Export Sector Liberalization and Forward Markets: Managing Uncertainty During Policy Transitions

By Jason A. Lovelace

 The point is to understand the conditions under which they [markets] fail or function at an inefficient level and to determine if appropriate policies grounded in an understanding of these conditions can fix such inefficiencies.

Debraj Ray, 1998

1. Introduction

The agricultural marketing and pricing policies pursued by developing countries have received considerable attention from the international community over the last two decades. Almost all developing countries have pursued agricultural (i.e., marketing and pricing) policies that have undermined domestic production and have depressed rural incomes with the aim of spurring industrialization. In a number of African countries, agricultural marketing boards provided a direct mechanism by which the price producers received for export crops was suppressed relative to world market prices. This was accomplished by granting marketing boards monopoly power over the pricing and marketing of cash crops. Following the seminal work of Bates (1981), a wealth of research has focused on the negative impact such policies have had on agricultural productivity and economic growth in Africa (e.g., Arhin et al., 1985; Schiff and Valdes, 1995). A commonly overlooked benefit of marketing boards, however, is their support of forward markets. A forward sale (purchase) is simply an agreement to sell (buy) a given commodity at a future date at a predetermined price. Marketing boards enabled forward sales to occur between overseas buyers and exporters, exporters and the marketing board, and ultimately through preannouned prices to domestic producers. In some countries, such as Ctte d’Ivoire, forward purchases were mandatory for licensed exporters. In the absence of an administratively determined minimum price, such transactions are particularly important to producers; the ability to secure a price in advance of harvest reduces the exposure of producers to market price fluctuations and enables producers to adjust their use of inputs accordingly. Analysts have also argued that forward sales provide an income benefit to the country as a whole by improving export earnings. This is because forward prices tend to be higher that spot prices (McIntire and Varangis, 1999).

Since the early 1980s the World Bank has promoted pricing and marketing reform of the cash crop sector in African countries, primarily through its structural adjustment programs. Reform measures include price liberalization (in the context of exchange rate reform) and the elimination of marketing boards (World Bank, 1994; Varangis et al., 1990). Although such reforms are often justified on the basis of higher average producer prices post-reform, in several countries price liberalization and marketing reform have also been associated with the temporary collapse of forward markets. The aim of this paper is to present an understanding of the conditions that have contributed to this phenomenon, and to outline the key issues that policy interventions will need to address in order for forward markets to be maintained during future reform programs. Section 2 presents a brief discussion of marketing boards in Africa and the impact of policy reforms on forward markets in Nigeria. Section 3 outlines the central elements of the problem, discussing how asymmetries of enforcement and information can result in the collapse of markets. Section 4 then highlights institutions that have emerged in several African countries as a consequence of liberalization. Such institutions suggest that with appropriate design, agricultural policy reforms need not result in the collapse of forward markets. Section 5 offers policy implications and concluding remarks.

2. Marketing Boards and the Impact of Policy Reform on Forward Markets

Marketing boards can be traced back to the colonial period, established to promote the interests of farmers, notably price stabilization and agricultural development and extension. Following independence, marketing boards were used by African governments to control the distribution of inputs for agriculture, to purchase farmers crops, and as instruments of political patronage. Attempts to stabilize commodity prices rarely occurred, and African governments diverted an increasing share of marketing board resources to general capital investment funds to support development initiatives. (Bates, 1981; Arhin et al., 1985; Krueger, 1993).

Marketing boards typically auctioned their expected crop forward to licensed private exporters prior to the actual harvest. Once exporters have purchased a forward contract, they may wait for delivery and sell on the spot market, sell through their direct contracts with overseas companies, or sell the forward contract forward to overseas buyers (Shepherd and Farolfi, 1999). Forward transactions carry significant risks, and in the absence of a margin system or recognized entitlement such as a warehouse receipt, forward transactions will occur only if the forward seller has good credit standing. This is because forward sellers have an incentive to renege on the forward contract if prices subsequently rise ("non-delivery risk"). The risk of non-delivery is reduced by the intervention of a marketing board. The marketing board, by setting the price producers will receive and being the sole legal purchaser of export crops, can be fairly certain of the aggregate crop it will have for the coming season. Hence, a marketing board may be viewed as a reliable counterpart. Because the risk of non-delivery, a marketing board is often able to sell its expected crop forward well in advance of harvest. In Ctte d’Ivoire, for example, prior to the 1995 reforms the Caisse de Stabilisation (Caistab) was able to sell cocoa forward up to 18 months in advance (McIntire and Varangis, 1999).

