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  • QA 103
    Question:
    Affordable credit for small growers versus price risk: what are the options?
    Background:
    I am trying to combine the processing and marketing for a group of small farmers to help them to bypass local traders. But it cannot be done without some form of affordable credit. And this is proving to be very difficult because of price risk. Is there some advice you can offer here?
    Asked by:
    Project adviser - Latin America
     
    Answer:

    The availability and cost of credit depend on the degree of risk that is involved and how it is managed. Good risk management usually equals easier access to credit and lower credit costs. 

    For the purpose of this answer, risk can very broadly be divided into physical risk and value risk:

    Physical risk (including security and quality risk) is linked to the status of the goods themselves, the collateral. Are the goods safe and sound; are storage conditions satisfactory to maintain quality; are the goods insured and under the control of the lender… Your question suggests this is not your immediate concern however.

    Value risk (including price risk) is linked to the value of the goods. Is the quality acceptable; is the value to be financed realistic; what is the sales value, respectively what is the risk the value may fall; in case of default, can the lender easily dispose of the goods…

    If your group would be able to conclude forward sales or long-term contracts with credible buyers then of course the credit problem would be much reduced. Where such contracts are in place affordable credit is much easier to obtain because the main value risk, that of price, is covered. As your question indicates that the goods to be financed will be unsold you may find the following of interest:

    In Tanzania the World Bank's International Taskforce on Commodity Risk Management has developed an innovative approach to facilitate the making of cash advances against delivery of coffee for processing and marketing. Without the ability to make reasonable cash advances farmers' groups and cooperatives lose product to traders who buy outright for cash. Uncertain or limited supply then makes it difficult to plan, reduces credibility and causes costs to rise, in the end thereby perpetuating the dependence by small growers on traders or coyotes.

    Working with Tanzania's Cooperative and Rural Development Bank - CRDB, a price risk management system has been developed by the World Bank's Commodity Price Risk Management Group for cooperative coffee processors, using put options.  Briefly, once coffee deliveries commence a cooperative purchases a put option for half its estimated seasonal intake - when this quantity is reached a further option is purchased for the remainder. Of course this can be varied according to seasonal factors.

    Options are purchased and financed by CRDB, using an international options and futures broker. The option cost depends on the scope of the price cover that is bought, but is historically around five percent. The option cost forms part of the cash advance provided by the cooperative and is recovered from the sales proceeds. Because the goods are hedged, i.e. the price risk has been covered, the interest rate growers pay is typically lower by about two percent. As and when an option shows value (see topic 09.03.02) a decision is made to sell or exercise it, again with the assistance of CRDB and its brokers. To date CRDB does not charge a fee for its intervention but this may change as the practice becomes more widespread - already lending against hedged coffee purchases has increased tenfold in the period 2001-2006.

    There is no doubt that this arrangement greatly facilitates access to credit and ensures the smooth running of post-harvest operations (advance payments, processing and marketing) carried out by cooperatives.However, it can only protect growers against price falls once their harvest has been delivered… 

    In a twelve-month cycle the smallholder grower may carry the crop for as long as eight or nine months, whilst the processing/sale exercise described above may take three months only. The reason price protection is limited to this stage is relatively straightforward: the cost of purchasing options for much longer periods is simply too high. And the alternative of using futures instead of options is out of reach: the level of potential margin calls cannot be quantified, nor can credit be obtained to finance these. A challenge undoubtedly remains therefore: apart from for example long-term sales contracts, is it at all possible to devise some form of affordable price protection instrument for the growing cycle itself…?

    NB: The links between price risk management and access to credit, as well as other types of risk such as performance risk, are discussed extensively in chapter 10 of the guide - this is absolutely recommended reading. The use of options is reviewed in section 09.03. For more on the work of the World Bank's Commodity Risk Management Group go to www. itf-commrisk.org.

    Posted 29 June 2006

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