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Commodity Price Volatility: Causes, Policy Options and Prospects for African Economies

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Logistics and Global Value Chains in Africa

Part of the book series: Palgrave Studies of Sustainable Business in Africa ((PSSBA))

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Abstract

This chapter outlines the main causes of commodity price volatility and their impacts on developing countries, especially those in Africa. The chapter considers the historical evolution of commodity price volatility, particularly for countries described by organisations such as the United Nations Conference on Trade and Development (UNCTAD) as commodity dependent developing countries (CDDCs), which rely on at least 60% of their export earnings coming from primary commodities. The chapter also sets out a historical analysis to map the evolution of policies to deal with the problem of commodity price volatility. It analyses the reasons why the price-setting international commodities agreements (ICAs) collapsed in the 1980s and 1990s. The chapter then reviews the academic literature on the subject including: the impact of financialisation; global value chains; and institutional initiatives, such as the creation of commodity exchanges in some African countries, which have been established to mitigate the negative effects of price volatility on producing countries. The chapter concludes by discussing the way forward in policy terms for CDDCs, especially those in Africa.

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Notes

  1. 1.

    The Singer–Prebisch hypothesis became the capstone in these early years to highlight the endemic problem that less developed countries faced with declining terms of trade as long as they continued to rely heavily on primary commodities for their export markets (Prebisch 1950, 1959, 1964; Singer 1950, 1958, 1975, 1982).

  2. 2.

    Economies of scale (and scope) are vital in commodities markets. Commodity producers are either characterised as latifundia (a small number of very large-scale producers); or minifundia (a very large number of extremely small producers). Minifundia are more common in African economies. A relevant example is the very large number (in the hundreds of thousands) of small coffee farmers/producers in Ethiopia.

  3. 3.

    Papers by Dercon (2004); Dercon et al. (2005); Morduch (1995) analyse a range of different shocks that can adversely affect vulnerable countries (e.g., Ethiopia) as well as the necessary consumption and income smoothing aspects of these shocks.

  4. 4.

    The Food and Agricultural Organisation (the FAO) has been active in developing “early warning systems” to be able to anticipate and respond to severe weather disturbances such as drought, famine and hurricanes, which can of course threaten life on a huge scale. The FAO has also facilitated the setting up of an effective agricultural management information system (AMIS), which tracks food outputs and yields across the world. It is an inter-agency platform aimed at enhancing food market transparency and security. It was set up in 2011 by the G20 ministers of agriculture after the major increases in global food prices in 2007–2008 and 2010. It incorporates the main producing countries of agricultural commodities and monitors global food supplies. It concentrates on wheat, maize, rice and soybeans and is effectively a platform to co-ordinate policy responses during periods of market uncertainty and volatility. According to the FAO website, its coverage of global production, consumption and trade volumes in the above crops may be as much as 80–90%. Although its main function is to ensure better global food security, it can also help to anticipate and hopefully mitigate agricultural commodity price increases, especially in these vital food crops.

  5. 5.

    “CommodityDependence and the Sustainable Development Goals: Note by the UNCTADSecretariat” prepared for the multi-year expert meeting, ninth session, in Geneva on 12–13 October 2017.

  6. 6.

    Two other examples from a recent Commonwealth Secretariat publication edited by Keane and Baimbill-Johnson (2017) are also illustrative of the potential to move up the value chain (see Keane’s article on the cut-flower sector in Kenya and Ethiopia, where some upgrading was discernible, especially in the context of Kenyan firms entering the Ethiopian supply chain; and the paper by Nana Asante-Poku in her analysis of Ghana’s participation in the pineapple GVC). In the former case, the upgrading that took place was largely based on the different tiers of suppliers prevailing within the Kenyan market and to some extent within Ethiopia, as well as Kenyan lead firms who are active in Ethiopia. In the paper it is referred to as a “flying geese” model. In the latter case, progress has been more erratic, which the author attributes to a combination of institutional changes and an inconsistent response on the part of producers to significant events such as the development and introduction of new product varieties.

  7. 7.

    We suggest in Sect 5.9 of this chapter further advantages of these derivatives instruments in terms of a principal–agent approach. These derivative instruments achieve a better incentives compatibility (avoidance of goal conflict) for farmers, intermediaries, distributors, large retailers and consumers alike. They achieve this by reducing the potential for rent-seeking behaviour on the part of these various stakeholders. A practical example of this incentives compatibility is the provision of a credit line to producers, which can then be drawn down in line with what happens to underlying commodity prices. When prices rise (fall) interest payments on the loan will rise (fall). A symmetry can therefore be established between the underlying economic activity, the production of the commodity itself and the financial means (in the form of credit facilities) that will assist in the production of the commodity which, in turn, can assist in the purchase of needy fertilisers, replanting of crops, etc.

