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oy,
Research,
and
External
Affairs
WC PAPERS
Debt
and International
Flnance
International
Economics
Department
The
World
Bank
August
1 991
WPS
749
Hedging
Commodity Price Risks
in Papua New Guinea
Stijn
Claessens
and
Jonathan
Coleman
With increasing awareness of commodity price risks and with
technical assistance -strategic advice and assistance in institu-
tion building and skills training --developing countries such as
Papua New Guinea can learn to use market-based commodity-
linked financial instruments to improve their economic manage-
ment.
The Policy. Research. and Extemal Affairs Complcx
distnbics PRE Working Papers todisscminatethe findings of work in progress and
to cneouragc the exchange of ideas among lIank staff and all others interested in development issues. These pipems
tany the names of
the authors, reflect only their views, and should be uscd and cited accordingly. The findings, interprctations, and conclusions are the
authors' own. Thcy should not be attributed to the World Bank, its Board of Directors,
its management, ur any of iLts
member countries.
Public Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure Authorized
i Policy,
Research,
and External
Affairs
Debt and Inte;,iational
Finance
WPS 749
'Ibijis
paper --a joint product ol tic Debt andi Internaitional Finance and International Trade Divisions,
Inteniational Economics Departiicit -is part of a larger clfort in PRE to stu(y' the use of financial
ins.ruilcints to mTanagc thc exictrnal exposures ol devcloping couIInties. Copies are ava&lable free from the
World Bank, 1818 1I Street NW, Washington, DC 20433. Please contact Sarah Lipscomb, room S7-062,
cxtension 33718 (31 palges, wiih figoures and tables).
Papua New Guinea faces substantial exposure to export earnings, short-tcrni hledging tools, such
price Iluctuaitionis for its major ptiimalr) coiminocd- as options and lutures, could be used effectively.
ifv exports: gold, copper, cotiee, Cocoa, logs, Claessens and Colemani design specific financial
anlld palmn oil. Its existinig conmmodily uisk strategies that Papua New Guinea could use, and
managcnient schemics its ninii-eral slabili/.ation demonstiratc the gains to be made from active
futind and agricultural commiillodit) funds -- are risk management.
cosily, provide only li iitied protectlion against
hlec
intpat of fluctuations in comtnodit) prices, Tle lcessons leIarIIe(d
IItc not unique. Many
aInd arc unablc o l)rovidce protection foI loIIg developing countries are hcavily depen(lent on
pcriods, primary cominodities for foreign exchange, and
thcir econlomic developmcnt has suffered from
(ilaesscris arid Coleman show thlat ma-rkct- thc resultinig risks and instabilities. With in-
hased financial instirumienits ate better suiled tO ct-casinig awareness of these risks and with
manage exteinal price risk for a countii) that is a technical assistance -strategic advice and
pric l taker in wvorld comimiiodity markets. T his is assistanlce in institution building and skills
especially itic case forI mineral and cnergy price training -developing countries can learn to use
iisks where f'inanicial instrum tcits (such as finanicial instruments to improve their economic
comin
modity swaps) exist for hedging export management.
ea1nin1gs over long periods. For agricultural
I'IhC PRE
Workinig Paper Setiie dissmniinales the f-indings of uNork under way in the Bank's lPolicy, Rcsearch. and External
Al
faiis Complex. An ohjeclivc ftiiescries is to ge thetsc findings
out quickly, cven ir presentalions are less than fullt pxlished.
The finndings,
interpretations, and conclusio', in these papers do not necessarily represent OrfiCial Bank policy.
Piodu(ced by ihe lPRE Dissemiiination Center
Table of Contents
1. Introduction .......... ...........1
2. Background:
Importance
of External
Risk Management
to the PNG Economy .1
2.1. Importance of Primary
Commodities to the PNG Economy .2
2.2. Nature of Primary Commodity Value Fluctuations .4
23. Problems Created by Commodity and Other Price
Instability .6
3. Existing Commodity
Risk Management Mechanisms . . .7
3.1. Mineral and Energy Price Risk .. 7
3.1.1. Taxation and MRSF .7
3.12. Mineral
Resources Development Corporation
(MRDC) Rules .9
3.2. Private Corporations .. 10
3.3. Agricultural Commodity
Boards .. 10
4. Impact of Commodity Price
Fluctuations on Economic Stability in PNG . .12
4.1. Tax Revenues.12
4.2. MRSF.13
4.3. MRDC and the Private Sector.14
5. Risk Management Schemes and Their Costs and Benefits.15
T.1. Stabilization Funds ................ .......................... 15
5.2. Other Instrument s 16
6. Financial
instruments to Manage Risk .. 17
6.1. Commodity Futures.17
6 t.2. Commodity Options .18
6.t3. Commodity Swaps .18
7. Mineral and Energy Price Risk
Management Strategies
.19
8. Agricultural Stabilization
Funds.26
9. Conclusions
........ ................................................................... 29
R eferences
...................................................................................................................................................................
30
Appendix ..... 31
Thc authors would like to thank Ron Duncan
for his vcry useful comments and World Bank staff in AS5CO
for their contributions to this paper.
1. Q IIDf
Papua New Guiuea (PNG) faces substantial exposure to price fluctuations of its major primary
commodity exports. Existing commodity risk management schemes provide limited protection against the impact
of commodity
price fluctuations, have high cost, and are not able to provide protection over long time periods.
(e.g., the agricultural stabilization funds are effectively exhausted).
This paper shows that financial
instruments available in developed capital markets are better suited to
manage the external risk of PNG than existing
schemes, and are less costly. This is especially true for mineral
and energy price risks where financial instruments exist for hedging over long maturities. This paper shows how
these instruments could be used by PNG. For the agricultural stabilization funds, short-term hedging tools
could be used effectively, and, for illustration, a simple hedging strategy is developed for the coffee fund,
The paper is organized as follows. In section 2, the importance of primary commodities to PNG is
discussed, as well as its exposure to volatile international commodity prices. In section 3, existing commodity
risk management mechanisms are discussed, and in section 4, the exposure of economic stability to past
commodity price fluctuations is quantified. In section 5, a general overview of risk management schemes and
their costs and benefits is presented, and section 6 discusses some specific financial instruments applicable to
PNG for external risk management. Risk management strategies for the mineral and energy sectors are
developed in section 7, and for the agricultural stabilization funds in section 8. Conclusions
of the study are
drawn in section 9.
2. Backaround: Importance of External Risk Management to the PNG Econom!
This section describes why external risk management is of primary importancc to the PNG economy.
