identify active role for private sector partners

Examples of Risk Management Activities: § Hedging the price risk of imported oil & Examples of Risk Management Activities: § Hedging the price risk of imported oil & its impact on consumers of electricity: Dominican Republic, Panama, Honduras § Hedging oil price volatility and evaluating budgetary impact of natural disasters: Morocco § Hedging price risk of edible oil & fertilizer imports: Bangladesh, Philippines § Financing safety nets with weather hedges, commodity hedges, or contingent financing instruments: Ethiopia, Mauritius, Jordan § Technical support to facilitate use of physical commodity hedges for key food staples: Malawi, Haiti, Indonesia § Risk-sharing of underlying credit exposure to help expand private sector access to hedging instruments – IFC Global Agricultural Price Risk Management Facility § Market intermediation to mitigate drought risk with weather hedges: Malawi, Niger § Analysis of potential for pooling drought risks: Africa 4

An Integrated Risk Management Approach in Malawi Capacity-Building § To model & assess the An Integrated Risk Management Approach in Malawi Capacity-Building § To model & assess the impact of drought § To quantify exposure to maize import price increases § To improve understanding of the cost/benefit of using market-based approaches Institutional Framework § Recognized that different instruments would be appropriate at different times Risk Management Strategy § IDA Credit provided funding to develop markets & strengthen meteorological services § Weather derivative – used to hedge risk of severe drought § Physical call option on maize – used to hedge risk of import price increases

An Integrated Risk Management Approach in Malawi Capacity-Building § To model & assess the An Integrated Risk Management Approach in Malawi Capacity-Building § To model & assess the impact of drought § To quantify exposure to maize import price increases § To improve understanding of the cost/benefit of using market-based approaches Institutional Framework § Recognized that different instruments would be appropriate at different times Risk Management Strategy § IDA Credit provided funding to develop markets & strengthen meteorological services and risk management § Weather derivative – used to hedge risk of severe drought § Physical call option on maize – used to hedge risk of import price increases The Government of Malawi, with the support of DFID, pays a premium in return for financial coverage (a payout) in the event of a severe drought; World Bank plays an intermediation role by standing between the Government and the market counterparty (Swiss Re)

An Integrated Risk Management Approach in Malawi Capacity-Building § To model & assess the An Integrated Risk Management Approach in Malawi Capacity-Building § To model & assess the impact of drought § To quantify exposure to maize import price increases § To improve understanding of the cost/benefit of using market-based approaches Institutional Framework § Recognized that different instruments would be appropriate at different times Risk Management Strategy § IDA Credit provided funding to develop markets & strengthen meteorological services and risk management § Weather derivative – used to hedge risk of severe drought § Physical call option on maize – used to hedge risk of import price increases The Government of Malawi, with the support of DFID, paid a premium to guarantee that white maize delivered to Malawi would not increase above a fixed, SAFEXbased price; World Bank played a facilitating role by helping to structure the contract between the Government and the market counterparty (Standard Bank)

An Integrated Risk Management Approach through a local bank Capacity-Building § To assess the An Integrated Risk Management Approach through a local bank Capacity-Building § To assess the impact of intra-seasonal price risk on an agricultural bank’s lending portfolio, and on financial sustainability of borrowers § To improve understanding of market instruments Institutional Framework § Local bank intermediates hedging transactions on behalf of borrowers, thus lowering risk of default on loans § Borrowers strengthen ability to manage intraseasonal price risk to secure revenue Risk Management Strategy § Swap transactions, option contracts, and forward purchases/sales can be used by agribusinesses to protect a forward price § Hedging price risks protects revenue stream and strengthens credit-worthiness

An Integrated Risk Management Approach through a local bank Capacity-Building § To assess the An Integrated Risk Management Approach through a local bank Capacity-Building § To assess the impact of intra-seasonal price risk on an agricultural bank’s lending portfolio, and on financial sustainability of borrowers § To improve understanding of market instruments Institutional Framework § Local bank intermediates hedging transactions on behalf of borrowers, thus lowering risk of default on loans § Borrowers strengthen ability to manage intraseasonal price risk to secure revenue Risk Management Strategy § Swap transactions, option contracts, and forward purchases/sales can be used by agribusinesses to protect a forward price § Hedging price risks protects revenue stream and strengthens credit-worthiness Through the new Agriculture Price Risk Management Product, IFC would share credit risk with a participating international bank which might otherwise face constraints on assuming credit exposure to emerging market counterparties; objective is to extend the reach of hedging products to strengthen resiliency of agribusiness

