Rabobank International: Insuring fair prices for farmers in developing countries
The prices of many agricultural products exported by the developing world are highly volatile, their fluctuation being entirely dependant on supply and demand. If the growing season for coffee, for example, was particularly good in Brazil or Vietnam (the world”™s two largest coffee producers), coffee prices will be low, due to abundant supplies. When a frost damages coffee in Vietnam, chances are that the international price for coffee will go up, because supply will be lower than expected.
From a macro-perspective, this volatility can be devastating: more than 50 developing countries depend on three or fewer leading commodities (such as coffee, sugar cane, cotton, wheat, maize) for at least half their export earnings. The prices fetched on international commodity markets therefore influence the government”™s fiscal revenue and public expenditure, its foreign reserves and its creditworthiness.
The same is true on a micro-level: volatility leaves a farmer uncertain about whether he will receive a high price or a low price for his crops at the end of the season. The problem is, however, not limited to how much cash a farmer receives for his harvest. Every investment decision a farmer makes during the crop cycle is a difficult one, since he doesn”™t know whether he will be able to pay back the loan for the investment (labor, fertilizer, equipment & repairs, etc.).
Uncertain prices also create risks for banks that might lend to farmers. Often, they will raise interest rates to cover uncertain risks, or simply will refuse to provide credit at all. As a result, it is not surprising that a lack of price risk management is one of the foremost reasons why poor farmers stay poor.
Price stabilization measures for farmers are not a new idea. Several non market-based mechanisms adopted in the 1970s were dropped soon after because they proved to be unsustainable and inequitable. Even though developing countries produce enormous volumes of commodities, they are not as active in price hedging as the developed world.
In fact, developing countries account for only about 2% of the futures and options instruments traded worldwide. This is most likely due to a lack of capital, know-how and access to information.
The World Bank”™s International Task Force
To counter this problem, in 1999 the World Bank formed the International Task Force (ITF) to increase the use of commodity price risk insurance in developing countries.
This partnership of private and public sector organizations explores new market-based approaches for assisting small-scale producers in developing countries to better manage their vulnerability to commodity price fluctuations. The World Bank is taking the lead in the development and implementation of this market-based approach. It is partially supported through contributions from donor countries (e.g. Switzerland contributed US$ 2 million).
Other stakeholders include farmer”™s organizations, commodity exchanges and companies, such as Rabobank, Marsh, ABN AMRO, Archer Daniels Midlands, Zurich Re and Credit Lyonnais.
A farmer’s cooperative purchases a price insurance that allows it to sell its crop at 30 cents/pound (=strike price). The insurance premium is 4% of this strike price, 1.2 cents/pound. Suppose that by harvest time, the international market price of the commodity has fallen to 28 cents/pound or lower. Now, the insurance can be claimed. The cooperative will receive the agreed upon 30 cents/pound minus the insurance premium (1.2 cents/pound), equaling 28.8 cents/pound.
The individual farmer knows that he will receive this amount as a minimum income and can therefore better plan his purchases and investments between the time he bought the insurance and the harvest.
What if the international market prices rise? Say, the prices increase to 35 cents/pound. The cooperative will fully benefit from these high prices. The only cost it incurs is the 1.2 cents/pound. So, in the end it receives 33.8 cents/pound.
The program delivers technical assistance to educate farmers on the design and implementation of price risk management programs, and links providers of such services directly with the farmers”™ cooperatives. The preferred risk-hedging tool is a simple put option, which is a contract that gives the cooperative the right to sell its crop at a certain price, irrespective of the market price at that point. It thus sets a minimum price that farmers will receive.
The cooperative is very important in these transactions because it would be difficult and extremely costly for individual farmers to use commodity derivative markets directly.
These markets are based on large volumes handled by exporters, large local traders, importers and large local processors — for example, a London International Financial Futures and Options Exchange lot of coffee is five (5) tons. Unless farmers have large commercial farms, they lack the volume and do not have the resources necessary to access derivative markets. An average farmer in Uganda, for example, produces 2.5 tons of coffee on his five (5) acre lot per year.
The benefits go beyond better financial planning. Producers who buy price insurance are likely to benefit from improved access to credit, and better terms of credit as a result of reduced risk.
However, a price risk mechanism such as a put option does not address other risks that growers are exposed to, including disease, weather and quality.
Rabobank”™s Commodity Price Risk Management unit and the International Task Force
Rabobank is a leading Dutch financial institution whose roots lie in agriculture. What began at the end of the nineteenth century as a collection of small rural banks has grown into an extensive financial group with assets of US$450 billion. The bank is particularly recognized for its expertise in the food and agribusiness sector, reflecting its roots as one of Europe”™s best-established cooperative organizations.
Rabobank”™s various units actively work together to help ensure fair prices for farmers in developing countries. Rabobank International, the corporate and investment banking arm of Rabobank, focuses on providing selected industry expertise and strong local knowledge to corporate and financial institutions.