First, PNG is highly dependent on the cxports of primary commodities for forcign cxchange carnings,
govcrnmcnt revenues, and employmcnt. Second, PNG is a price takcr in the world markcLs
of its major
primary commodity cxports. During the 1970s
and 1980s period thcsc markets have bccn highly volatilc, with
2
large intra-year and inter-year fluctuations
in prices, and thus a major source of instability
in the PNG economy.
Third, PNG's debt structure exposes it to both exchange rate and interest rate risks. Therefore, the use of
commodity,
interest rate, and currency
risk management instruments
would
be of considerable
value by reducing
these exposures.
2.1. Motane of Primary CoModities to the PNG Econom
The performance of the PNG economy
is determined largeiy
by the strength of the export sector which
is composed mainly of mineral and treecrop exports (see also Table 2.1). These are crucial to the economy
in terms of foreign exchange earnings, government revenues, employment, and external debt servicing.
However, agricultural production is the major source of employment in PNG. Within this sector, coffee and
logs dominate, with the importance
of cocoa,
copra and cocc.nut
oil, and palm oil declining
since the mid-1980s.
Thbe
importance of primary commodities
in export earnings is illustrated in Table 2.1. In 1989,
almost
70% of the total export earnings of PNG were obtained from the exports of gold and copper compared with
less than 50% in 1985. It is projected that the mineral sector will continue to dominate in the early 1990s,
contributing a little less than two-thirds of total export earnings in the 1990-1992
period. Outside the mineral
sector, logs and coffee contribute the most to export earnings. In 1989,
coffee and logs contributed 10.9% and
6.6%, respectively,
with cocoa and palm oil at 3% to 4% and copra 1.4%. These proportions are forecast to
remain fairly stable in the early 1990s
period.
The minerals sector makes a large contribution to governmcnt revenues through corporation income
taxcs, dividend
withholding
taxes, and dividends
from government
equity in mineral prcjects. In addition, there
are the import duties and payroll taxes paid by the mining corporations. In total the mineral sector providcd
20% of govcrnment revenues in 1989,
and by the end of the decade their share is forecast to rise to over 35%.
3
Tabl 2.1. Contnbuion
of Maior Primary
PgmModiyEWs to Total Emrt pamin.NG. t.
Commodity 1985 1986 1987 1988 1989 1990 1991 1992
Percent
Minerals 46S 60.9 61.7 70.6 69.0 6S5 64.1 64.7
Gold 25A 402 413 36.4 25.1 31.2 34.3 40.1
Copper 21.1 20.7 20.2 34.2 43.9 34.3 29.8 24.6
Nonmintemls 535 39.1 383 29A 31.0 345 3S.9 353
Cocoa 75 63 5.3 35 3.8 3.2 2.6 2.6
Coffee 13.4 IS4 16S 9.4 10.9 9.2 7.2 6.9
Copra 5.1 2.0 1.0 1.3 1A 135 IA 1.2
LOP 7.7 5.7 6.9 7.6 6.6 8.9 10.1 9.6
Palm Oil 73 3.9 2.8 1.7 3.1 4.3 5A S.6
Other 12.3 5.8 S.8 5.9 5.2 7.4 12.2 9.4
Source: Based on Table H in Annex Vil of IMP, 1990.
Although less important than the mineral sector, the agricultural sector makes a significant contnibution
to government revenues though direct taxation of company income, taxes on agricultural exports, and profits
from government equity in agricultural
projects (e.g, oil palm estates). In addition, there are the indirect taxes
imposed on imported agricultural inputs, as weil as the taxes paid by individuals earning agricultural incomes,
and the excise taxes levied
on items such as fuel, beer, and cigarettes purchased with incomes generated from
agriculture. It is estimated, for example that the contribution to total government
revenues of the coffee sector
alone is as much as 10% (see Brogan and Rewenyi (forthcoming)).
The mining sector generates few opportunities for employment in PNG. Most of the capital used in
the mines is technologically
advanced and is imported. The two major mines, BCL and OTML, together
cmploy about only 6,000 people (many of whom are expatriates) which is about 0.3% of thc labor force. The
labor force in PNG (estimated to be 1.8 million in 1987) is primarily employed in agriculturc. Within the
formal sector, agriculture is the most important source of cmployment, taking about 20% of the labor forcc.
Whilc the terms of trade havc movcd against the agricultural
exports of PNG sincc the mid-1960s, rcal
4
consumption
and investment
have
been maintained
by overseas
borrowing. As a result, cxternal
debt has
increased
dramatically
from
less than $200
per
capita
in 1970
to more
than $1,200
currently.
The debt service
to exports
ratio is currently
at about
30%. In the 1988
government
budget,
and
interest
paymtents
alone
made
up almost
7% of total expenditures.
External
debt (servicing)
has further been influenced
by two external
factors: intermational
interest rates and cross-currency
exchange
rates. The influence
of movements
in
international
interest
rates
on PNG's
debt service
obligations
has been
relatively
small
compared
to many
other
developing
countries,
since
a considerable
part of PNG"s
long-term
debt is of a fixed
rate nature (approximately
45 percent).
Still,
a change
of one
percentage
point
in the interest
rate alters
debt service
by about
$13
miUion.
The influence
of exchange
rate movements
on the level
of ntebt
measured
in US dollars
has been large since
a significant
part of PNG's debt is in non-dollar
currencies
(approximately
60 percent).
Over the period 1985
to 1989
the absolute
value
of the currency
valuation
effect
on debt stock
has,
on average,
been
about
$72
million
annually
or about 3 percent
of the debt stock
(see also
the Appendix).
2.2 Nature
of Primaa Commodity
_alue
Eluctation
The instabilily
of export revenues
of primary
commodities
is associated
with fluctuations
in both
quantities
produced
and
prices. Indexes
of the value,
volume
and unit
value
of the major
primary
commoditics
of PNG between
1985
and 1989
and projections
for 1990
to 1992
are reported
in Table 2.2. Also
reported in
Table
2.2 are the coefficients
of variation
(CV)
(the ratio of standard
deviation
to the mean)
which
provide
a
crude
measure
of instability.
The CV for the index
of the value
of mineral
exports
for the 1985-1992
period
is almost
20%,
indicating
that cxport
value
is quitc unstable.
