From September’s Business Diary Botswana:

Derivatives market helps farmers weather storm and smooth returns In “Fool’s Gold,” Financial Times global markets commentator Gillian Tett writes that “versions of derivatives trading have existed for centuries,” citing “rudimentary examples of futures and options contracts found on clay tablets from Mesopotamia dating back to 1750 B.C.” And the relatively modern practice of futures and later options trading to hedge against price volatility–used by farmers in order to lock in the price of a crop as it is planted, and thus negating the risk that prices will drop before it is harvested–began as early as 1849, when the Chicago Board of Trade opened. Yet within frontier markets the use of derivative contracts amongst farmers has been notoriously fickle, despite the obvious benefits that such techniques would bring not only food producers, but ultimately consumers. A 2006 paper published by the University of Pretoria’s Department of Economics, for instance, concluded that “the problems concerning food and income insecurity [would] be reduced if farmers [could] adopt derivative contracting on a large scale, since the producers [would] then be able to produce the staple food on a continuous basis at relatively profitable levels.” In Botswana’s case, a mature derivatives market could ultimately ignite a moribund industry whose waning impact is readily felt even in the face of robust GDP. According to the World Bank, despite the country’s seismic growth rates during the 1990s, the prevalence of hunger actually increased. Since then, the agricultural sector’s output has continued to disappoint, hampered by lackluster farming technologies and practices, sporadic rainfall and rampant disease outbreaks. Such degree of inefficient food production leaves not only consumers vulnerable, but state coffers as well. Per the Ministry of Agriculture, current annual arable production levels are only between 15-20% for cereals, and 45% for fruits and vegetables–meaning that imports must pick up the slack. Moreover, the risk of large-scale calamity due to, say, drought, leaves a given country’s fiscal surplus in a perilous position should wide-scale humanitarian intervention become necessary. And with food inflation a near certainty in the long-run, given a rise in price of major commodities related to food production due to growing world demographics, coupled with an ever-diminishing amount of farmland-per-person and an increasing scarcity of cheap, fresh water, it is no wonder that a lagging agricultural sector is continually singled out by worried Botswana officials.

Facilitating the sector’s resurgence, however, may be the emergence of Bourse Africa, a Pan-African commodities and derivatives exchange that will have a technology hub in Botswana and will link to other exchanges in the continent, and which is expected to be operational this month. The exchange, which in sponsored and coordinated by Financial Technologies India Limited (FTIL), a global leader in creating and operating financial markets that also owns MCX India, the Mumbai-based, world’s 8th largest commodities exchange, will trade contracts for agricultural commodities, oil and metals across Africa with a hub and spoke model centered in Botswana. According to Adam Gross, its Head of Strategy, the exchange will be of greatest benefit to farmers. “[Farmers] will understand the real value of what they produce. They get bad prices on the world market,” he said, noting that they will be taught about market information and how to execute orders and risk management. Additionally, the Exchange notes: “it has been demonstrated in academic literature how exposure to price volatility encourages commodity producers to pursue risk-minimizing strategies with the consequence that investment in production is limited and the cultivation of higher revenue but higher risk products remain off-limits. Whilst this is particularly the case for rural producers and informal sector workers, even a relatively sophisticated private sector enterprise can be critically wounded by sharply rising prices for fuel or essential raw materials, or a significant year-on-year drop in realized prices. Moreover, volatility has particularly damaging effects on poor people in low-income countries whose ability to cope is limited by shallow financial sectors and political and economic constraints that place limits on the type and nature of government interventions.” One specific subset of the agricultural derivatives industry centers around weather risk management. Per research by the World Bank, while international food prices have fallen, local food prices in many countries haven’t followed suit. While below their 2008 peaks, major food grain prices are still above average; maize is 50% more expensive than its average price between 2003 and 2006, and rice prices are 100% higher, for instance. One explanation is that production and supply cannot always be neatly correlated to fit demand; extraneous random variables such as weather patterns have an integral impact on a given crop’s yield. Per one academic paper, “weather is undeniably one of the most important sources of risk in agriculture, and it seems that fluctuations of temperature and precipitation have even increased in the last decade [and will continue to increase?] due to global climate changes.”

Sensing the need to help farmers manage this risk and to reduce the impact of drought in developing countries, the World Bank last year launched a series of financial intermediation services to low-income client countries of the International Development Association (IDA), and added to the range of risk-management tools available to middle-income client countries of the International Bank for Reconstruction and Development (IBRD), to help transfer risks to the financial markets. Such “index insurance” is tied to an objectively measurable indicator (e.g., rainfall, temperature, humidity, crop yields), in lieu of loss. At present, the use of rainfall totals to hedge against drought-related crop loss is the most prevalent derivative found in developing markets. In September 2008, the Bank reported, Malawi became one of the first countries to use a weather derivative financial product–index-based weather derivatives, in which “payments are triggered by adverse weather events according to pre-specified conditions.” In practice, it explained, “the Bank enters into mirroring transactions with the client country and a financial market counterpart. In the event of a severe weather event, client countries receive a payout from the Bank, the total value of which would be based on an index used as an estimate of the financial impact. This would be funded with the payout that the Bank would receive from the mirroring transaction.” In Malawi’s case, the World Bank Treasury acted as an intermediary on behalf of the government to ease and expedite its access to the international weather derivatives market–thus reducing transaction costs. “If there is significant drought in the country, the government will get a payout whose level is determined by the size of the premium paid and the severity of the drought. This payout may be used to help purchase grain to resolve supply shortfalls or to distribute grain from national strategic grain stocks,” commented David Rohrbach, a senior economist at World Bank’s Malawi office. Concurrent with the Malawi deal, the World Bank also began to support weather index insurance initiatives across Thailand, Bangladesh, Senegal, Burkina Faso, Kenya, Jamaica and Fiji. And in Indonesia, per its website, the Bank and IFC are completing a “feasibility study on a crop insurance pilot for maize small farmers.” While not an innovative product per se–weather market and index-based insurance products in agriculture have grown rapidly over the past decade and are widely used by private companies to manage risk–their adoption in developing countries is relatively novel. Skeptics, however, note that the long-term future of weather derivatives will ultimately depend on what improvements can be made to their pricing. “Because weather cannot be traded, that is, the market for weather risk is incomplete, a straightforward application of standard pricing models for financial derivatives is impossible. Actually, the poor transparency of pricing algorithms employed by sellers is considered a major cause of the slow development of weather markets,” stated a paper published last November by the American Journal of Agricultural Economics. That said, proponents such as Rohrbach point to an already burgeoning global industry (which now exceeds some $32 billion, including energy firms that make up roughly 36% of the market) and posit that “as the international weather derivatives market becomes accustomed to these transactions, the World Bank expects [a variety of governments] to begin pursuing such transactions independently.”