Can a hedge stop us falling into a ditch? Food security, high food prices and risk management

When I said I was off to a workshop with some well-known City finance firms, my neighbour said:  “How can you talk to those terrible hedge fund people?”  Fear and distrust of the whole concept of ‘hedging’ has become widespread following the economic downturn.  In India, one of the first acts when food prices started to get out of control in 2007-8 was to ban futures markets in staple grains and other key commodities.  The US Senate has been equally suspicious of the role of speculators in pushing up world wheat prices.  

I don't understand the complexities of high finance. But hedging in its simplest form makes sense to me - it is just a kind of insurance.  Farming is a terribly risky business, and tools like forward contracts and options help both farmers and buyers (such as flour millers) fix prices ahead of time, when they are planning their own investments.  This might mean giving up some potential profit, but most people think it is worth it to insure against a massive loss if prices don’t go the way you expected.   

In the absence of such insurance mechanisms, farmers are reluctant to take risks, and this means they are likely to invest less and produce less.  This is a big problem for most developing countries, where farmers have little money to invest and face very high risks.  Low food production is one of the reasons that an estimated 1 billion people in developing countries still go hungry.  Although pilot risk management schemes such as weather insurance have been started up over the past few years, including by NGOs such as Oxfam, the numbers of people benefiting are still very small.   To really have an impact on hunger, the world needs to scale up risk management work drastically (as discussed in ODI’s last annual report).         

Over the past few years there have also been moves to introduce hedging tools to governments of developing countries, who have an acute interest in keeping their food import costs down.  Better use of hedging during the international food price spike in 2007-8 could have saved poor countries billions of dollars in foreign exchange. For example, Egypt imported an estimated 7 million tonnes of wheat in 2007-8, when international wheat prices were rocketing upwards.  According to World Bank calculations the country might have saved over 600 million dollars if they had bought options contracts.  The World Bank - together with the UK Government through the Department for International Development (DFID) - supported the Government of Malawi to do just this in 2005, when drought set food prices soaring for the third year in a row.  The Government saved several million dollars on maize imports for humanitarian use, over a two month period. 

The World Food Programme (WFP) is also taking expert advice from the World Bank and others on how it might use hedging tools in future.  If WFP can persuade its big funders to think ahead instead of waiting until pictures of hungry children appear on the telly, it will be able to use tools like forward contracts and options to cut the price of its food purchases.  That could mean a lot more hungry people fed for the same money. 

So what was I doing with the aforementioned City slickers?  I was representing the ODI/DFID High World Food Prices Project at a workshop on Agricultural Risk Management in Developing Countries, organised by the World Bank with the governments of Switzerland (SECO) and the Netherlands (MFA). The workshop brought together experts in hedging and derivatives, insurance companies and banks with farmers’ organisations, NGOs, donors, and lots of other people interested in developing country agriculture.  We had lively debates about the spectrum of risks that farmers face (weather, locusts and sudden government policy changes, among others!) and improving ways of tackling them.  The organisers are developing a web site to share international experience on this.

It would be great if we could see farmers and governments in developing countries able to manage and insure their risks in the way that rich countries routinely do.   Many experts predict increasing uncertainty in international food markets, due to climate change and unpredictable oil prices, among other things.  So managing risks will become a vital skill for national food security - and if developing countries don’t have access to the right ‘hedges’ then they will be at a disadvantage. 

I look forward to hearing readers’ views - and any examples of risk management being used in agriculture and food security.  Do you agree that a hedge can stop us falling into a ditch?

11 November 2009