The
value
of copper
exports
is espccially
variable
with
a CV
of 36.5%,
while
the CV of gold
was
19.0%. Also,
copper
prices
werc
highly
unstable,
recording
a CV
of 24.4%. The index
of
the value of nonmincral
exports
was more stable than the mineral
index,
with
a CV of 14.4%. The most
important
commodities--logs
and coffcc--reported
CVs
of 20.6%
and
34.5%, rcspectively,
which
arc both
lower
S
than the CVs for the other major commodity exports, except for gold.
Ta le 2.2 P-n Mew -uinea: -zMEW Value. Volume. and Unait Value, b Maie CommOdity. 19951992
Commodly 1985 1986 1987 1998 1989 1990" 199177 199277 C$'1
YAks
Minerals 68 9S 86 131 128 100 96 111 19.3
Gold 78 132 122 141 98 100 108 14S 19.0
Copper S9 62 54 121 156 100 8S so 36.5
Nonminerals 152 124 109 109 116 100 96 107 14.4
Cocoa 229 20S 1SS 134 148 100 81 94 345
Coffee 139 169 164 123 144 100 77 84 26.3
Copra 327 133 67 104 117 100 91 91 59.9
Logs 83 65 71 116 90 100 111 121 20.6
Palm Oil 167 93 S8 47 88 100 122 143 37.2
Volume
Minerals 81 11S 104 136 118 100 108 129 14S
Gold 72 125 115 124 102 100 110 149 188
COpper 90 1OS 94 146 133 100 106 110 16.4
Nonminerals 82 83 86 91 92 100 100 106 8.9
cocoa 83 82 80 78 115 100 92 103 111
Coffee 68 64 76 87 87 100 87 90 13.7
Copra 135 IS0 131 117 104 100 88 89 17.9
LOP 87 90 93 114 95 100 112 lS 11.0
Palm Oil 70 78 72 48 76 100 118 129 29.3
Uoint Value
Minerals 84 83 83 96 108 100 89 86 95
Gold 108 106 106 114 96 100 98 97 5.6
Copper 66 59 57 83 117 100 80 73 24.4
Nonminerals 185 149 127 120 126 100 96 101 22.3
cocoa 276 250 194 172 129 100 88 91 39.9
Coffee 204 264 216 141 166 100 89 93 38.1
Copra 242 89 51 89 113 100 103 103 47.7
Lop 95 72 76 102 95 100 99 103 11.9
Palm Oil 239 119 81 98 116 100 103 111 38.0
Source: Based on Table iii in Annex VII of IMF, 1990.
I/ Projections.
2/ Coctficient of Variation.
With thc cxccpzion of gold and logs, thc unit value variability of each export commodity in the table
6
is greater than its production variability. This reflects the high degree of instability
of intcrnational agricultural
commodities
prices. Also of interest is the fact that the commodity
unit values have declined over the period,
especially
for coffeeand cocoa.
The dependence of PNG on primary commodities
will be strengthened with expected developments in
the energy sector. Oil export earnings
could amount to as much as one-third of mineral export earnings
by the
year 2000, equivalent to 25% of total export earnings. With greater dependence on oil cxports the economy
of PNG will open itself to risks associated with fluctuating
oil prices. Recent events have been a reminder that
oil prices are highly
unpredictable which suggests
that risk management instruments to lower these risk will be
of great importa-ice in the future .
2.3 Probems Created by Cmm-odity and Other Price Instability
The previous section clearly demonstrates that commodity price, exchange rate and interest rate
instability has had and will continue to have major impacts on PNG's macroeconom; through its cash-flow
effects on export earnings and the relative burden of debt service.
The impact of volatile external prices does
not, however, limit itself to its contemporaneous effect on cash-flows
but also impacts on production and
investment
decisions. For PNG, the problems involved
in developing
the non-mining
sector of the economy
can, in part, be traced back to the large dependence on mineral exports and the volatility
in mineral prices. In
times of high mineral prices and high real exchange
rates, the international competitiveness
of the non-mining
sector deteriorates and little investment
occurs. However,
in periods
when mineral prices and the real exchange
rate fall, the non-mining
sector may still not develop, as investors realize the situation can casily revcrse itself
in the future, rendering investments
in the non-mining
sector possibly
unprofitable.
Ilistorically, the CV of oil prices
has bccn
hctwcen
20%
and 30%.
7
3. Exslin CommadiAisk Mananemet Mechaisms
In this section the linkages between
the commodity
sectors
and other sectors of the economy
are
explored in greater detail and a description
of the important
institutions
and mechanisms
through which
commodity
prices affect
the economy is provided. There
are three main
entities which
bear the risks
associated
with fluctuating
commodity prices. These are (i) the Government
of PNG (GOPNG); (U) the private
corporations
that operate in these sectors;
and (iii) the agricultural
marketing
boards for coffee,
cocoa, copra,
and palm oiL We discuss
the allocation
of mineral and energy price risks first,
followed
by agricultural
price
risks, and the specific
risk management schemes
in place in each sector.
3.1. Minera and E Price Risk
The GOPNG is affected by price changes in tdie form of tax revenues channeled
through
the Mineral
Resource
Stabilization Fund (MRSF), and through
the, Mineral Resource
Development Corporation
(MRDC)
(through
its equity stak. n mines and energy projects
and its responsibility
for raising
the necessary
funds to
rinance
the equity
participation
in new projects).
3.1.1. Taxation and
The structure
of mineral
resource
taxation in PNG reflects the authorities'
objective of providing
adequate
incentives
to producers
while ensuring
that the government
is able to secure most of any windfall
profits (see further Coopers and Lybrand
(1989)).
The tax regime in place for both the mining and the
pctrolcum projects places a heavy
tax burden on the more profitable
operations while minimizing
tax
requirements
from
marginal
projects. Mining
cnterprises
arc subject
to an effectivc
tax rate of 46%. Highly
profitable
operations
are subject
to an additional
profits
tax (APT),
which
can result
in marginal
rates
of a;;nost
65%. The mining
APT is payable
when
the project
shows
a return on investmcnt
abovc
a specificed
rate. As
a result of the APT, the government's
revenues
increascs
sharply
in periods
of high commodity
prices.
8
Petroleum projects are subject a company
tax rate of 5;9%. The APT for the petrel'
-um .ndustry is payable at
a rate of 50% once the project has achieved a 27% nominal rate of return after income tax.
The Mineral Resource Stabilization
Fund (MRSF) was established by an A.., of Parliament in 1974,
with the objective
of reducing the impact of fluctuations
in mineral revenues or. the government budget.