Bridging the market Gap Challenges: Governments & Private Sector Entities in Developing Countries • Bridging the market Gap Challenges: Governments & Private Sector Entities in Developing Countries • No precision in assessing & quantifying the risk • No legal framework • No institutional framework Risk Markets • No technical expertise • Fears about reputational risk • Lack of sustained attention 10

Capacity Building is Critical Objective: To strengthen a government’s ability to implement commodity risk Capacity Building is Critical Objective: To strengthen a government’s ability to implement commodity risk management strategies supported by sound analysis and a robust institutional framework Country-based work: § Risk assessment to analyze impact of commodity price shocks on the budget § Assessing legal and regulatory infrastructure § Review of potential commodity hedging solutions § Technical support to design a framework and governance process § Review of other institutional issues that would impact implementation, including decision-making and technical capacity § Education for ministry staff, stakeholders and policy-makers § Technical advice related to structuring and executing transactions with the market International cooperation: § Sharing best practices & establishing guidelines § Organizing a network of experts & practitioners 11

Managing the Fiscal Impact of Commodity Price Shocks Two main questions: 1. Can the Managing the Fiscal Impact of Commodity Price Shocks Two main questions: 1. Can the risk of a price shock be mitigated using market instruments? (commodity hedge component) 2. Are there other ways to finance responses to the price shock? (contingent financing component ) NOTE: A commodity risk management strategy can use either of these components, or a combination of the two. 12

Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Tools Investment Banks Multinational Trading Companies, Importers, Exporters Futures Options Forward Contracts Option Contracts (Contingent Imports/Exports)

Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Tools Investment Banks Multinational Trading Companies, Importers, Exporters Futures Options Forward Contracts Option Contracts (Contingent Imports/Exports) Can be very challenging to use since: - Creates an unknown and unpredictable future liability since the market counterparty must be paid if the market moves in an adverse direction - Requires financing of a credit line or a credit guarantee which can be sizeable - Does not generally result in physical delivery of the commodity - Involves locking in prices at an absolute level with no flexibility to take advantage of favorable prices later

Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Tools Investment Banks Multinational Trading Companies, Importers, Exporters Futures Options Forward Contracts Option Contracts (Contingent Imports/Exports) - Caps prices but allows flexibility to take advantage of lower price movements that may occur in the future - Requires payment of an “insurance” premium - Does not generally result in physical delivery of the commodity - Can work well for energy commodities, cash crops, food crops well-integrated with international markets (wheat)

Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Tools Investment Banks Multinational Trading Companies, Importers, Exporters Futures Options Forward Contracts Option Contracts (Contingent Imports/Exports) - Locks in a fixed price or price which fixes over the average of a specific time frame in the future (for example one month or a set of months) - Available through physical supply chains for most commodities - Results in delivery of the physical commodity

Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Categories & Types of Hedging Products Commodity Hedging Tools Financial Hedging Tools Physical Hedging Tools Investment Banks Multinational Trading Companies, Importers, Exporters Futures Options Forward Contracts Option Contracts (Contingent Imports/Exports) - Caps prices but allows flexibility to take advantage of lower price movements that may occur in the future - Requires payment of an “insurance” premium - Results in delivery of the physical commodity - Can work for food crops not well-integrated with international markets such as rice, edible oils, and other commodities with high basis risk vis a vis futures exchanges

Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Commodity Hedging Products Contingent Finance Products Investment Operations / Public Goods

Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Commodity Hedging Products Contingent Finance Products Investment Operations / Public Goods Risk assessment to analyze impact of commodity price shocks Assessing legal and regulatory infrastructure Technical support for ministry staff, stakeholders and policy-makers Technical advice related to structuring and executing transactions with the market

Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Commodity Hedging Products Contingent Finance Products Investment Operations / Public Goods Commodity swap/cap linked to loans – requires liquid futures market (i. e. available for energy products, wheat/corn, not available for rice) Financial hedging products – also requires underlying liquid futures market Physical hedging products – involves pre-arranging contingent import/export agreements for protection on commodity price and supply (more flexible as to products covered – i. e. rice, edible oils)

Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Commodity Hedging Products Contingent Finance Products Investment Operations / Public Goods Weather Derivative or Catastrophe Bond – relevant for weather shocks affecting commodity production (local or elsewhere) Contingent Loan for Catastrophes –could be used to provide immediate liquidity in the event of a natural disaster affecting commodity production Contingent Loan for Budget Support –could be supported by an overall commodity risk management strategy that incorporates policy/market responses and hedging tools

Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Bridging the Market Gap A Programmatic Approach to Risk Management Analytical & Advisory Services Commodity Hedging Products Contingent Finance Products Investment Operations / Public Goods • Modernizing meteorological services (investments in reporting & communications infrastructure) • Financing regional approaches to risk pooling (Africa Drought Risk) • Investment in agricultural productivity growth, agricultural institutions, extension services, roads, ports, power, storage, irrigation systems and information and communication technology

World Bank Proposed Approaches 1. Expand capacity building for commodity risk management as an World Bank Proposed Approaches 1. Expand capacity building for commodity risk management as an integral part of broader fiscal risk management – using successful debt management advisory service program as the anchor point 2. Integrate risk management approaches into loans and credits 3. Facilitation of commodity hedging by: § providing assistance to help governments and private sector entities structure & execute physical hedging transactions § providing market intermediation services for financial commodity hedges de-linked from loans 4. Risk-sharing of underlying credit exposure to help expand access to risk management tools to agribusiness entities (through the IFC’s proposed Global Agricultural Price Risk Management Facility)

World Bank Proposed Approaches Deliverables for June Agriculture Ministers Meeting § New IFC Global World Bank Proposed Approaches Deliverables for June Agriculture Ministers Meeting § New IFC Global Agricultural Price Risk Management Facility § Expanded capacity building for commodity risk management § Scaling up of efforts to integrate risk management approaches into loans and credits § Launch of facilitation of commodity hedging by helping governments and firms structure & execute physical hedging transactions , and launch of new service to provide market intermediation services for financial commodity hedges de-linked from loans At November Summit § Implementation: what, where and who § Sharing of lessons learnt § How we can expand the toolkit, including with other MDBs, donors and the private sector

Concluding Thoughts ü Budget vulnerability as a result of price volatility & exogenous shocks Concluding Thoughts ü Budget vulnerability as a result of price volatility & exogenous shocks is detrimental to longer term investment and development programs (public and private) ü Both low and middle-income countries have problems accessing risk markets due to lack of knowledge about products and how to use them ü There are no risk management instruments that can mitigate the impact of longer term trends, but short-term volatility has a big impact and can be managed ü There may be natural hedges and/or benefits to risk pooling & regional collaboration ü Broad participation is needed to make this work: MDBs, CAADP/NEPAD, International Organizations, bilateral donors, countries with similar experiences, and private sector partners

Banking and Debt Management Contacts Cyril Muller Director 202 -458 -4645 cmuller@worldbank. org Julie Banking and Debt Management Contacts Cyril Muller Director 202 -458 -4645 cmuller@worldbank. org Julie Dana Senior Financial Officer 202 -458 -4988 jdana@worldbank. org

Annex Annex

Stand-Alone Financial Hedging Instruments (Examples for Importers) Instrument Description Advantages Disadvantages Futures Contract An Stand-Alone Financial Hedging Instruments (Examples for Importers) Instrument Description Advantages Disadvantages Futures Contract An agreement to buy a specific quantity of the exchange traded commodity contract, at a specific price, on a specific date in the future. • No upfront costs. • Provides ability to “lock in” forward prices through a financial contract. • Since prices are “locked in” the hedger can not take advantage of lower prices if they occur in the future. • Creates an unknown and unpredictable future liability since hedger will owe the market counterparty if the market moves in an adverse direction. • Requires financing of a credit line or a credit guarantee. • Requires managing cash flow /liquidity requirements to support (potential) daily margin calls. • Requires significant operational capacity to manage the hedging program. Call Option Contract An agreement that provides the hedger with the opportunity, but not the obligation to buy or sell a specific quantity of a commodity, at a specific price, on a specific date in the future. Can be used to cap prices by creating a price ceiling. • Provides ability to cap prices while still providing hedger with the ability to take advantage of lower price movements that may occur in the future. • In this way acts as an insurance contract. • Ease of administration. • Has an upfront cost, which is marketdriven and volatile but can range from 512% of the value of the underlying price for a 6 -18 month coverage, depending on market conditions.

