Pilot operation on price risk management for cotton sectors in West and Central Africa

1. Pilot operation on price risk management for cotton sectors in West and Central Africa Philippe Chédanne – Agence Française de Développement (AFD) International Conference on cotton ; Woodrow Wilson Center ; October 26, 2006

2. PLAN of the PRESENTATION • Introduction : • Background context : • Main factors of the success • Major evolutions • What roles for Aid ? • French aid strategy • Pilot operation on PRM (Price risk management) • Conclusions

3. INTRODUCTION : background context • Cotton production in WCA : a success • production * 3 in 50 years ; growth rate cotton : 6,6% per year (over 30 Y) • Today Africa : 2nd world exporter, after USA • 2 millions farms grow cotton (in rotation with cereal) => 16 millions depend on cotton revenu • important driver of economic growth, rural development (rural infrastructure, organisation of producers, modernisation of agricultural practices : access to input, credit, improvment of food security…)

4. Cotton production in WCA : a success 1949 2003

5. Main Factors of the success • One fact : current (or traditionnal) use of PRM in WCA cotton sector is low… • Price mechanism to determine the producer price : • garanteed, announced before sowing, second payment at the end of the season if commercial profit • Minimum price garanteed thanks to stabilization fund => producers bear fairly no price risk => ginning companies : bear intra-seasonnal price risk and inter-annual (minimum price). In practice : State donor of last resort when stabilization fund exhausted or insufficient • Consequences : low volatility of prices at the producer level / high budget risk - rapid volume growth over decades (and rural monetary revenue) - lower share of world prices for the producers - low incentives for ginners to manage price risk (poor commercial policy => traders) - large risk (and rising) on the State budget • New institutionnal framework => need to develop PRM capacity • Privatisation of ginners + rising nber of traders => ginners bear PR and have to manage cmcial policy • New price mechanism ex Mali => producer bear PR (receive 60% of world price) • Still cotton sector important for economy => State bear some responsability (macro and social policy)

6. Major evolutions • Today’s challenges for cotton sector in WCA • Countries vulnerable to world price volatility more than 90% of cotton is exported (very limited textile industry) • Macro level (growth rate, budget), social (poverty), politicaly • Competitiveness challenge for the WCA cotton • World price decline in recent years, worsened by dollar depreciation against EUR • Subsidies (wide range of estimated impact on level of world prices : from 2% to 72%) • Productivity gains (GMC,…), India, Brazil : rising yields ; stagnation or decline in WCA • Quality issue of the cotton fibers and US standards dominating the market • Institutional issues : reform undertaken to strengthen the producer org involvment in the management of the commodity chain, privatisation to bring new capital and skills, incentives… => low alternative products in the sahel region

7. What roles for Aid ? • French Coop / AFD strategy to address those challenges : • Mitigate the impact of world price volatility to the sector => pilote operation on price risk managment combining different instruments (smoothing funds, market instrument, and safety net) to mitigate world price volatility impcat on the income of cotton sectors and cotton producers in WCA • Enhance the competitivness of the cotton chain • Projects aiming at rising yields (dev equipment credit, improved extension services, strengthen PO capacity…), reduce ginning costs,… • Support institutionnal reform (special attention for critical functions : credit, input,…) • Support to the C4 negociation capacity on the Doha round trade negociations • Promote donor coordination in cotton interventions : • UE-African Partnership : Action Plan adopted july 2004 in Paris • Cotton-Club (include WB, and open to new cotton donors) • Scheme proposed to manage price risk : joint Feasability Study with WB and CRMg, participation of EC, and result will be shared with WB, CE, NL, Germany in a informal steering Committee

8. Pilot operation on PRM (price risk managment) • Development of PRM capacity : a necessity for cotton sector in WCA • Donor consensus on that issue because of the assessed negative impacts of price volatility on poverty, performance of the cotton chain, and macro policy =>macro level : FLEX (EC), ESF (IMF), WB research to introduce vulnerability index in aid allocation • Donor commitment to deliver on that issue PRM is one of the 7 issues that constitute the Action Plan of EU-Africa Cotton Partnership • Where do we stand ? • e • French Coop /AFD have launched several studies since 2004 => proposed this PRM scheme • These studies were regularly shared with donors (WB, CRMG, EC, cotton club) => improvement At the beginning, first discussions tensed (ideological opposition : market instrument vs stabilisation funds =>then progressive convergence on the complementarity of these tools : market based instrument deal with intra-annual volatility, whereas smoothing funds deal with inter-annual volatility • This scheme was presented to all the stakeholder of cotton sector in Dakar in Nov 2005 (producers, Ginners, public Administration from 6 WCA couontries, banks, traders, regional institutions, donors, NGOs) ; april06 FZ => strong demand on PRM capacity building, improved tools and funds • Joint feasability study (WB, CRMG, EC) => result shared « informal » Steering Committee (Cotton Club)

9. INTRODUCTION : pilot operation on PRM (price risk managment) • PRM scheme objective : The objective of the scheme is to mitigate excessive variations of prices for producers, without running against long term market trends, by using a series of tools adapted to the nature and scope of the risk. = transmit long/medium term market signal to producers, withdrawing noise (volatility) => Optimise economic decisions on resource allocation

10. The model • Use of reference markets (NYBOT/Cotlook A and exchange rate USD/EUR to define a « fair » CIF-FCFA reference price • Non manipulable reference prices: establishment of a pivot price linked to an international price index and automatic operating modalities of the smoothing fund • Design « price layers » with respect to probability of occurrence • Layer A : Risk retention layer Prob(Layer A) ≈ 90 % • Layer B : Market instrum. layer Prob(Layer B) ≈ 10 % • Layer C : Market failure layer Prob(Layer C) ≈ 1-5 % • Design tools matching each layer with portfolio consistency and governance potential • improvement of banking services to the sector (mangmnt of smoothing funds, sell market instruments ?…) • Define a formula pricing for sharing cotton value between ginners and producers

11. INTRODUCTION : pilot operation on PRM (price risk managment) • PRM scheme : design and implementation issues • design issue : Modeling of world price behavior (choice of price index, deflator, time period) has an impact on the asumptions to simulate forecasted price series, and thus parameters of the sheme =>ongoing expert technical discussions • implementation issue : how to build on current practice and move toward this intended better managed PR ? - transitional period and measures must take into account country specificities (relative importance of cotton in the economy, institutionnal organisation of the cotton chain, bargaining power and capacity of the different stakeholders…) - Parametrisation of the different tools of the mechanism must be defined within the interprofession, according to the level of risk smoothing desired/acceptable. => Issues to be adressed by the joint feasibility study for a pilot operation in BF and Senegal.

12. INTRODUCTION : pilot operation on PRM (price risk managment) • Schedule for the pilot operation : • Joint Feasibility study : May to June (5 experts + expertise from J. Cordier and Ch. Gilbert) • Informal Steering Committee (Cotton Club) : June /July2006 • Joint evaluation mission : end of 2006 • pilot project : • AFD : Board decision in January 2007 for 10 MEUR (funding the regional smoothing fund, training and capacity building on the PRM scheme,…) • ?? BM / CRMG ?? : funding the training and pilote introduction of market based instruments ? • EC ? …

13. Thank you for your attention

14. PRESENTATION OF THE MODEL price risk managment scheme combining smoothing funds, market instrument, and safety net to mitigate world price volatility impact on the income of cotton sectors and cotton producers in WCA …by Professor Jean Cordier