Under this legislation,
all dividends
in state shareholdings, companv
income taxes, and dividend withholding
taxes (identified above) from all designated mining operations must be paid into the MRSF. The assets of the
MRSF are held by the Central Banik
of PNG (BPNG) which invests
them in securities
abroad, primarily in the
form of interest-bearing deposits and central bank securities.
The surplus funds, managed BPNG, constitute the
main source of reserves.
Drawdowns from the MRSF are determined on i;- basis of recommendations
submitted to the Board
of Management of the MRSP. The general rule for withdrawal
is that the amount to be drawn down should
ensure that the Fund is sustainable in terms of real purchasing
power over the next five years (see also Guest
(1987)). The Board of the MRSF is bound to make forecasts of future receipts for eight years ahead and
(implicitly)
for inflation forecasts for five years ahead. The commodity
prices implicit in tke forecasts should
not vary more than 10 percent from the historical moving-average
of commodity prices (20 years for copper
prices, the preceding
year for gold and silver).
In practice there has been considerable
flexibility
in the operation of the MRSF and a revision made
to the MRSF Act in 1987
allows
the government
greater discretion than before. This, while providing greater
flexibility
in the use of mineral revenues, carries the risk of larger increases being allowed in drawdowns
and
expenditures in anticipation of future growth in these revenues.
The contributions to and drawdowns
from the
MRSF have varied substantially
over the past decadc. The degree of stabilization
the MRSF has provided can
be quantified by comparing the Cv of its outflows
over the pcriod 1980-1988
(45%) with the CV of revcnues
(56%). This suggcsts
that very
little stabilization
of the government's
budget has taken place by placing
MRSF
9
between
tax receipts
and inflows
in the budget:
only a relative
reduction
of about 20%2. The result is to be
expecced
given the implicit
use of the moving avera2-e
price with short time periods (one year for gold and
silver)
as an indicator
of the future price and the (recent)
flexibility
in the rules.
3.1X Min:rp1Kesources
l)pnentCorporation (MRDC)
Ruiles
The govermment
has followed a policy of taking
an equity
share in all major mineral
projects.
Although
these investments
have been characterized
by a high
degree of risk, there has been popular
support for the
principle
that the government
should maintain
a share
in the ownership
and control
of projects
involved
in
exploiting
nonrenewable
resources.
The equity-participation
in new mineral
projects has taken place
lusing the
MRDC
as a vehicle. In the case of mining projects,
the govermment
has reserved the right to take an equity
share ok tip to 30%, although
in most
projects to date it has taken a 20% share. The expectation is that, in
some form or another, the state, provinces
and landowners
will,
through MRDC,
retain an equity stake in the
mining
projects. For petroleum projects,
the government
reserves
the right
to take d 22.5% carried
interest.
MRDC
has financed
its equity
participation
in the different
projects
in a variety
of ways
from deferred
payback
on future dividends--in
which case the foreign
investors effectively
provides
the financing--to
loans
obtained
through external
commercial
borrowing
(with a government
guarantee)
3. More re ently,
MRDC has
relied on foreign financing. MRDC receives
their dividends
on its equity stake and pays any excess of dividends
over financing
costs to the r[FP. Through
its participation,
MRDC
is exposed
to commodity
price risk since
its expenses
(interest and
principal payments
on foreign
loans)
are not dependent
on commodity
prices
whereas
its rcvcnucs are. The substantial level
of government
equity
in new mines ^nvisaged over the next few
years will
This result is conflrmcd by the analysis of Guest, which dcrivcs thc similar result that the NIRSI has
reduced the instability of
mineral revenues by only 30 percent.
31'frcctively, the Departmcnt of Financc and Planning
(DI') has arrangcd the financing under its nanc and thcn passcd it on to
%IRDC.
10
require large amounts of new financing, (commercial
external borrowings) which arc estimatcd to amount
to
about $500 million in 1991 and 1992. This will greatly increase MRDC's exposure.
3.2. Prinate Corrations
Foreign companies operating mines in PNG are exposed to commodity price risks through thc impact
of price changes on the cash-flow derived from the mines (dividend remittances and other transler payments
to the parent company). Most foreign firms have put in place some risk management program to protect cash-
flow streams to parents against commodity price swings. It a-ioears, however, that the risk manage:mnit is dlone
at the parent, off-shore level, i.e. net profit remittances received by the parent from the subsidiary are hcdlged
at the off-shore
level, leaving export receipt and taxes exposed. This implies that much of the commodity price
exposure remains at the subsidiary level and consequently that the PNG economy remains ecposed to
fluctuations in the price of its main exports.
33. Abr,icultural Commodity
Boards
Given the importance of agricultural commodity exports to the economy and the volatility of
international prices, stabilization schemes have been established in PNG since the 1940s for the impor.iant
export crops in Papua New Guinea (PNG) -- namely
cocoa, coffee, copra and palm oil. The four schlciiems zirc
similar in design (see Figure 1). A threshold pr;ie is determined equal to a ten-year moving averate 1 F(F)l
prices, adjusted for inflation. Then a buffer zone is set at 5% above and below the thrcshold price in wvhich
no bounties or levies apply. When the current FOB price is more than 5% above the threshold price, levies
are imposed on producers at 50% of the difference between the threshold price and the current FOB pricc.
The levy
revenues are paid into a commodity
stabilization fund. When the current FOB price is more than 5"s,
below the threshold price, bounties are paid to growers at 50% of the difference between thc curreint
I01)B prrice
and the threshold price. Bounties are paid out of the stabilization fund.
11
price/ton/
Farner
Figure 1 ~ ~ ~ ~ ~ ~ ~ ~ the
Unt_ recently,_-he9schemes5were succeSfulinstabilizing
of thresoold prices..w.i.dn
...... '..-'
4 jj / ~~~~leuyg A obUt uFfer
/ 1 3 ~~~~~bounty m// no levy zone
Figure I
Until recently, the schemes were successful in stabilizing producer prices. Howcvcr, in ilic midl- aInd
late-1980s, commodity prices fell in real terms, so that current FOB priccs were consistently below thc tlhrcslold
price. As a result, subsidy payments were made to growers over an extended period. This lcd to thc eventual
exhaustion of the cocoa, copra and palm oil funds, and the coffee fund is expected to run out carly in 1991.
To prolong price support, the funds were kept solvent through government financial contributions, commiiier-ciall
bank loans and STABEX transfers.
