Ajai Nair is a Consultant with the Agriculture and Rural Development department of the World Bank He is involved in both analytical and operational work at the World Bank in the area of microfinance and rural finance. He has published papers on commercial banks and financial access, rural leasing, savings and credit groups, and financial cooperatives. He currently advises three livelihoods projects in India and is leading a six country study on agricultural finance. Ajai also consults occasionally for the International Fund for Agricultural Development. Before starting to work with the World Bank, Ajai worked with DHAN Foundation and PRADAN, two leading NGOs in India, in their community-based microfinance programs. Ajai has graduate degrees from the Princeton University in the US and Tamil Nadu Agricultural University in India.

Financing Agriculture: Risks and Risk Management Strategies Ajai Nair, Consultant, World Bank 3rd Agribanks Forum, theme ‘Africa Value Chain Financing’, October 16-19, Nairobi, Kenya .

What are the major risks agricultural financing? Systemic/Correlated Risks Production Risks –weather, pests, farming practice. Price Risks – for inputs and outputs. Political Risks – export bans, price caps, debt write offs Idiosyncratic/Independent Risks Willful default Over-financing, under-financing, wrong pricing. Life, Health, Asset Mention other constraints – transaction costs, collateral related, etc. From, Skees (2006) Independent risks are insurable because they are unrelated and generally impact different people at different points in time. Correlated risk (i.e., commodity price risk) affects a group of people in a region or multiple regions at the same time to a similar extent. Most weather-related events and natural disasters are “in-between” risks, neither perfectly correlated nor independent, resistant to traditional insurance pooling.

What is the impact of these risks? At a proximate level, Low availability of finance for farming and agribusiness. Slow adoption of agricultural technology and private sector investments in agribusinesses. Ultimately, High volatility in household income / food security for households Higher impact on low income households because of reduction in consumption and liquidation of assets. Bargaining power: Smaller producers and traders who do not have the skills to hedge out there procurement or sales price risk. As a result, they often get poor terms from the banks and are forced to sell produce at prices that are not renumerative/competitive. Poverty Traps: Reduction of consumption reducing human capital Liquidation of assets leading to reduction of income generation base.

What are the solutions? Reduce / better manage Systemic and Idiosyncratic Risks Development and improved access to seeds, farming practices and technology, agricultural development services. Development and improved access to physical (forward sales, minimum price guarantee contracts, etc) and financial tools (insurance, derivatives) Better credit-risk assessment and management by lenders. As can be seen, only part of the challenge in reducing / managing risks are financial. Financial tools include not just insurance directly related to agriculture, but also life, health, and assets. Credit assessment techniques - credit scoring, credit bureaus, efficient asset registries

World Bank’s work on Commodity Risk Management Ongoing work Price Risk Management: Options (Tanzania, Zambia, Mozambique, Malawi) Weather Risk Management: Rainfall Index Insurance (India, Malawi, Ethiopia, Thailand) Users: Governments, Financial Institutions, Producer Organizations, Agribusinesses, and producers. Services offered Policy advice Technical assistance: Risk Assessment, Contract Design, Pricing, and Program management.

Experience so far: Price Risk Management Price risk management products have been offered: Product for intermediaries linked to financial services Product for governments to manage food-security. Pilot in Tanzania CRDB, a local bank, has offered product tthrough coffee producer organizations and cotton ginning companies Hedging helped coffee producer groups offer a higher purchase price to farmers Demand for contracts has varied with rise and fall in commodity prices. Better ability of bank and borrowers to manage price risk. Tanzania cotton: This season, a large number / majority of ginners sold forward prior to the start of the season without upside price protection. A subsequent rise in world cotton prices led to ginners being committed to selling their lint at prices below market levels (or defaulting on the orders). Ginners were forced to compete heavily against each other - paying prices for seed cotton inputs which would lead to losses on the orders pre-agreed/sold - to secure seed cotton to fulfill their orders. As such the Tanzanian ginners found themselves in a situation of being obliged to deliver on orders that generated significant losses. These losses could have been mitigated by either a) not pre-selling b) pre-selling at a price to be fixed c) pre-selling with an inbuilt call option d) using call options to protect these forward sales. Tanzania coffee: Last season many traders experienced losses at the end of the season. They had built up their coffee stocks throughout the season (when prices had been relatively high) however when they came to sell at the end of the season (December 2006 / Jan 2007) prices had fallen significantly leading to them generating significant trading losses. These losses could have been prevented by a combination of a) shortening the period between purchasing coffee stocks and selling coffee (back to back sales) b) taking out put options to protect their break even price. These losses have raised awareness of the risks of not control price risk exposure amongst coffee sector traders - and increased interest in better understanding how to calculate and control price risk exposure. Many coffee traders are now shortening the period between purchase and sale of coffee and considering using put options to protect periods of greatest exposure. Malawi Maize: As the government expected shortages locally, a call option was written by the government as a contingent import strategy to secure both the commodity and the price. The option was exercised and the maize was delivered to Lilongwe. The cost of the option was under $30/tonne while maize was bought in places like Zambia at $90/tonne more. Caveat: Government involvement in markets is justified ONLY when it is a food security issue. In this case, use of a call option to ensure availability of food at reasonable prices at costs for government that are predicted ex-ante.

Experience so far: Weather Risk Management Index based weather insurance offered as: a stand alone insurance contract, part of a loan package or linked to other services such as seed provision, and portfolio coverage for a bank or lending institution`  Pilot in Malawi: 3rd year of program development through NASFAM. Insurance contracts helped ground-nut farmers use improved varieties as contracts enabled access to finance from MRFC and Opportunity International. Malawi: In year 1 and 2, groundnut farmers were offered the opportunity to take out a loan package that included index based weather insurance. The loan was in kind and farmers received high quality groundnut seed. In the event of a payout from the insurance proceeds went to the bank to pay down the loan.

Lessons Learned: Price Risk Data: Robust historical commodity price data needed to design good contracts. Technical Skills: Local institutional capacity needs to be developed in price risk assessment (duration, volume) and accessing derivatives markets. Institutions/Markets: Presence of robust, liquid market in the specific commodity to transfer risks. Local supply chain participants willing to undertake the significant investment in staff time and financial resources, and market the product and provide necessary education. Link to finance critical for take up. Hedging (with options) to protect your prices without assuming some risk yourself (as with futures) implies that there is an upfront cost (usually in 8-10% range) for this price protection. We have seen in years where the prices do not move out of the money that the users of these products sometimes feel that they have paid for something which was unnecessary. This is a mindset that needs to be overcome, just like wanting life assurance premiums back because you have not died.

Lessons Learned: Weather Risk Data: Good quality historical data required to design contracts and reduce basis risk. Technical Skills: Local expertise in contract design, pricing, reinsurance, and program management are critical and must be developed. Institutions/Markets: Local insurer willing to take risk or intermediate transaction Marketing organization able to market the product and provide necessary education Link to finance critical for take up

In Conclusion… Risks in financing agriculture involves not only production and price risks, but also risks to life, health, and assets. Optimal production and price risk-management involves a combination of physical and financial tools. There are no silver bullet solutions.

Contacts Price Risk: Roy Parizat royparizat@hotmail.com Weather Risk: Erin Bryla ebryla@worldbank.org