As already mentioned, in many countries the provision of credit for smallholder coffee remains mostly if not entirely limited to the post harvest process.  That is, credit can only be obtained once the crop has been harvested and presented for final processing and marketing, for example to a cooperative.  Warehouse Receipts or WRS therefore appear to be an ideal vehicle to facilitate the flow of credit to small-scale borrowers. After all, the goods are in safe hands, quality and weight have been verified, etc.  However, as already pointed out in topic 10.12.02, usually, WRS represent unsold goods. Goods that do not carry price risk protection. For commercial banks this means there is a missing link: WRS provide physical collateral and of course present a better credit risk but, if the price risk has not been hedged then WRS still present a risk, both to the bank and to the owner of the stock, since the market value of that product could move down.

Tanzania avails of a well-developed Savings and Credit Society or SACCO network of some 182 Societies. Functioning as mini-banks these SACCO's offer micro banking facilities to their members, sometimes by retailing commercial banking products provided in bulk by commercial banks. Banking industry sources suggest it is far simpler to provide finance to individual micro-borrowers through this network than to rely on Warehouse Receipts or WRS. To a large extent the SACCO system relies on local insight and peer pressure and is better able to deal with the technical challenges that micro financing inevitably presents. But it is impossible for commercial banks to offer price risk protection management tool at this micro level.

Currently in Tanzania, most of the lending to the coffee sector continues to flow to smallholder farmers through market intermediaries such as producer cooperatives and farmer unions. These organizations typically announce a first payment price to farmers at the beginning of the season, which is usually April/May.  Budget projections and revolving lines of credit needed to run the organization are negotiated with the local bank based on this first payment price, which the intermediary organization will pay to farmers once the crops are harvested and collected.  Over the next 4-8 months the market intermediary then works to sell the crop, through the coffee auction in Moshi or through direct sales for export. If the actual achieved sales price ends up higher than the purchase price originally paid to farmers, the cooperative or union will return that profit to the farmers in the form of a 2nd payment.  But if the sales price is lower than the original purchase price, the cooperative or union will face a trading loss, have difficulty meeting debt obligations, and may lose the ability to continue to offer services to farmers because the organization is in a negative financial position.  Price risk in the coffee sector, therefore, is most severe at the level of the market intermediary, in this case the cooperative union, which carries a direct financial exposure for the time between announcement of the purchase price to farmers and completion of sales agreements at the end of the season.

Interesting work has been done by the World Bank's Agricultural Risk Management Team in Tanzania to alleviate this problem. Working with Tanzania's Cooperative and Rural Development Bank (CRDB*), a price risk management program has been put in place to help CRDB's  borrowers - coffee cooperatives and unions -  improve their ability to manage this intra-seasonal price exposure. Briefly, when the first payment price is announced, the cooperative or union can purchase an InterContinental Exchange (ICE - previously known as NYBOT) based put option to help protect the global price level which is equivalent to the first payment price announced to the farmers.  The put option can be designed to cover the cooperative's "break-even" position, and ensure that there will be a payout from the market if global prices fall below the level equivalent to the purchase price.  Cooperatives, unions, and millers  can choose to use put options to hedge all or a portion of their projected volume, and make adjustments to the contract volume as needed throughout the season. 

The  options are purchased by CRDB, using an international options and futures broker. The option cost depends on the scope of the price cover that is bought, historically around five to eight percent to protect at market price levels.  CRDB's borrowers who choose to hedge using this instrument must pay the cost, but it can be recovered through lower interest rates, as negotiated with CRDB.  For the bank, hedged lines of credit to coffee borrowers carry much less risk than providing credit to organizations who continue to carry high levels of price exposure throughout the season. As and when an option shows value, and the cooperative or union has made a sale, a decision is made to sell or exercise the put option, again with the assistance of CRDB and its international broker. To date CRDB does not charge a fee for its intervention but this may change in future as the practice becomes more widespread.

The CRDB Price Risk Management program is referred to, in Kiswahili, as "Kinga Ya Bei" and is only in initial stages of operation.  Ongoing work with CRDB will examine how the bank might be able to offer lower cost hedging solutions, using futures contracts that do not have an upfront cost like options. 

Working in the sector on price risk management issues for a number of years yielded two important lessons about improving the ability to manage price volatility.  First, it is virtually impossible to target smallholder farmers with these instruments directly.  Since hedging the price exposure for more than one year is prohibitively expensive, the only hedgeable risk is intra-seasonal price exposure, which should be managed on behalf of the farmers by the marketing organization.  Second, since risk management involves financial products, involvement of a local bank is critical.  Local banks must be part of the solution in improving risk management practices in the sector as they can add significant value to by helping to deliver risk management products to the local market.  Advocating and creating incentives for improved price risk management is also a key local banking function, and will go a long way toward improving the financial health of the sector as a whole.

So far, good progress has been made in this work but there are points to consider:

• Put options are attractive as long as prices remain at reasonable levels.  Put options help to create a price "floor", but need to be put in place before, not after, market prices fall. 
• If prices are high growers may feel paying a premium for a privilege they will end up not using is not worth the investment. Yet, it is entirely possible for coffee prices to fall well below say 75cts/lb, and banks may insist cover is taken, at say 50 cts.
• The system has the potential to facilitate access to credit and ensure the smooth running of post-harvest operations (advance payments, processing and marketing) carried out by cooperatives. However, it can only protect individual members against price falls once the crop has been delivered, i.e. they are not protected during the seasonal growing cycle.

This remains a separate challenge: how to create equally innovative (and affordable…) ways to allow intermediaries to extend smallholder price protection beyond the processing/marketing cycle.

* CRDB BANK LIMITED is a private commercial bank. The Bank was established on July 1st 1996 to succeed the former Cooperative and Rural Development Bank (CRDB), which was a public institution with majority of shares held by the Government of the United Republic of Tanzania. The succession was a result of the liberalization of the banking industry in Tanzania.

This text was originally written by Julie Dana and Jan van Hilten, and was first published in F O Licht's International Coffee Report.