  8. 8.

    Some possibilities are: the setting of speculative position limits on commodity futures contracts to minimise the potentially volatile effects of excessive speculation (for example, arising from short-trading); the setting of maximum limits on daily price changes and on inventories held by non-commercial participants to reduce excessive volatility; the introduction of volume and frequency trading limits; and attempts to ensure international consistency across exchanges in order to prevent regulatory arbitrage. However, it is still early days as to whether such initiatives have been effective, especially in Africa (UNCTAD2009a).

  9. 9.

    Two prominent examples of these indexes are: the Standard and Poor’s Goldman Sachs Commodity Index (S&P GSCI) and the Dow Jones American International Group Commodity Index (DJ-AIGCI). These are composite indexes of weighted prices of a range of commodities, which includes energy products, agricultural products and metals.

  10. 10.

    See Mananyi and Struthers (1997) for an econometric study of the EMH in the market for cocoa futures.

  11. 11.

    See Table 6 of the UNCTAD (2009a) report.

  12. 12.

    A contrary position on the efficacy of financial derivatives markets is presented by Breger-Bush (2010) in her study of the use of price-risk management instruments for coffee farmers with specific reference to Mexico and the 1998–2002 coffee crisis. Her argument is that it is ambitious of international organisations such as the World Bank and UNCTAD to recommend such instruments for small-scale producers. The basis for her argument is that the use of derivatives for hedging can create direct and indirect costs for small farmers in terms of actually contributing (as opposed to offsetting) the destabilisation and reduction of farmers’ incomes. She also argues that support for such instruments carries high opportunity costs in terms of other more relevant and effective risk management schemes that will support small coffee producers who face volatile commodity prices. Her argument is that futures hedging can lead to small coffee farmers’ incomes becoming more unstable, because they are less well capitalised to be able to meet the required margin calls with their low level of reserves. Moreover, she argues that they may cause chronic oversupply in these markets, which can accentuate the plight of small farmers. This may be due to the incentives provided to producers to increase output. A crucial element in her argument is that the required combination of “initial margin” along with the subsequent “maintenance margin” in the context of a daily “mark to market” accounting mechanism will put undue pressure on small farmers to keep their positions open. In essence, a futures hedge that may be profitable over relatively long periods, such as a year or two, might be unprofitable day to day, week to week or month to month. The opportunity cost that Breger-Bush (2010) refers to is the lost opportunity that an excessive focus on futures hedging may produce in terms of foregoing alternative approaches such as: more effective supply management and Fairtrade. However, a fuller discussion of these alternatives is beyond the scope of this chapter.

  13. 13.

    One study by Benavides and Snowden (2006) has suggested that the use of futures markets may not be taken up by farmers or producers as extensively as may be thought. In a study of the Mexican corn scheme, Benavides and Snowden discovered that low take up of corn futures and options in the late 1990s was due to rational calculations on the part of farmers rather than inertia. This was seen in terms of the benefits to them from participating in the scheme sponsored by the Mexican government to facilitate access by farmers to futures and options contracts traded on various US commodity boards such as the New York Board of Trade (NYBOT) and the Chicago Mercantile Exchange (CME). Within a cost-benefit and break-even framework, the authors discovered that the hedging costs (implicit in the subsidy given by the government) were very similar to the farmers own estimates of their “price of risk bearing”, which meant it was not worthwhile for them to participate, at least on the scale that was hoped for.

  14. 14.

    See Table 5 in Page and Hewitt (2001).

  15. 15.

    One exception to this general trend is the continuing role of the Ghana Cocoa Board in Ghana, which effectively acts as a marketing board for the production, processing and marketing of cocoa in that country.

  16. 16.

    Rashid et al. (2010) have suggested that the development of domestic commodity exchanges in many African countries is impeded by the small size of their domestic commodity markets, poor physical infrastructure and inadequate legal and regulatory environments. For these reasons, they argue that the development of regional exchanges might be a better option for such countries, alongside a focus on improving investment in transportation and other physical infrastructure (for example, warehousing and improved information services). (See Chap. 9 by Eba and Struthers in this book for a discussion of the potential for establishing a regional commodity exchange in West Africa).