In response to these problems, in November 1989 the government decided to implement it number of
interim measures which would provide support to the agricultural export sectors while a new approach to pricc
stabilization was found. The objective of these new measures is to give price protection to growers while thiv
adjust to lower international prices without the support of bounty payments from the stabilization funds.
Instead of establishing a threshold price based on a long-run moving average, support durinig the atlisltlllct
pcriod is based on the difference between the estimated costs of production and the international price. T'h.
level of price support will decline over an adjustment period of about three to five years dcpendiing on ihc
commodity. By the end of this period producers will face international priccs. The loans used to finanec pricc
support payments are to be repaid by the commodity boards from cxport rcvenues when the international pl ice
exceeds the support price.
12
The rationale for this policy is that without such a scheme agricultural incomes would decline
substantially
with a significant proportion of the estatc sector going out of business. With support, as well as
initiatives
to improve productivity,
such as extension and research, the sectors will be able to adjust to low prices
and to gain international competitiveness, as well as being in a position to repay existing loans.
4. Impact of Commodity Price Fluctuations
on Economic Stability in PN(G
In this section we provide empirical estimates of the magnitude by which each institution is affccted by
commodity price risk. We identify the following parties: tax revenues, MRSF, MRDC, and the private sector.
4.1 Tax Revenues
Historically, PNG's total tax revenues have been very sensitive to variations in commodity prices. This
can be estimated by running the regression:
(1) t a + ,Pt 1+ -YPt
2+ ... + error
where TRt are percent changes in tax revenues in period t, and Pt, are percent changes in the prices of relevant
commodities (e.g., copper and gold)
4.From these regression cquations, the clasticity of tax revenues with
respect to the copper price (both expressed in percentage annual changes of dollar values) over the period 1976-
1988
was about 0.25 (with a t-statistic of 3.3 and a R2of 0.56). The clasticity with respect to gold prices was
about 0.18 over the same period, but not significant. A similar regrcssion was done for export earnings. Thc
elasticity of export earnings with respect to copper prices was about (1.18 (with a t-statistic of 1.37 and a R2(if
"Scc further G(emmill (1985) and Kolb (1985) on how to cslimnatc thcsc sensitIvifics.
13
0.135).
The elasticity
with respect to gold prices was about 0.738 over the same period (t=2.84, R2= .45)5.
These results suggest that the exposure of tax revenues to export prices is quite different from the
relationship between export earnings and export prices in the case of the gold price, but similar in the case of
the copper price. Since the average share of copper and gold in export earnings over the 1976-1988
period was
about 25% and 30% respectively,
these elasticities
indicate also that movements
in volumes
cxported have partly
offset the effects of price movements in the case of copper exports and exacerbated those movements in the
case of gold exports.
42 MRSF
Similar regressions
were performed for the dividend
stream on the government's share in the mining
projects accruing to MRSF. The elasticity
for gold was 1.22 (R2= 0.28,
t = 2.06) and for copper 0.72 (R2=
0.05, t= 0.77).
The regression coefficients
for the annual levels of dolar dividends
(in millions)
on the level
of
prices for the period 1981-1988
were 0.076 for gold (RG = .43, t=2.14) and 0.005631
for copper (R2= .42,
t=2.11). Since the last regression is in levels,
the coefficients
measure the exposure of the dividend
stream to
prices and can be interpreted as the quantity of physical
commodities
'received' by the government each year.
These quantities are equal to 2.56 tons of gold (converting ounces to tons) and 5,631 tons of copper (or 8
percent of gold exports and 2.5 percent of copper exports).
Regarding future price sensitivities,
the World Bank (1989)
reports results for two scenarios: in scenario
I the price of gold is 15% lower than in the base case and the price of oil stagnates in rcal terms; in scenario
2 the price of gold rises proportional to international inflation.
The diffecrcnce
in thc currcnt account between
thcse two scenarios is 7.5 percent of GDP and in the fiscal balance is 6.7 perccnt of GD?, indicating thc largc
scnsitivity
of both aggregates to international commodity pricc movements.
' Ovcr a longcr period
the
elasticity
of cxport
earnings
with respect to copper
priecs is
0.54 (with a t-statistic
of 2.97), and the clasticitv
with respect
to gold prices
is 0.64
(with a t-statistic
of 2.11).
14
43 MlDQCadlhe Private
ScLtor
Sensitivity
scenaros regarding future prices can also be performed on the profitability
and resulting
tax
revenues in the case of an individual
mining operation.
This was done for a mine similar to the recently opened
Porgera mine, which largely
produces gold. Based on production estimates, costs of production, and current
tax regulations profits, tax receipts and dividends paid abroad (the excess cash-flow after subtracting the
government's share) are calcuated under different gold price assumptions.
Present values of Dividends and Taxes
£00
w~~~~~~~o
700-
a m0
SOO
-400-
70)
'000
0- S300 $325 S310 £375 £400 £425 £41O05475 %S00 1550 5600
Gold b-Ic.. S/ounc
~Figure 2
Figure 2 plots the results for the present value of dividends
paid abroad and the present value of gross
receipts
to MRSF (tax receipts, royalties and dividends)
over the life time of the project. As one can observe,
the prcsent value of MRSF receipts, PVT, is more sensitive
with respect to the gold price than the prescnt value
of dividends paid abroad, PVD. As the gold price increases, the APT comes into cffcct and raises the PVT
rclatively
morc than the PVD. In rcgrcssing the PVT on the gold price, the slope is around two, while thc
slope of a regression of the PVD on the gold pricc is only 0.75.
Tlhus,
the govcrnment
is rclatively
(about thrcc
times) morc cxposed
to gold price risks than the forcign investors arc, since ilicy share less in the upside of
15
a price increase while the government
shares more because of the APT6.
5. Risk Management Schemes and Their Costs and Benefits
The above section indicated the need for risk management, especially
commodity risk management.
There are many different forms of commodity
risk management that can be used by developing
countries. We
will discuss here the ones in use by PNG.
5.1 Stabilization Funds
The principle behind the agricultural product stabilization
funds and MRSF in PNG is that in periods
of decline in commodity-related tax revenues the government draws on its reserves to finance its normal
expenditures. The experience
with commodity
stabilization
funds in other countries has shown, however,
that
these funds are seldom sufficient
to sustain expenditures in times of prolonged downturns in commodity
prices
and that consequently the funds only insure against short-lived and temporary declines in commodity prices
(Gilbert (1990)). Evidence of this is provided by the agricultural stabilization schemes which are effectively
depleted.