Beyond suppressing the price producers received for their crops, marketing boards were typically inefficient in the distribution of agricultural inputs, with stories of fertilizer being delivered after harvest and other breakdowns of the distribution system being quite common (Shepherd and Farolfi, 1999; Krueger, 1992). To improve the terms of trade for domestic producers and increase agricultural output, the World Bank has promoted the elimination or privatization of marketing boards as a central component of its agricultural policy reform strategy. A key motivation behind the adoption of market reforms is that the decentralized operation of a private-sector based marketing system is more flexible than a centralized marketing board system, and can therefore respond more appropriately to changes in market conditions.

Assessments of reform programs in Africa suggest, however, that in countries where the government has fully withdrawn its activities, in general the private sector has not been able to effectively replace the functions provided by the state (OED, 1997; Badiane, 1994). One evaluation of reform efforts concludes, "liberalization and privatization have replaced often unreliable, high-cost, and centralized forms of state marketing with private markets that are competitive but often lacking in information, infrastructure, and are poorly integrated and coordinated with other key production and market enhancing activities." (Jayne and Jones, 1996:4).

I argue that in African countries and in developing countries more generally, problems of enforcement and information emerging at the time of transition represent the key obstacles to the efficient functioning of forward markets. The simple model of a smoothly operating market with complete information which underlies the conventional argument for policy reforms is therefore misleading. Under conditions of asymmetric information, there may be private traders who would like to secure their quantity for export in advance, and similarly, producers who would prefer to "lock in a price" for their crops in prior to harvest. In the absence of government intervention, however, market forces alone need not result in a Pareto efficient equilibrium. In Nigeria, for example, evidence of this market failure is the dramatic decline in forward sales following policy reforms. After liberalization and marketing reforms were implemented in 1986, producer prices increased, but forward sales in the country’s major export crops also temporarily "disappeared." (McIntire and Varangis, 1999).

3. Enforcement, Information and Forward Markets

A common explanation of the failure of local forward markets focuses on problems of enforcement; in the absence of a margin system or collateral, producers have an incentive to renege on the forward contract if prices subsequently rise (McIntire and Varangis, 1999). Knowing this, private traders will be reluctant to engage in forward transactions with producers. Overseas buyers, in turn, will be unwilling to commit to forward transactions with private traders. However, similar problems have been resolved through certain mechanisms in rural credit markets. Credit markets and forward markets share the characteristic that a promise is made today, that may not want to be fulfilled tomorrow. This section outlines the mechanisms used in rural credit markets to induce borrowers to want to fulfill that promise, and then describes why such mechanisms have not emerged in markets for exportable crops. The fact that such mechanisms have not been established in exportable markets prior to the implementation of policy reform does increase the difficulty of enforcing contracts. I argue in section 3.2, however, that the common explanation of forward market failure overstates the risk of non-delivery.

In rural credit markets, it is common to see lenders employ indirect mechanisms to enhance the probability that borrowers will pay back their loans. First, lenders may use the threat of cutting off future access to credit to induce borrowers to undertake the actions desired by the lenders. Hoff and Stiglitz (1993) point out that for this incentive to be effective, borrowers must enjoy some surplus from obtaining loans. "Those who are lucky enough to get loans get a consumer surplus, and that consumer surplus, being denied to the unlucky, is in effect a rent." (1993:40).

Second, lenders may use cross-contractual terms to affect the probability of default, thereby linking the terms of transactions in the credit market with those of transactions in other markets. For example, traders in local crops, who are also lenders, generally require their clients sell all their crops to or through them. This trader-credit linkage makes information on the size of the borrower’s operations available to the creditor and to no one else. A useful by-product is that the lender has first claim on the crop (Ray, 1998).

Understanding the dual roles played by marketing boards also enables one to gain an understanding of why similar mechanisms have not emerged to reduce the risk of non-delivery for exportable crops. First, marketing boards themselves extended credit to producers. As the sole purchaser of export crops, marketing boards could be confident that that they would obtain repayment for this credit when they marketed the crop. Second, marketing boards also subsidized and distributed agricultural inputs such as fertilizer and pesticides (Bates, 1981; Krueger, 1992; 1993; Shepherd and Farolfi, 1999). Private traders who now supply inputs have no guarantees with regard to credit repayment, and consequently, input use for cash crops has dropped significantly (Shepherd and Farolfi, 1999). Both cases illustrate that because of the operation of a marketing board, the informal institutions that would likely have developed in response to enforcement problems did not need to emerge. The fact that such mechanisms have not developed prior to policy reforms raises the difficulty in enforcing forward contracts relative to rural credit obligations.