Physical Hedging Instruments (Examples for Importers) Instrument Description Advantages Disadvantages Fixed Price Forward or Physical Hedging Instruments (Examples for Importers) Instrument Description Advantages Disadvantages Fixed Price Forward or Average Sales/Purchase Contracts Agreements to purchase a commodity on a specified forward date for a specified, predetermined price, or price formula. Pricing of forward contracts can be customized - hedger can lock in at a fixed price or over the average of a specific time frame in the future (for example one month or a set of months). • If forward prices are fixed, hedger loses the ability to take advantage of lower prices if they occur in the future. • If forward prices are based on the average of a future time period, hedger still has uncertainty associated with what that final price level will be. Buying a Physical Call Option (Price Cap) for Imports • Forward contracts which provide a maximum price, i. e. a cap. • Provides ability to cap prices while still providing hedger with the ability to take advantage of lower price movements that may occur in the future. • In this way acts as an insurance contract. Has an upfront cost, which is market-driven and volatile but can range from approximately 5 -12% of the value of the underlying price for a 6 -18 month coverage, depending on market conditions.

Commodity Hedge Linked to a Loan (Examples for Importers) Instrument Description Advantages Disadvantages Commodity Commodity Hedge Linked to a Loan (Examples for Importers) Instrument Description Advantages Disadvantages Commodity Swap linked to a Loan Existing or new loan is structured so that repayments decrease when the market price moves up; and repayments increase when the market price moves down. • No upfront cost. • Provides ability to index loan repayment to a fixed commodity price. • Creates an unknown and unpredictable future liability since borrower will have higher repayment obligations to IBRD if the market moves down. • Is based on an underlying futures price (i. e. on an exchange) so coverage may imply some basis risk. • Is a financially-settled instrument (i. e. does not result in delivery of the commodity). Commodity Cap linked to a Loan Existing or new loan is structured so that repayments decrease when the market price moves up. • Provides ability to index loan repayment to a capped commodity price and in this way acts as an insurance contract. • Does not create an unknown and unpredictable future liability since borrower will not owe IBRD if the market moves down. • Has an upfront cost, which is marketdriven and volatile but can range from 512% of the value of the underlying price for a 6 -18 month coverage, depending on market conditions. • Is based on an underlying futures price (i. e. on an exchange) so coverage may imply some basis risk. • Is a financially-settled instrument (i. e. does not result in delivery of the commodity). 30

Physical Hedging Instruments (Example for Exporters) Instrument Description Advantages Disadvantages Repurchase Agreement for Exports Physical Hedging Instruments (Example for Exporters) Instrument Description Advantages Disadvantages Repurchase Agreement for Exports • Agreement to sell now at a pre-agreed price, with the option to repurchase at a later time (i. e. 6, 12, 18 months) if needed. • Provides ability to lock in value of high export prices now without being concerned about deficit in the future. • In this way acts as commodity “loan” – product is sold now and will be re-supplied at a later date if needed. Repurchase option has an upfront cost, which is market-driven and volatile but can range from approximately 5 -12% of the value of the underlying price for a 6 -18 month coverage, depending on market conditions.

Contingent Financing Instruments: (Examples for Food Importers ) Instrument Description Potential Application for food Contingent Financing Instruments: (Examples for Food Importers ) Instrument Description Potential Application for food Importers Weather Derivative IBRD Intermediates these contracts on behalf of borrowers; Payments are triggered by adverse weather events according to pre-specified conditions (e. g. levels of rainfall, seasonal temperatures, etc. ). • Could be used to address impact of a weather shock affecting national food production or food imports from another country. Catastrophe Bond Fixed income security that insures the sponsor of the bond against a pre-defined set of natural disasters such as earthquakes or hurricanes. If a covered event occurs during the bond’s life, the sponsoring country retains the bond principal to fund emergency relief and reconstruction work. • Could be used to address impact of a weather shock affecting national food production or food imports from another country.

Contingent Financing Instruments: Potential Application for Food Importers Instrument Description Potential Application for food Contingent Financing Instruments: Potential Application for Food Importers Instrument Description Potential Application for food Importers Contingent Loan for Budget Support Provides borrower with access to immediate liquidity following a shortfall in resources due to adverse economic events or unfavorable changes in commodity prices or terms of trade. • Could be used to address impact of commodity price shock or unfavorable changes in terms of trade • Triggers could be established which relate to overall commodity risk management strategy. Contingent Loan for Catastrophes Provides borrower with access to immediate liquidity following a natural disaster. • Could be used to cover adverse weather events affecting food production. • More likely applicable for coverage of national events than events happening in other countries.

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