The PNG agricultural
stabilization
schemes
were designed originally
to stabilize price around the long-
run average price. The non-stationarity
of commodity prices means that use of the moving-average
of past
prices is unreliable as an estimate of the long-run price, and that the scheme is likely to fail. As reported
above, the agricultural
stabilization
funds in PNG have indeed become exhausted following
the persistently low
prices of cocoa, coffee, copra and palm oil during the late 1980s. Thcre are many
similar cxamples from other
countries (e.g., coffee and cocoa stabilization funds in Cote d'lvoirc and Cameroon). MRSF is the onlv
stabilization
fund in PNG that has so far performcd successfully
for a prolonged period. The recent closure
of BCL has shown that cvcn the MRSF can only provide vcry limited insurance against a major shortfall in
6In terns of Icvcls. the cocfficicnt for PVD is about $80,000
for the govcrnmcnt's sharc.
16
government revenues and that additional support for PNG's balance of payments has becn necessary.
Adjusting
the rules of a scheme will not prevent the funds from exhaustion
over the long-run, unless
the effectiveness
of the scheme in stabilizing
prices is drastically reduced. For example, using historical data
it can be shown that if the moving average period were to be shortened and the inflation adjustment were
eliminated from the PNG agricultural schemes, the funds would not now be exhausted. However, while such
changes would certainly
reduce the frequency of depletion of the stabilization funds, the trade-off is that the
price paid to producers would be less stabilized. Another modification to the design of the schemes which
would
slow the exhaustion
of the funds would be to allow only 50% of the fund be paid out as bounties in any
one year. In this case the fund would never become exhausted (although it could asymptotically
decline to
zero), but it would become progressively
weaker in its ability to stabilize producer prices.
The agricultural schemes in PNG have failed largely because of the difficulty
of determining the long-
term price which in turn determines the level of withdrawals. Funds in other countries have failed for this
reason but also because of lack of discipline
in accumulating
reserves in times of high commodity price. The
increased flexibility
with respect to drawdowns from the MRSF thus raises some concerns with respect to
budgetary discipline.
5.2 Other Instruments
PNG has also benefitted of the international commodity
agreements for cocoa and coffee. Most of the
international price stabilization
schemes have collapsed
in recent years because of a breakdown in cooperation
among its members or because of the exhaustion of support funds. PNG has also drawn funds from
compcnsatory
financing schemes (such as STABEX/SYSMIN
facilities, and CCFF), which can serve as risk
managemeni schemes. However, they have the drawback of their limited and uncertain availability,
as was
shown following
the reccnt closure of the Bougainville
copper and gold mine (BCL).
17
6 Financial Instruments to Manage External Risk
The failure of the international commodity
agreements to stabilize prices on a reliable basis and the
possible drawbacks of compensatory
agreements and domestic stabilization schemes point to the importancc
of financial
market instruments for commodity
price risk management purposes. The most important financial
instruments from PNG's point of view are commodity futures, commodity options, commodity swaps and
commodity-linked
fnance (loans and bonds) (Masuoka (1990)). More specifically,
forward contracts, futures
contracts and options could be used to eliminate price exposure over a short time period (e.g., one year) for
the agricultural commodities. Swaps
could be used in the mineral and energy sector for longer horizons. The
nature and usage of these short- and long-term hedging instruments in the context of PNG is now further
described.
6.1 Commodity
Futures
As an example, the Cocoa Marketing Board in PNG may wish to set a guaranteed price to producers
for the coming season without incurring significant
financial losses if international prices change suddenly.
Based on historical export patterns, the Cocoa Board could predict fairly accurately the quantities of cocoa
available for export during different months throughout the year. Then it could sell futures contracts at the
beginning of the season for each of the delivery months in the coming year in proportion to the volume
available
for export in each of those months. The guaranteed price at the beginning
of the season to producers
could be set as the weighted average of the futures prices (with weights given by the export volume). As
exports are sold at international prices throughout the year, near-by futures contracts (i.e., those closest to
expiration)
could be purchased (thus offsetting the original short position) at prices close to the international
price. Such a strategy would eliminate intra-year price risk for the Marketing Board.
18
6.2 Commodity
Options
Commodity
options (on futures contracts) could also be used by the commodity
boards. For example,
say the Coffee Marketing Board wished to hedge the future price of its coffee sales with options instead of
using futures or forward contracts. Suppose
the Board wished to scll 50,000
tons of coffee in six months timne
and wants to receivc a price of at least $2,000
per ton. In this situation, the Board purchases
put optiorns
giving
it the right to sell coffee futures contracts at a price of $2,000
per ton. Say the premium quoted is $50 per ton
so that $2.5 million is p2id to cover the entire 50,000
tons. If after 6 months the price is greater than $2,000
per ton, say at $2,200
per ton, the Board would not exercise the options and receives $110 million
in revenues.
If, however, the price falls to $1,800 per ton, the Board will exercise its options, enabling it to sell futures
contracts at $2,000
per ton. The futures contracts can then be bought back at $1,800
(since
the spot and futures
prices are always
equal at the expiration
of the contract) making a profit of $200
per ton. The Board then sells
the coffee at the spot price of $1,800
per ton. Combining the $200 per ton gain on the futures contracts and
$1,800
per ton on the physical
commodity
gives an overall price of $2,000 per ton and total revenues of $100
million. The coffee options provide price insurance to the Board, guaranteeing it at least $100 million in
revenues in exchange for an insurance premium of $2.5 million.
6.3 Commodity
Swaps
Assume that PNG and a big German company
agree upon a long-term export contract in which the
German company buys
2 million
pounds of copper every six months over the next five years and pays the then
current copper price at each six-month interval. Assume also that the PNG exporter wants to "lock-in"
the
dollar value of thcse revenues now. The exporter now enters into a commodity
swap contract with a U.S. bank.
Assumc that the term for the swap is $1/lb. (indicative).
The U.S. bank agrecs to pay the exporter U.S. $2
million cvcry six months for the next 5 years. The exportcr agrecs to pay thc value at the spot price of 2
million pounds of copper on the same dates when the bank is duie
to make its payment--in
effect a "diffcrcnce"
19
check settles
the transaction
each 6 months. Thus, the commodity
swap
contract
is, in cffect,
a series
of 10
forwari contracts
lined
up over
the next
5 years
and has locked
the price at $1/lb.
PNG has sufficient
access to private
financial
markets
to be able to use any of these financ
al risk
management
techniques.
Given
the increase
in exposure
of the PNG economy
to commodity
price risk, the
economy
will increasingly
depend on a handful
of commodity
exports for its growth and development.
