Many developing countries that are dependent on commodity prices have found previous approaches to price instability unsatisfactory. Increasingly, they are relying on market-based instruments to deal with price uncertainty.
In 1995, 57 countries depended on three commodities for more than half their exports, reports UNCTAD. And commodities, fuels, grains, and oilseeds are important imports for several countries. The notorious volatility of commodity prices is a major source of instability and uncertainty in commodity-dependent countries, affecting governments, producers (farmers), traders, processors, and financial institutions. Further, commodity price instability has a negative impact on economic growth, income distribution, and poverty alleviation.
Early attempts to deal with commodity price volatility relied on buffer stocks, buffer funds, government intervention in commodity markets, and international commodity agreements to stabilize prices. These were largely unsuccessful—sometimes spectacularly so. Buffer funds went bankrupt, commodity agreements were suspended, buffer stocks proved ineffective, and government intervention was both costly and ineffective.
As the poor performance of such stabilization schemes became more evident, academics and policymakers began distinguishing between programs that tried to alter price distribution (domestically or internationally) and programs that used market-based approaches for dealing with market uncertainty.
This change in approach coincided with a significant rise in the use of market-based commodity risk management instruments—aided by the liberalization of markets, the lowering of trade and capital control barriers, and the globalization of commodity markets.
By the mid-1990s, several governments, state companies, and private sector participants began using commodity derivatives markets to hedge their commodity price risks. Participation in those markets is growing, but important barriers to access remain, including counterparty risk, problems small groups (such as farmers) have aggregating risks, basis risk (no correlation of local and international prices), no local reference prices, low liquidity, no derivatives markets for certain products, and low levels of knowhow.
International institutions, local governments, and the private sector could facilitate developing countries' access to derivatives markets and the use of risk management tools to solve public sector problems.
This paper—a product of Rural Development, Development Research Group—was prepared for the roundtable discussion on New Approaches to Commodity Price Risk Management in Developing Countries (Washington, DC, April 28, 1998). Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Pauline Kokila, room MC3-544, telephone 202-473-3716, fax 202-522-1150, Internet address pkokila@worldbank.org. The authors may be contacted at dlarson@worldbank.org, pvarangis@worldbank.org, or nyabuki@worldbank.org. (36 pages)
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