The following is an excerpt from this piece by Peter Harrigan:
Abject poverty in the world is declining. Both the number of people and, of course, the percentage of the world’s population living in poverty is declining at a rate never seen in history. This is great news.
But the sheer number of people getting by on $2.50 a day or less remains staggering. It’s over 3 billion people.
While many organizations perform invaluable work attempting to address this problem, one of the more overlooked sources of poverty in the developing world is price risk. There are, of course, plenty of risks for the small farmer, but price risk adds to the overall burden.
Now, a former derivatives trader like myself is the most likely to see this particular aspect of the problem. It looks like a nail to my particular hammer. But don’t take the word of a mercenary, profit-seeker.
Oxfam America, Risk and Risk Transfer in Agriculture (2010): “Current high prices seem to hold excellent prospects for farmers. But prices may fall before any future crops can be sold, and poor farmers, in particular have to contend with this risk when they make their growing decisions. Price risk may thus stymie their ability both to contribute to solving the crisis and to benefit from what today appear to be lucrative opportunities.”
Harvest Choice, A Review of Agricultural Production Risk in the Developing World (2010): “With inadequate access to savings, credit, and insurance, as is typical in most developing countries, theory suggests risk averse farmers will devote resources to reducing risk and tend to produce less, a result that is corroborated by many of the empirical studies reviewed.”
Overseas Development Institute, World Commodity Prices and their Impact on Developing Countries (2003): “World commodity prices being notoriously volatile, driven by changes in global demand and supply, developing countries are particularly affected by external shocks that can result in increased poverty and reduced public funding for health and education.”
Third world farmers face constant risk from price volatility — risk that results not only in reduced profits, but can, in many cases, lead to bankruptcy and even starvation. It is, therefore, no surprise that they are some of the world’s most risk-averse economic actors.
This risk aversion leads to underproduction. It leads to under-investment of capital and under-utilization of new production methods. All this in turn contributes to continued food insecurity, while sharply constraining new wealth creation. Moreover, because wealthier producers are less risk-averse (losses are far more survivable), price volatility contributes to greater wealth inequality.
Further, the very price risk that increases risk aversion among farmers can also lead to risk aversion in credit markets. How much do you want to lend, if price declines can wipe out borrowers’ ability to repay?
Some of the first attempts to deal with this problem were price stabilization schemes. These methods have a “strong tendency to be financially nonviable over the long term” (Oxfam study). This type of scheme run by a central authority results in substantial risks. Prices tend to be non-controllable over time. Even worse, such methods intentionally remove feedback mechanisms from the market. Instead of lower prices leading to decreased production, they will lead to gluts of products and, usually, the collapse of the price stabilization.
Instead, what these markets need is derivatives. According to Oxfam, “While hedging may have the second-order effect of reducing the amplitude of price surges… its primary benefit lies not in reduced volatility itself but in the reduction or elimination of uncertainty about prices that will be achieved in a hedged future transaction.” Moreover, “such tools for instance do not result in the significant disincentive problems that price setting, buffers, and flexible trade regimes are fraught with.”
With future prices locked in, producers are more likely to try new methods. They are more likely to increase production. Lenders will be far more willing to extend credit when the odds of repayment are higher, so access to much-needed capital will increase. All these lead to new income and wealth for growers as well as reduced food insecurity for consumers.
And, in contrast to price setting operations, hedging markets provide informational feedback to producers. If in a functioning market, producers hedge their planned production, the selling will decrease prices. Such a price drop would be signal to other producers that they might need to scale back production. Alternatively, high prices from product user hedging can signal that more of a given product is needed.
But “an appropriate hedging product must exist”, according to the Oxfam study:
- Basis risk, the risk that the price of the commodity produced and the price of the hedge contract do not move in parallel, must be minimized. If the local price of the product does not move in concert with the price represented by the hedging contract, hedging can be not only ineffective but dangerous.
- Access to the market must be available. The vast majority of all futures activity takes place at the largest exchanges, serving developed markets, accessible mostly from developed countries. New local markets, new technologies offering better access, or a combination of the two must be developed.
- There must be a market in derivatives for the product to be hedged. Corn and wheat futures are great products, but many of the agricultural products of the developing world have no contract or one with little to no volume. For instance, pepper prices have been highly volatile in recent years, soaring then collapsing with new supply out of Vietnam and Cambodia. Yet pepper futures on the Indian NCDEX exchange see little volume.
- Contract sizes must be reasonable. The sizes of most Chicago contracts “far exceed the total production of almost all individual farmers in LDC (Lesser Developed Countries) settings.”
(Note: The rest of the piece is about the idea of blockchain being used to bypass lack of access to traditional financial instruments, which while moderately interesting, I think is a bit of a distraction from the more interesting and general points made in this excerpt.)