Therefore,
commodity
risk management
should
become
an integral
part of the GOPNG's
economic
strategy.
We discuss
in the next
two sections
some
possible
ftnancial
risk management
techniques
for the mineral
and
energy
and agricultural
stabilization
funds
respectively.
However, PNG will
need to establish
first a proper
institutional
framework
and
overall
strategy
and
acquire
training.
Only
then
specific
risk
management
operations
can be implemented.
Since
PNG is not only
exposed
to commodity
price risks,
but also to other forms of external
risks
arising
from
its financial
liabilities
and
assets
(i.e.,
exchange
rates
and
interest
rates),
it is furthermore
important
that the links
between
different
exposures
are taken
into account.
The interactions
between
the different
forms
of external
risks which
need to be taken into account
are the following.
First, movements
in cross-currency
exchanges
rates may offset (or exacetbate)
movements
in primary
commodity
prices,
implying
that both
commodity
and exchange
rate management
may need to be modified. Second,
there can be an inverse
relationship
between
commodity
prices
and
quantities
traded.
Depending
on the elasticity
of supply
and demand,
the effect
of price changes
on export
revenues
or import
expenses
can be offset
by changes
in the quantity
of
goods
exported
or imported.
This
may
reduce
the need for hedging
price risks
as a way to hedge
revenue
or
expensc
risks
(Coleman
and Qian
(1991)).
7. Mineral and Encrgy Price Risk Managcmcnt Stratcgics
As discussed
above, the MRDC docs not insulate thc governmcnt
budget from Ilic risks associatcd with
commodity priccs because MRDC's liabilities
(loans) and assets (dividend streams) arc not matched. This is
20
because its obligations on exdermal loans (debt service payments) are independcnt of commodity prices while
its dividends are highly dependent on commodity prices. A matching between assets and liabilities over the
long-term can be made with either a commodity swap or commodity-linked
finance.
An example is when MRDC has an equity stake in a copper mine. In that case, its revenues are
sensitive to the copper price and a copper swap can be used to convert copper-price sensitive cash-flows into
a certain cash-flow stream which can be used to service obligations on conventional
loans. As mentioned by
Masuoka (1990), this structure was successfuUly
used in the case of the Mexicana de Cobre copper mining
company.
The notional amount of copper swap would depend on the sensitivity of the dividend stream to the
copper price. Based on our earlier analysis, the annual value of dividends (and thus MRDC's revenues) can be
expressed as:
(2) Dt = a + ,Pt
where D is the value of dividends
and P is the copper price. Graphically
this is shown in figure 3.
In section 4, B was estimated to be about 5,631 tons. This implies that for every one dollar change in
the price per ton of copper, MRDC's annual revenues change by approximately
$5,631. This is equivalent to
MRDC receiving (having
a long position of 5,631 tons of copper annually, since
the value of owning 5,631 tons
of copper would change by an equal amount as a result of a price change.
This long position of the MRDC in copper can now be hedged by a commodity
swap. The swap would
oblige PNG to pay annually the spot value of 5,631 tons (P*$P
1, which is about $15 million dollars at the
current spot copper price) in cxchange for a fixed payment received. The tixed payment would depJ,nd on
conditions in the market for copper-swaps
and on the futures prices for copper, but for iltistrative purposes
a Fixed price of $2,500/ton can he uscd. The coppcr-price
sensitive
dividend stream will tlien be matched with
21
the copper-price sensitive obligation on the swap.
The net result will be a cash-flow stream which is
(1argely)
independent of copper price swings and °t
which would thus, without any risk, be available to
service conventional loans.
Commodity-linked loans can achieve the
same result. Consider the case of the participation
of
MRDC in a gold-mine, (e.g. a mine similar to I n,^: t
Porgera). Once the project comes on stream, the Figure 3
dividend payments received by MRDC will depend
on the price of gold. It was shown above that for every dollar change in the price of gold, the present value
of a dividend
stream to MRDC coming from a project like Porgera changes by approximately
$80,000,
or,
equivalently, the annual dividend stream changes by about $8,ooo7. In order to hedge this risk, the financing
of the equity-participation
by MRDC should consist of an obligation whose servicing
also changes by $8,000
for
each dollar change in the price of gold and for the remainder of a conventional loan. A gold-loan could
constitute the price sensitive part. Gold-loans stipulate payments in terms of ounces of gold and the costs of
servicing
the gold loan would thus vary one-to-one with the price of gold. In every period, MRDC would want
to owe 8,000 ounces of gold, since this obligation
would vary in the same way as the dividend
stream with gold
price changes.
Currently, gold interest rates (gold fees) are between 2% and 3%, so that MRDC could borrow
betwecn 250,000 and 400,000 ounces of gold. At currcnt gold prices, this means MRDC could obtain betwecn
$100 million and $150 million dollars in a gold loan. The rcmainder would havc to be borrowed in a
'Notice that we measure here thc sensitivity of thc present value of dividend strcams
and not thc annu;al dividend streams.
Thc
prcsent value
of all future dividcnds will be more
sensitive to assumptions about thc futurc the gold pricc than the annual
sircams.
Approximately,
thc diffcrcnce will be the factor 1/(discount
rate).
22
conventional dollar loans. The combination of the gold-denominated and the vonvcntional
loans would
perfectly hedge MRDC.
Similar rinancial hedging tcchniques are possible for MRSF. The current investment policy for the
reserves of the MRSF is that they are invested
by the Ccntral Bank in rclatively
low-yielding,
safe assets. This
policy does not seem to provide PNG with the best mix of return maximization
and risk minimization.
Even
though using foreign exchange reserves provides a smoothing mechanism, it does not involve laying
off risks
to other parties and is an expensive
self-insurance
scheme, because the fund's asset returns are unrelated to
commodity price movements and because it cannot sustain a prolonged decline in commodity prices. Further,
the fund tes up a significant
amount of foreign reserves.
A better reserve management policy
would
be to manage reserves through commodity
loans, commodity
swaps, or short-term commodity hedging
tools. Commodity
swaps are the most suitable. Based on projected
revenucs streams that depend on the price of a particular commodity,
MRSF could enter a commodity swap
with a foreign frinancial
institution (altogether MRSF should eventually
enter several swaps, i.e. separate ones
for gold, copper, and oil).
