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Drought Risk Management for Malawi
Joanna SyrokaCRMG, Agriculture & Rural Development
World Bank Regional Workshop, Querétaro 9 October 2008
Malawi Background
• Low economic growth, with significant volatility• Economy is highly vulnerable to adverse weather shocks • Agriculture about 40 percent of GDP, largely smallholder
rain-fed maize production
Maize production and GDP growth in Malawi, 1985-2005
-15-10-505
101520
GD
P g
row
th r
ate
(per
cent
)
-150-100-50050100150200
Mai
ze P
rodu
ctio
n G
row
th R
ate
(per
cent
)
GDP Grow th Rate Maize Production Grow th Rate
c
Impact of Weather Shocks
• Direct and indirect economic impact of weather shocks:– Direct impact on agricultural production and GDP– Indirect impact on government finances and BoP
• Fiscal impact due to unanticipated need for emergency interventions (resulting in increased domestic borrowing)
• Increased pressure on the current account due to need for exceptional food imports
• Further, long-term impact of the volatility is substantial, as economic uncertainty hampers investments and economic growth (World Bank CEM, 2004)
• Clear Malawi needs to plan for contingencies ex ante.
Malawi Context• Malawi’s maize marketing policy is dominated by
concerns about food insecurity
Erratic Rainfall, Recurrent Drought
Thin MarketsProduction Uncertainty
Maize Supply/Price Volatility
Food Shortages
Government Responses*
* 2005 Drought Response Cost: > $200 million for Government
Integrated Risk Management
Problems
• Recurring drought• Maize price supply & price
volatility
• Thin markets & very low levels of private sector trade, finance, and storage
Market Solutions
• Weather risk management• Contingent import/export
arrangements based on option contracts
• Warehouse receipts-based lending
• Government's Agricultural Development Program (ADP) focuses on strengthening maize markets in Malawi to respond to production shocks– Market-based risk management instruments can help
Weather Risk Management
• What is it?– Financial protection against adverse weather conditions
that result in volume volatility– Contracts can be structured as insurance or derivatives– Based on the performance of a specified weather index– Payouts are made if the index crosses a specified
threshold at the end of the contract period
• Malawi Context:– GoM is concerned about the impact of rainfall on maize
production– Can provide payouts in the event of contractually
specified shortfalls in rainfall during growing season– Essentially “budget insurance” for GoM– Timely access to cash in times of crisis, reducing reliance
on international appeals
The Weather Market
• First weather derivative transaction in U.S. 1997– Deregulation of the energy
industry
• Market has rapidly grown, well over $100b transacted to date (PWC Survey 2008)– Non-energy applications– New participants– Global development– Broader product offering
• Key Players: – (Re)insurers– Banks– Hedge Funds
Market wants to diversify and grow their portfolios, wants new
risks
Prerequisites for a Program in Malawi
• An index that captures national drought risk in Malawi faithfully
– Government’s Maize Yield Assessment Model– Rainfall-based FAO model used since 1992
• High quality historical weather data and reliable real-time communication
– Malawi Met Office data excellent: 23 stations with over 40 years, few gaps
– Can provide real-time data required by market
• $200k invested by DFID Jan 2008 to support a pilot transaction
• Premium:– DFID want to support initial premium cost
in piloting phase starting 2008– EU and USAID interested for 2009+
Limitations of Approach
• Only covers national severe drought, not localized events• Only covers risks that can be indexed
– Does not cover production losses due to input supply, area planted variations, pests, floods etc.
• Basis Risk: The potential mismatch between actual losses and payouts, can be managed by:– More secure stations– Better crop modelling and index specification– A comprehensive approach to minimize undue pressure
on one instrument to manage production risk– World Bank ADP Support Project contains funds to
support these investments
Term-Sheet ExampleTransaction Type: Put Option
Option Buyer: Government of Malawi
Calculation Period: 1st November 2008 - 30th April 2009 (inclusive)
Locations: 23 Reference Weather Stations
Weather Variable Measured at Locations: Daily Precipitation Measurement Unit: mm
Commodity Index, I: Malawi Maize Index
Index Strike Level, T: 95.00 Index Units
Payout per Unit Index, N: $USD 500,000 per Unit Index below Strike T
Max. Transaction Payment Amount, M: $USD 20,000,000
Settlement Calculation: I) If the Index I is greater than the Strike T no payment is made.