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Authors and Affiliations

  1. School of Business and Enterprise, University of the West of Scotland, Paisley, UK

    John J. Struthers

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    Adebisi Adewole  & John J. Struthers  & 

Appendix: Case Study, Ethiopian Commodity Exchange (ECX): Source: Adapted from ECX Website (http://www.ecx.com.et)

Appendix: Case Study, Ethiopian Commodity Exchange (ECX): Source: Adapted from ECX Website (http://www.ecx.com.et)

The ECX was established in 2008 as a public–private partnership enterprise. The government of Ethiopia owns the ECX. The ECX issues membership seats for sale. These are privately owned and can be freely transferred against any earnings derived from trading on the exchange. The commodities traded on the exchange are: coffee, sesame, haricot beans, wheat and maize.

One of the key strengths of the ECX is that it is structured as a demutualised corporate entity with a clear separation of ownership, membership and management. In principle, owners cannot have trading rights and members cannot have ownership rights. The management cannot be drawn from the owners or from the members.

1.1 Membership

Membership is acquired through the purchase of a membership seat, and gives a transferable right to trade on the exchange.

1.2 Trading Procedure and the Role of Warehouse Receipts

Commodities are deposited in warehouses operated by ECX in major surplus regions of the country.

At the ECX warehouses, commodities are sampled, weighed, graded and certified. The ECX guarantees the grading of the commodities and maintains a central registry of warehouse receipts. The ECX provides standardised ECX commodity-based contracts, which specify grade, delivery location, lot size and other contract terms. The contracts can be either for immediate delivery or at a pre-specified date in the future. In 2012, ECX introduced electronic warehouse receipts, which help members to secure collateral finance.

1.3 ECX Trading System

The ECX trading system uses a physical trading floor located in Addis Ababa. Here buyers and sellers engage in “open outcry” bidding for commodities. Market prices can change throughout trading hours. These prices are transmitted in real time to producers and consumers by electronic price tickers, which were initially located in 21 locations around the country, although the ECX’s aim is to increase these to 200. The prices also appear on the ECX website (http://www.ecx.com.et) and via a mobile phone service.

1.4 ECX Mechanisms of Reduction of Transaction Costs and Co-ordination Risks

A clear aim of the ECX is to reduce transaction costs and other risks for those who participate in commodity markets in Ethiopia. The ECX website says that this is achieved through the following.

  • Market order is enhanced via an organised trading platform, formal rules and procedures. Contracts are standardised, as are the commodities. Along with the system of membership-based participation, this facilitates monitoring and enforcement of compliance to the rules, and helps to mitigate risks in the market.

  • Market integrity is achieved through grading and certification of the quality and quantity of commodities, along with warehouse receipting of commodities traded. A touchstone of the ECX is to achieve fair competition, ethical business and efficient clearing of all payments between buyers and sellers.

  • Market transparency is achieved via a system of industry-accepted product grades and standards, dissemination of market information that is speedy and reliable to all participants, as well as effective disclosure and audit reporting requirements for members.

  • Market efficiency is enhanced through effective use of information technology to facilitate the end-to-end system, that is, from warehousing, trading, clearing and settlement of payments to delivery of the commodity.

The essence of the ECX is that it is a centralised low-cost trading platform where warehouse receipts along with quality and standards play key roles. There are also other benefits.

  • Since the physical transfer of the product is made only after the commodity is sold, this reduces transportation costs.

  • A market information system also exists within the ECX in order to increase accessibility to different markets and also to the general public through different media.

In summary, the whole framework is designed to assist in the process of price discovery for farmers and producers through the key roles of members.

A number of empirical papers have been written with the aim of assessing the performance of the ECX against its own objectives. For example, Andersson, Bezabih and Mannberg (2015) studied the impact of the ECX on market efficiency in Ethiopia, specifically whether regional warehouses that are connected to the national commodity exchange in Addis Ababa reduce transaction cost and price dispersion between regions. For the period 2007–2012, they found that the average price spread was reduced significantly as more regional warehouses were established across the country. In another study, albeit over a more limited time period and only with reference to sesame production, Alemu and Meijerink (2010) did not find similar reductions in transaction costs. Similarly, Worku et al. (2016) found in a survey of exporters that the grading and sampling system of the ECX suffered from bias, lack of technical knowledge and equipment. They also found that some distrust existed between the seller, buyer and the ECX. This was attributed to the high penalty cost imposed by the exchange for delaying or withdrawing commodities as well as the perceived high membership fee. There is a need for further empirical studies to assess the performance of the ECX, in particular a time series analysis, as relevant data builds up going forward.

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Struthers, J.J. (2019). Commodity Price Volatility: Causes, Policy Options and Prospects for African Economies. In: Adewole, A., Struthers, J.J. (eds) Logistics and Global Value Chains in Africa. Palgrave Studies of Sustainable Business in Africa. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-77652-1_5

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