Module 11 - Tanzania: Accessing Price Risk Management Solutions Through Local Bank

The fall of coffee prices to 40-year lows in 2001 and 2002 affected over 400,000 low-income coffee-producing households in Tanzania. The 1993 liberalization of the coffee sector exposed farmers and their marketing organizations to intra-seasonal price fluctuations. These fluctuations have made it difficult for farmers to optimize production technology, timing of sales, and use of assets that could eventually result in higher household incomes. Exposure to price volatility greatly diminished the overall welfare of coffee and cotton farmers and market intermediaries.

Project Objectives and Description

To confront the negative effects of short-term price volatility, one of the largest coffee cooperative unions in Tanzania, averaging 20-100 kilograms production of coffee per farmer, utilizes market-based price risk management instruments to hedge price risk and make multiple payments to farmers throughout the year. Cooperative members receive a uniform minimum first payment price for their coffee when they deliver it, and later in the season, depending on sales and market performance overall, may receive subsequent payments for their product. The guaranteed first payment provides farmers a form of price stability but can have disastrous financial impacts for the cooperative. If the cooperative guarantees a low first payment at the beginning of the season and the market price rises, farmers, instead of selling to the cooperative, will sell to traders who pay full market price in cash at the time of delivery. If the cooperative guarantees a high first payment at the beginning of the season, and market price falls, it will take losses on the negative margin between first payment price to farmers and actual market prices.

In past years, the cooperative union received loans for its operations from a local commercial bank. However, the loan agreements and the union’s access to financing were in serious jeopardy due to a history of poor financial performance, which related in large part to the pricing problems previously described. The government had supported many of the cooperative unions through difficult times but was indicating impatience about continuing to do so indefinitely.

To assist the cooperative’s attempts to strengthen its operations, the World Bank began working with the union in the summer of 2001 to help it protect its prices with market-based hedging instruments. The World Bank’s Commodity Risk Management Group (CRMG) aimed to provide services consisting of training and education about price risk management markets, principles, and products for the cooperative, the local bank, and others in the Tanzanian coffee sector. The cooperative union used put options to design a hedging strategy that matched its risk profile, using the options in the international market to provide a floor price to protect against declining prices.