II) If the Index I is less than or equal to the Strike T the Buyer receives a payout X from the Seller according to the following Settlement Calculation:
X = min( max(T - I, 0)*N, M )
Premium: E.g. $USD 3,000,000
Historical Payouts Example95% Strike, $500k per % Payout
Value of Contract to Market = Average Payout + Risk MarginValue of Contract to Government = Average Payout + Value of Timely,
Reliable Funds
Leveraging a Payout Example: 2005• Government purchased between 200,000-300,000 MT maize in
October/November 2005 on the South African spot market.
• Had the Government been able to able to purchase the maize in June they could have saved approximately $110 per MT, i.e. between $22-33 million.
• In September 2005, Government piloted the use of a SAFEX call option on 60,000 MT of maize– This cost the Government $1.7 million in premium– It saved the Government $80 per MT, i.e. $4.8 million
• Had the Government had a payout from weather insurance in June 2005 they could have bought a call option for 60,000 MT of maize– A $2 million payout would have saved $110 per MT on 60,000 MT
of maize, i.e. a total saving of $6.6 million
• This is equal to a leveraging effect of x 4– Significantly smaller than the “risk margin” charged by insurers
• Value of contract to Government > premium charged by insurer
E.g. Future Scenario for Drought Response
•Purchase insurance
•Measure & monitor daily rainfall throughout season
Jul Oct-April
•Payout for drought
May
•Purchase of SAFEX call option
June-July
•Encourage commercial imports
Aug- Oct
Nov
•Imports through Option
Dec-Jan
•Exercise Option
Operational ArrangementsApproved by World Bank Executive Board, June 2008
MarketCounterparty
World BankGovernment of Malawi (MoF)
DataProvider
Premium
Payout
Premium
Payout
DataVerification
DataVerification
Transaction Flow
The Government of Malawi (GoM) will enter into a weather derivative agreement with the World Bank. In exchange for a premium, Malawi will be covered against drought-related financial risk
The GoM will receive a payout from the World Bank if the index hits a pre-determined trigger. The trigger is selected by the GoM, based on coverage and cost considerations
The World Bank will enter into a mirroring agreement with a market counterpart that will “compensate” the World Bank in case the trigger is hit
Charges to the GoM will be determined on a pure cost recovery basis (premium charged to the Bank by the market counterpart and administrative cost)
Intermediation service is available to all IBRD and IDA clients (given certain pre-requisites) – first time an IDA country can access a derivative product from World Bank Treasury
World Bank Intermediation: Value Added
Reduces start-up costs for private sector market players in Malawi Facilitates competition by organizing bidding process among market counterparts Attracting
Market Players
Market participants are concerned about possible manipulation of weather data as the data provider (Met-Office) is a Government agency. The World Bank involvement eases these concerns
Mitigating Moral Hazard
Concerns
As risk and start-up cost is reduced for the counterparts, and the Bank facilitates competition, the pricing might benefit from World Bank intermediation
Pricing
Building capacity to facilitate future direct transactions between the Government and market counterparts
Legal Transaction structuring. E.g. choice of the coverage level Bidding process, execution, valuation, accounting
BuildingCapacity
Proposal for 2008/9 and Beyond• For 2008/9:
– Pilot a transaction through competitive market process (with World Bank Treasury assistance)
– Critical for price and process discovery– Link potential payout to maize or SAFEX call option purchases
• 2009 onwards (funded as part of World Bank 5-yr ADP Support Project):
– Further investment in Met Office network• Improve index by better regional coverage• Reduce risk-transfer costs by increasing market confidence in settlement
data– Improve Government’s Maize Yield Assessment Model
• Include impact of excess rainfall– Link with national early warning system to strengthen drought
preparedness and planning• Value of contingency funds is in effective planning
– Understand the role of weather insurance in Government’s suite of risk management tools
• Designed to work in tandem with other tools• TA and capacity building for Government
• Establish budget line for premiums