The Commodity Price Risk Management (CPRM) unit provides customers with price risk management tools, including swaps and options for various commodities, including grains, cotton, sugar, cocoa, coffee and fertilizer. Rabo International Advisory Services (RIAS) provides consulting on establishing/restructuring agribusiness companies, as well as the provision of advice in establishing agricultural cooperatives.
Finally, the Rabobank Foundation is the umbrella over the initiative by funding institutional development, loans for credit schemes, guarantees, and holdings in risk-bearing capital. The Foundation”™s funds are obtained partly from the local Rabobank branches, who allocate a percentage of their net profits to the Foundation, and partly from Rabobank Nederland, the central bank of the Rabobank Group, which doubles the contributions from the banks.
These funds enable the Foundation to support an average of 150 projects each year: fifty in the Netherlands and one hundred in over 40 countries spread throughout Africa, Asia, Latin America and Eastern Europe.
The disconnect between official development assistance (ODA) and foreign direct investment (FDI) is the main hurdle to poverty alleviation in rural developing country areas. For example, great amounts of ODA are spent on infrastructure development without considering how the improvement benefits the economic development of the respective region.
A better coordination of ODA and FDI could achieve a greater integration of commercial and socio-economic aspects, which need to go hand in hand in order to achieve sustainable development.
Another disconnect exists between growers in developing countries and the large purchasers and processors. Many of these usually multinational corporations have failed to establish the connections and trust with the local populations needed for a sustainable business operation.
A typical challenge seems to be obtaining a steady quantity and quality of raw material supply, or getting the local farmers to respect contracts. In order to overcome these hurdles, foreign businesses need to invest more time and resources on enhancing their cultural understanding of the local communities and building trust through interaction and education. They also need to understand that “œbest practice” in the developed world is not necessarily applicable to local conditions, but that new/creative ways of doing business are required.
Rabobank saw an opportunity in the ITF to address these issues.
Originally, its involvement with the World Bank project was part of Rabobank”™s corporate social responsibility activities. Now, it is part of the CPRM unit. However, ITF activities remain unprofitable. Rabobank does not expect these activities to become money-makers, but engages in them because they exemplify what the bank is all about: sustainable business.
Additionally, two members of the Managing Board of Rabobank have a personal interest in assisting poor farming communities. It is clear that Rabobank has benefited financially from the work of these farmers ” this is an opportunity to give something back beyond the typically low market prices for commodities.
Some of Rabobank”™s clients, such as large commodity traders (e.g. Cargill) also benefit from the ITF”™s activities because they manage exposure to fluctuations in the supply of raw-materials and keep farmers loyal to their buyers. However, the bank hasn”™t considered promoting its activities as a service that is beneficial to its clients.
The CPRM unit is well positioned to provide its services to the cooperatives, as it is already providing similar services to all units down the commodity supply chain. The knowledge was pre-existing, but a new approach was required to make derivatives work for the poor farmers.
By applying an innovative business model, Rabobank can deliver derivatives to a sector that has never had access to them before. Before a transaction can take place, Rabobank needs to perform a variety of tasks:
* check the regulatory background in the respective country
* get to know the client (farmer”™s cooperative) and check their capacity/ability of engaging in a transaction
* advise the cooperative on risk management strategies.
The World Bank provides assistance in this due diligence work.
Actual completed transactions as of January 2003 include five for coffee in Nicaragua, Uganda and Tanzania, initially small in size but growing larger and with some repeats; transaction volumes range from 50-7,000 tons. The period of coverage ranged from one to six months consistent with physical transactions.
Two hundred and fifty (250) farmers in Nicaragua, 450 in Uganda and a few thousand in Tanzania benefited from the scheme. All initial transactions were put options and premiums range from 2-9% of the strike price.
Rabobank executed most of these ITF transactions. A positive side effect was that many thousands of African farmers, making up membership of one specific large cooperative, saved halve of their traditionally paid lending fee of 18%.
In total, the ITF work represents 10% of a full-time employee”™s time and forms approximately 5% of global CPRM work. So far, the unit has invested approximately US$ 950,000 (Euro 750,000).
The bank plans to further increase the current volume (several thousand tons a year) of raw-material insured through the farmer”™s cooperatives. In addition, the unit aims to obtain a full-time person to work on ITF projects over the next three years.
There is great potential for a global business reaching the millions of farmers that export commodities. What would it take to turn this into a profitable business ” at scale?
Take the Uganda example: Rabobank helped 450 farmers each producing on average 2,500 kg of coffee per year; therefore the total transaction amount is about 1.13 million kg. With total coffee production in Uganda in 2002 at 3.1 million kg (source ICO), there is clearly room for growing the derivatives business.
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Publication Date 03.03.2004
Issue/Topic Financial Sector
Company Rabobank Group