Risk Management Schemes for West African Cotton

1. Risk Management Schemes for West African Cotton Christopher L. Gilbert Panos Varangis Commodity Risk Management Group, World Bank EU-Africa Cotton Forum, Paris, 5-6 July 2004

2. Objectives • To reduce revenue risk for cotton farmers and/or to allow ginners to set realistic minimum prices at the start of each crop year. • We should do this recognizing the interdependence of ginners and cotton farmers which allows risk management to be efficiently intermediated through ginners. • We should aim to encourage ginners to manage their price risk, if possible through market mechanisms. • To do all this taking account of existing structures. • To advance these risk management objectives in a manner consonant with further liberalization of, and increased competition in, the sector. • To use world financial markets to diversify risk away from the countries themselves. • To avoid the danger of budgetary over-runs or calls for emergency financing from donors.

3. Possible Schemes • Self-Insurance: When prices are high, countries contribute to a national or regional stabilization fund, and draw on this fund when prices are low. • Options Scheme: Options are purchased by or through a national or regional fund. These pay out when prices are low. • Hedging Scheme: Ginners set minimum prices at the start of the season. Donors assist ginners in hedging the associated risk position. A national or regional board takes on residual quantity risk, not hedged by ginners.

4. The Proposed Hedging Scheme • We propose a hedging scheme which would guarantee minimum prices to farmers. • The scheme is in harmony with the objective of further liberalization and increased competition. • The scheme will enhance the professional capacity of the ginners. • The scheme does not aim to stabilize producer revenues (too expensive and too dangerous) – instead it sets itself the objective of allowing ginners to offer a high, market-based, minimum price at the start of the season. • The scheme could be extended to cover input finance. • The scheme will require significant technical assistance, and this may be financed by donors. It will not require major donor capital or income support.

5. Proposed Hedge Structure • Ginners will assume the obligation of announcing a guaranteed minimum price in advance of each season. This corresponds to the current prix initial in francophone countries. • Where competition exists, there would be no requirement that this guaranteed price will be identical across ginners, although this may be the outcome. • The objective is to induce the offer of a minimum price which is as high as possible consistent with prevailing market conditions. • The minimum price commitment leaves ginners with a long exposure. They will need to off-set this exposure either through forward trade sales or by sale of OTC forwards or purchase of puts. We suggest that a donor-supported (regional?) authority provides technical assistance in doing this.

6. Proposed Hedge Structure (contd.) • This arrangement leaves ginners with residual risk since they have offered a minimum price on a potentially unlimited quantity. • The residual exposure is to the combination of either high quantities and low prices or to low quantities and high prices. • We propose that the regional authority will insure these risks. • Insurance will be based on quantities (at a national level) in excess of say 110% of or less than 90% of recent levels (measured on some rule) and prices below say 90% or in excess of 110% of the CotLook A forward price at the time ginners offered their minimum prices. • Because payments involve double coincidences (low price and high quantity and vice versa), and because the quantities involved will be small (insurance payments relate only to the excess over 110% or under 90%), the fee charged to ginners will be modest. • The World Bank can provide technical assistance to which donors may choose to contribute – without any open-ended commitment.

7. The Options Scheme • The scheme will give good protection against low prices but does not deal with basis risk. It does not offer any quantity protection. • It does diversify risk away from the countries themselves. • It needs to be carefully costed (it depends on annual donor contributions rather than capital payments). • There will always be a demand for subsidized options – but the scheme does little to increase the capacity of the system to absorb risk once payments end. • There is a danger that recipients of subsidized options may simply appropriate the subsidies by selling offsetting positions. • It is unclear how the benefits at periods of low prices will be transmitted to ginners or farmers – further details are required. • If organized at a national level, the scheme does little to encourage further liberalization and moves towards a more competitive sector.

8. The Self Insurance Scheme • This meshes well with some existing institutions in the sector. • The scheme only covers price risk (quantity risk is of equal importance). It is therefore likely to deliver only a low degree of revenue stabilization. • Such schemes would likely run into cash constraints, limiting their ability to intervene (perhaps up to 50% of years). We believe that the proponents underestimate the full extent of market uncertainty. • We see the schemes as doing little to encourage further liberalization and moves towards a more competitive sector. • Under self-insurance, risk is retained within the countries themselves, despite their low capacity to bear these risks. • Revenue movements are very highly correlated across the West African cotton producing countries - little benefit from risk-sharing across the west African producers (le troisième niveau régional).

9. The Balance Sheet • The World Bank sees cotton as an ideal crop in much of West Africa. Cotton can provide remunerative returns to African farm households in regions where there are few other profitable crops and much-needed dollar export revenues at the national level. • Support of this sector provides a direct means of attacking poverty in some of the world’s poorest economies. • We see self-insurance as a variant of traditional stabilization - risky and expensive. Stabilization schemes work well when they are least required; they tend to fail in the periods in which they are most needed. We should aim to be ambitious, but we should not become reckless. • The World Bank sees such support as being aimed at increasing the capacity of institutions in competing in the world cotton marketplace, and not as a temporary palliative for current low prices or as a substitute for trade reform. We should aim to get ginners to manage their price risk, not manage it on their behalf.