3.2 Informational asymmetries and producer exploitation

Klitgaard (1991) observes that in many developing countries, farmers are often poorly informed about market prices. A study in Malawi, for example, shows that three-quarters of maize farmers did not know the price of maize that could be obtained through the legal outlets; 50 percent of survey participants "had no idea" of the current market price and were unwilling to even guess. The implications of Klitgaard’s finding are striking - it is inconsistent to argue that producers will renege on forward contracts if the market price rises above the forward price, while observing that most producers are unlikely to even know that the market price has risen. Consequently, by assuming that farmers have perfect information regarding prices, the common explanation of forward market failure is likely to overstate the risk of non-delivery. I suggest that an important, though largely ignored risk is the risk that private traders will use such information asymmetries to their advantage, for example, by offering producers a less than fair forward price. More importantly, traders have an incentive to mislead producers on price. When no widely known forward price exists, each transaction is conducted by bargaining and the trader will collect excess profit by inducing the producer to think that the forward price is lower than it actually is. Understanding this, the producer cannot overcome asymmetric information simply by asking each trader about price. Even if enforcement is perfect, informational asymmetries may drive the market to a Pareto inferior equilibrium in which no forward sales take place, and neither the producer nor the trader, when acting individually, has an incentive to change his behavior so as to help move the market to a Pareto efficient equilibrium.

The exploitation of farmers by private traders is not uncommon in African markets, or for that matter, in developing countries generally. Price exploitation has been observed in Ethiopian markets, for example, through the covert use of false weights and measures. Price exploitation by "unscrupulous traders and speculators" was also observed in a number of markets in Zambia during the early 1980s (Klitgaard, 1991:38). Moreover, because marketing boards offered producers an administratively determined price, producers had no incentive to form cooperative organizations or develop the skills necessary to engage in price discovery. McIntire and Varangis (1999:23) note that in the absence of a marketing board, the lack of such organizations and skills result in producers being "dependent" on both the government and well-organized private exporters.

3.3 Explaining the temporary collapse of forward markets in Nigeria

The case of Nigeria is interesting, in part because it represents the "worst practice" in terms of managing a transition. In December 1986, the government abolished the six marketing boards that held a monopoly on the pricing, subsidization, purchase, and marketing of oil palm, cocoa and coffee, rubber, cotton, groundnuts, and grains. These changes were made rapidly and with little planning. The roles to be played by the private sector were not clearly defined, and steps were not undertaken to ensure that major functions being carried out by the marketing board were adequately transferred to the private sector. Also, administratively determined prices were liberalized "overnight", but indicative prices were not provided (Shepherd and Farolfi, 1999).

There are obviously a fair amount of policy mistakes in this example, and isolating the specific factors that lead to the forward market collapse would be difficult. In the preceding sections I have presented two general points: first, informal enforcement mechanisms require time to develop; and second informational asymmetries emerge at the time of transition. When no widely known forward price exists, such as this case, I have argued that asymmetric information is likely to drive markets to a Pareto inferior equilibrium. While it is arguable that this collapse was driven by other factors, it is unlikely that poor contract enforcement is a sufficient explanation, as forward sales surged three seasons later under similar conditions of contract enforcement (Shepherd and Farolfi, 1999).

I have argued that in African countries, and developing countries more generally, enforcement problems and informational asymmetries emerging at the time of transition represent the key obstacles to the efficient functioning of forward markets. An understanding of these two conditions is necessary if development organizations and country governments wish to pursue export sector liberalization while also maintaining forward markets. The following section presents institutions that I believe reflect this understanding.

4. Overcoming Problems of Enforcement and Information

Established after liberalization and marketing reforms were implemented in several African countries, commodity exchanges have shown that it is possible for institutions to be designed to overcome problems of information and enforcement in the agricultural marketplace. The process of price discovery at these exchanges is transparent and market-driven, and prices are widely disseminated. In addition to conducting spot and forward transactions, commodity exchanges also provide services such as transportation, storage, and information dissemination. For producers, forward transactions can minimize the costs related to storage as well as the risks associated with price fluctuations. Contracts are also fairly standardized, which tends to enhance market liquidity and reduce transaction costs (Lovelace, 1999).

Although transactions are not handled through a clearinghouse system, several mechanisms are employed to mitigate the risk of non-delivery. First, producers much purchase a membership in the sponsoring farmer’s association to be eligible to participate in the exchange. Second, producers are often required to adhere to rigorous time schedules for delivering their crop. Third, producers must agree to abide by the constitution and rules of the farmers association or risk financial penalty or expulsion. Here too, "membership has its privileges." In addition to participation in the Agricultural Commodity Exchange, members of Zambia’s National Farmers Union, for example, are also eligible to received technical assistance, financial advisory services, legal advisory services, and a monthly newsletter. Exchanges in Zimbabwe, Zambia, Kenya and Uganda are described below.

