Malawi Eyes Markets to Help Manage Drought Risk

Malawi Country Page

Related Links

• Website Food Price Crisis
• Website: Malawi Country Page

• Malawi's food security strategy incorporates risk-management tools
• The country is likely to be the first to use a new weather derivative financial product offered by the World Bank.
• Malawi's goal is to reduce vulnerability to weather shocks in the context of strengthening food security.
• The approach makes use of derivative contracts which help transfer risks to the financial markets so that nations are better equipped to cope with extreme weather and commodity price and supply shocks.

Malawi’s maize crop withered in the fields and the government was forced to seek help. The country spent US$200 million responding to the crisis, and the World Bank and donors contributed a similar amount.

This year, as high prices and food shortages tax many nations, better harvests have meant that Malawi has enough to feed itself and even export to neighbors.

Still, the government and its development partners acknowledge the prospect of future food shortages is real. Even as the drought crisis unfolded, the Malawi government began looking at new ways to protect the country from such risks in the future.

With help from the World Bank Group, it is beginning to use risk-management tools as part of a comprehensive strategy to reduce the impact of drought on food security, say World Bank staff working closely with the country. 

Managing Drought Risk: A Range of Tools

As food shortages hit in 2005, one of the strategies used by the government was to purchase commodity hedging contracts to lock in the price of maize for future delivery. That move lowered the cost of imports of grain over the next four months by US$50 to $90 per ton and assured food supply during a critical time, says Julie Dana, a commodity specialist working for the Bank’s Agriculture and Rural Development Department.

Since then, the Bank and other development partners in Malawi have been working on strengthening food security through a wide range of interventions and tools, including agricultural technology, investments in irrigation, and the use of various financial instruments.

During these discussions, Malawi expressed interest in reducing weather risk, says Dana. The Bank responded by preparing a new weather derivatives product that would allow Malawi and other developing countries to use financial markets to offset weather risks.

The Bank added the new weather derivatives product to its growing toolkit of catastrophe risk financing products and services on June 5. 

“The use of the weather market and index-based insurance products in agriculture in developing countries is a brand new thing,” says Dana.

The 10-year-old weather derivatives market has been growing rapidly but is mainly used by private companies to manage risks.

“What’s novel in this case is you’ve got one of the world’s 10 poorest countries that also has substantial weather risks getting access to those same tools.  And that’s the exciting thing” says Timothy Gilbo, Malawi Country Manager.

Faster Emergency Response

By using weather derivatives, Malawi will get funds within days if a payout is triggered by inadequate rainfall. That’s much faster than standard crop insurance, which requires loss assessment and on-the-ground monitoring and can have high administrative costs.

“The advantage is you don’t have to argue with your insurance agent,” says David Rohrbach, Senior Agricultural Economist in Malawi. “The payout structure is simply dependent on how many drops of rain you get, so it’s straightforward to everybody in the market.”

Olivier Mahul, Program Manager, Insurance for the Poor, Financial and Private Sector Development, observes that “these kinds of products provide liquidity rapidly to governments,” allowing them to respond to an emergency while waiting for additional help, if needed. 

“With all these instruments, and this one in particular, it’s all about trying to find a new way,” to deal with risk, adds Gilbo. “We know from the poverty assessment that by the time an emergency is declared, there’s an appeal, and governments put in money, many poor have sold what little assets they had, like a cow or a goat.”

“We’ve had this pattern where people here get a little bit ahead and then a shock comes and they’re back lower than they were to start off with.”

The idea is to empower Malawi to protect its food supply and be able respond quickly to a looming crisis, says Dana.  Payouts may be used to purchase a commodity option which, as in 2005, would ensure that the country has timely access to maize at a capped price.

With future grain prices capped, the private sector can better predict  the government response and has more time to respond to shortages before prices get too high, says Dana.  She adds this is a key aspect of the overall strategy, since strengthening local market responses is also critical to improved food security.

World Bank Intermediation

With the approval of weather derivatives, the World Bank can for the first time offer financial intermediation services to low-income client countries of the International Development Association (IDA), and will add to the range of risk-management tools available to middle-income client countries of the International Bank for Reconstruction and Development (IBRD).

In the case of Malawi, the World Bank will act as intermediary between the country and reinsurance companies or investment banks that offer weather risk management products. An independent third-party will monitor the weather data which will be then entered into a crop-rainfall model that determines whether Malawi receives a payout. The weather derivative for Malawi requires an upfront premium and is desiged to manage the risk of low probability but high severity events, like severe droughts, rather than the risk of events that occur more frequently, like minor or normal droughts.

The World Bank hopes the new weather derivatives product, along with a growing number of catastrophe risk financing products, will help close a “serious market gap between the banks, insurance companies and commodity trading companies that offer hedging products and the developing countries that need them,” according to Dana.

It’s also an opportunity to develop new relationships and customized financial products for countries. Other applications of the product are also possible, says Gloria Grandolini, Director of the Banking and Debt Management Department in the World Bank Treasury.

Many countries don’t have expertise in handling such financial instruments. While the Bank is intermediating these transactions, it’s also helping to build capacity in the country and training personnel so that countries will eventually be able to continue this type of business on their own, says Grandolini.

Another goal is to build a “risk-management culture” that favors “paying up front for something that might happen” rather than trying to respond post-disaster, she says. These instruments are most effectively used in the context of a broader disaster risk management framework.

Adds Dana: “The current food price crisis is also creating new interest in these kinds of approaches. Governments are feeling very vulnerable to the external environment, including climate change issues, and all these things are coalescing. So there’s an opportunity here to really provide solutions that are very interesting to governments.”