Summary of a paper contributed by UNCTAD to the 26th Session of the Intergovernmental Group on Grains, May 1995
The issue of using risk management instruments by grain importers is not new to the FAO Intergovernmental Group on Grains, which discussed these aspects at its Twenty-first Session in October 1982. The purpose of this paper was to inform the Group of possible tools to reduce or alleviate price risks in the grains sector, which are compatible with trading conditions in an open market system and of particular interest to grain importing developing countries.
During the last few years, there has been a growing trend towards liberalization of commodity markets, both domestically and globally. The impetus for such changes stemmed from structural adjustment programmes and government commitments to more open trade policies in the context of the Uruguay Round of Multilateral Trade Negotiations. Many governments of developed and developing countries have abolished structures and institutional arrangements that regulated commodity marketing and market prices in the past. Especially in the developing countries, often drastic measures have been taken to give a larger role to the private sector.
However, reducing government intervention in commodity markets has also left important vacuums. One of these relates to the role formerly played by the state in setting producer and consumer prices for food commodities, enhancing the image and reliability of export regimes and providing counterparty guarantees to overseas importers. The second relates to a considerable shift of exposure to the risk of world market price instability from the state to farmers, private traders and processors. By and large, the degree of their exposure to price risks and their capacity to manage such risks have not been taken into account fully in the new liberalized environment.
For an important share of internationally traded agricultural commodities, risks can in principle be laid off on the market, by using risk management instruments. The two broad types of market-based commodity price risk management instruments are standardized or tailor-made contracts. The former (commodity futures and options) stipulate the price to be paid for a specified volume of the commodity, its precise quality and delivery period. The latter are over-the-counter contracts (forward contracts, swaps and commodity bonds and loans) offered by commodity trading houses and financial institutions and are tailor-made to the needs of the client.
The two major benefits grain importers can draw from the use of risk management instruments are greater marketing flexibility and greater price security within a budget year or over a period of several years - from which consumers can also benefit. Using futures and options markets, grain traders can effectively price purchases at any time they want, irrespective of physical purchases; similarly, they can purchase options to warehouse "paper grain" at relatively low storage costs, thus replacing expensive physical stocks. Importing agencies can also ensure that they are within their budgets, or that long-term purchasing prices are within their means.
Grain importers ultimately have their own responsibilities in determining whether or not they would benefit from the greater use of risk management markets. This would depend on objective factors, such as the size of the operations and the rigidity of budgets, but also on subjective factors, such as the flexibility given to purchasing managers and the understanding of risk management markets among political decision makers. Existing international "risk absorption", through food aid and compensatory finance, should also be taken into consideration. It would appear that countries which manage their imports better may have less need for food aid and compensatory finance, and donors may therefore consider providing direct support to such risk management activities.
Two developments may have made it worthwhile for importers not yet using risk management instruments on a regular basis to re-examine their policies. First, with the conclusion of the Uruguay Round, an increasing part of grain trade is likely to take place at world market conditions, rather than on a preferential basis. Importers will be under pressure to adapt their purchasing policies to these new conditions, including the use of trading instruments. Second, risk management markets have become much more diverse and may better fit the particular needs of individual grain exporters and importers. Whereas in the early 1980s, importers were basically limited to locking in forward prices for up to a year, nowadays it can be done for longer periods, and rather than being forced to fix a certain price (with the risk that, at hindsight, this price was unfavourable), they can elect to obtain "insurance" against price rises.
However, there are certain areas where risk management is of limited value. Risk management markets do not provide protection against volume risks, nor do they change the trends of world market prices. They are not easily accessible by smaller actors, and even larger ones have to overcome a series of conceptual, organizational and policy barriers in order to put the proper conditions for a sound use of these markets in place. A poorly managed company, or a company which operates from a country where government policies strongly limit its flexibility, may do better to refrain from using these markets. Inadequate supervisory controls can also expose importers to speculative losses on commodity markets.