Zimbabwe Agricultural Commodity Exchange. The Zimbabwe Agricultural Commodity Exchange (ZIMACE) was established by a group of farmers in 1994 in response to the gradual liberalization of state-controlled agricultural marketing. The Exchange conducts spot (i.e., cash) and forward transactions in a number of commodities, including maize, wheat, sunflower seed, groundnuts, cottonseed, popcorn, sorghum and recently, live pigs. Maize transactions tend to dominate trading activity, however, the trading volume of wheat contracts are increasing steadily (ANS1, 1995; ANS2, 1997).

Zambia Agricultural Commodities Exchange. The Zambia Agricultural Commodity Exchange (ACE) was established in 1994 by the Zambia National Farmers Union (ZNFU) and the Commodity Research Institute. The Exchange conducts spot and forward transactions in wheat, white and yellow maize, sorghum, oilseeds and groundnuts. The success of the ACE has contributed to the development of the Kapiri Commodity Exchange (KCE) in Zambia’s central province and the Eastern Agricultural Commodity Exchange (EACE) in Zambia’s eastern province, both launched in 1997 (ANS3-4, 1997). ACE, in conjunction with South African Futures Exchange (SAFEX), also publishes SAFEX prices ex-Lusaka – futures prices on SAFEX plus transport, duties, and clearing differentials, thereby enhancing liquidity in both markets.

Nairobi Coffee Exchange. The Coffee Board of Kenya set up the Nairobi Coffee Exchange as a separate entity in 1998. In doing so, the Exchange replaced the functions previously performed by Kenya Coffee Auctions Limited. Equipped with an electronic trading system, the Exchange aims to become the hub for coffee trading in eastern Africa, and eventually expand its coverage to include additional agricultural commodities. If successful, it is possible that futures and options will be listed in the future (ANS5, 1998).

Uganda Commodity Exchange. The Uganda Commodity Exchange (UCE) is expected to begin operations in 1999. Basic commodities to be traded include coffee, maize, cocoa, wheat and rice. The Exchange is expected to evolve in stages. The first stage will be a coffee shop, lasting for six months. The coffee shop will bring buyers and sellers together without the use of graders (testers) or inspection by UCE. The second stage will be a spot exchange, in which trading will take place using samples under UCE supervision. The final stage will be a cash exchange, in which spot and forward trading will take place. The latter two stages have two-year development windows (ANS6, 1998).

5. Policy Implications and Concluding Remarks

Klitgaard (1991:37) has stated, "When information is an obstacle to fair and efficient markets, information may also be part of the solution." Examples both from other markets and from other countries suggest that when markets fail to generate sufficient information, governments or third parties should intervene to perfect their workings. This paper has argued that enforcement and information problems are the primary reasons why forward markets are likely to fail following export sector liberalization. It has challenged the conventional "wisdom" of market failure in local forward markets, suggesting that, because it assumes that producers have perfect information regarding prices, this view overstates the risk of non-delivery. It has also drawn attention to a largely ignored risk, the risk that private traders will mislead producers on price to capture excess profits. Even if the trader’s profit margins are small, the resulting equilibrium is likely to be socially inefficient.

It concludes that, while formal legal institutions and enforcement mechanisms are both important and necessary, the key to maintaining forward markets during policy transitions lies with providing information and carefully managing transitions. Managed transitions, rather than rapid transitions, are likely to provide the time necessary for producers to function effectively in a liberalized environment and informal enforcement mechanisms to develop. Enhancing the flow of information through widely disseminated pricing and other market information and fostering the development of producer and producer-trader associations are all options that warrant attention. It has been said, "The role of governments should be to try to create conditions where a climate of trust between the farmers and private sector can be developed." (Shepherd and Farolfi, 1999:75). Commodity exchanges illustrate the possibilities when such virtuous conditions are created. As Debraj Ray notes, if policymakers look beyond the surface and understand how information and enforcement problems can lead to market failure, then appropriate policies grounded in an understanding of these conditions can be designed. If they do not, I imagine that policy reforms will continue to expand markets in advance of the institutions required to manage them and ensure their sustainability.



African News Service, Inc. (ANS):

_____,ANS1 - "Zimbabwe Farming Commodity Exchange Seen Growing." August 25, 1995.

_____,ANS2 - "Zimbabwe: Private Exchange Looks Bullish." March 25, 1997.

_____,ANS3 - "New Commodity Exchange Firm Set Up." May 17, 1997.

_____,ANS4 - "Zambia; East Unions Form Body." June 23, 1997.

_____,ANS5 - "Kenya: New Coffee Auction System a Great Boost." May 4, 1998.

_____,ANS6 - "Commodity Exchange to Ease Marketing." September 11, 1998.

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By Jason A. Lovelace
Woodrow Wilson School of Public and International Affairs
Princeton University
E-mail: lovelace@princeton.edu

Transmitted: 1999



Date Uploaded 1/23/2008
Copyright Africa Economic Analysis 2005