As an example, consider MRSF's gold-dependent revenues. MRSF received K42.5 million in total
revenues in 1988. Based on the production numbers of BCL and on prevailing
gold and copper prices, it is
estimated that revenues related to gold-mining
amounted to about 30 % of total revenues or 12.4 million Kina
(or $14 million)
in 1988. This revenue stream depends on the gold price and is equivalent to MRSF holding
a long position in physical
quantities of gold. Using the 1988
gold price, this long position in tax revenues was
equal to about 33,300
ounces of gold.
Thus, for every dollar increase in gold price, annual tax revenues of the
8
9lowever,
since thc gold loan is likely to bc in exccss
of MRIC's financing necds. thc rcmnaindcr
could hc invested in convcntional
sccuritics.
23
MRSF
change by about $33,000,
or the change
in the value of 33,000
ounces of gold9.
6MRSP could now
enter a gold swap
with a foreigm financial
intermediary
with an interest payment
of
33,000 ounces of gold
(based on a spot price of 425 S/ounce with
a notional interest payment
of $14 million)
in which it would effectively
sell gold
at a fixed price
for, say, the next
10 years. The ngjQnnlprincipal
amount
would depend
on the current market gold
fee; at a rate of 2% it would amount
to about 1,650,000
ounces or
about $700 million
10.
In this way, MRSF
pays the third party
at certain times the equivalent value of 33,000 ounces of gold
at the then prevailing
spot price--which exactly
offsets the tax and dividend
receipts it gets from the gold
producer. In exchange, it receives from the third earty (commercial bank) a fixed payment
of $X times 33,000
at each date (where X depends on the gold fee, the current spot price of gold and the current interest rate),
and MRSFs tax revenues for the next 10 years are effectively fixed at $X times 33,000.
Swap
transactions will not result in a perfect hedge since MRSF revenues
do not depend linearly on
the underlying price of the commodity, but the revenues depend in a non-linear way on commodity prices
and
go up progressively when commodity prices rise. Considering the gold sector only, the dependence of the
revenues paid into MRSF can be represented as:
11
(3) Rt = a + pQ9max[Pt-F-O + AQ*max[Pt-M,O0
where Rt is the revenue going to MRSF, P is the effective corporate tax (the combination of the regular
91he carlier analysis of the gold mine indicated that the regression coefficient of the net present value of taxes
(NPT) on the gold
price was about 2. This result is confirmned in a regression of the tax revenues paid into MRSP on gold prices which
has a slope of about
0.23. Sincc N'P1 is the discounted value of all future taxes, it will be more sensitive to the gold price by approximattly the factor
1/(discount rate), or about 10.
'0Notc that the notional principal
amount is never cxchanged between the two parties. l.ffectively only intcrcst payment are settled
on a nctting out basis.
1tTbis example concerns the revenucs
after depreciati3n allowances have expired and the procct gencrates a positive profit.
24
corporate tax rate (currently 35%) and the withholding tax (17%), making for an effective tax of 46%), 0 is
the quantity exported, F is the fixed costs per unit for the producer (including depreciation allowances in the
early years of the project), P
1is the gold price, and A is the APT tax rate which comes into effect when profits
exceed a benchmark, which is assumed to occur when prices P, exceed the level M.
This exposure of revenues to gold prices can be hedged using swap transactions (as outlined above)
combined with long-dated options. Once the company has largely depreciated its fixed costs, i.e. F = 0, the swap
transaction would involve a (notional) amount of gold equal to P*Q which would hedge revenues on account
of the regular profit part. This would result in more stable streams to the general budget. In addition to the
swap, MRSF could sell today a series of long-dated call-options to a third party with exercise prices of M, for
amounts equal to AQ and with maturities on which tax receipts are due in future years. The sale of the call
options would give PNG a premium income today. This premium could be invested in safe foreign obligations
(e.g. commercial bank deposits or Treasury bills or bonds), from which an annuity could be passed on to the
general government budget.
The gold swap would now hedge the normal corporate and dividend withholding tax revenues, and
paymnents on the swap will be matched with tax receipts at each maturity date. The options would hedge the
APT. At the maturity date of the option, the commodity price could either be below the level M (at which the
APT is not in cffect) or above it. When it is below, the call is also out-of-the-money and MRSF would not be
required to make payments to the third party. When the call is in the money, the paymncnt on the call will
cxactly be offset by the tax revenue to the MIPSF from the APT. Again, the transaction would result in
converting a risky tax revenuc income stream into a ccrtain yield on the invested premium.
These transactions
arc shown in Figurc 4. It is clear that the nct payoff thcre is almost indcpcndent of the price of gold as it is
horizontal for almost all price ranges.
The transactions result in MRSF largelv locking in its revenics over a long period independent of thc
gold price. It also allows the MRSF to pass on a fixed stream of payments to the general budget, and not to
25
Hedging Taxes Using Swap and Option
ProfIt at $400, APT at $650
250 -^
200 f
100 -
0 0s
0 A
-50
-100
300.00 400.00 500.00 600.00 700.00 800.00
Cold Price
a Taxes + Swap 0 Option A Net Payoff
Jrigure 4
rely on formulas based on expected prices or ad-hoc decision making.
The use of short-term commodity hedging instruments would be similar to that of swaps. An example
using commodity futures to hedge carrent year tax revenues against copper price risks would be the following.
At the beginning of the fiscal year, PNG would sell copper futures contracts with maturities spread out over
the year. The amount to be sold would depend on the sensitivity
of the tax revenues to copper prices. The
carlier analysis
showed that this elasticity
was about 0.25, implying that PNG would have to sell futures with
a contractual face value cqual to about 25% of anticipated
tax rcvenucs. This would
cffcctivcly reduce as much
as possible the combined effcct of price and quantity unccrtainty on next pcriod tax rcvenue unccrtainty.
26
8. AgiQltural Sabilionu
In the description of the fiancial instruments by Masuoka (1990) it was indicated that for most
agricultural commodities the longer term hedping instruments were not yet well developed. For these
commodities, however, the short term hedging instruments are in general easily available. Since the four
agricultural
stabilization funds have very similar main features, we will develop below a hedging strategy for the
Coffee Marketing Board using coffee futures traded in New York.
While the prime objective
of the coffee fund is to reduce the effects of sharply changing
prices over
time, substantial problems can be associated with sudden price movements within
the year. This was illustrated
very recently
with the breakdown
in the International Coffee Agreement, leading to coffee prices declining from
$3,356 per ton in January 1989
to $1,515 per ton in December. The largest month!y
decline was between June
and July, with price falling from $2,762
per ton to $1,942 per ton, a reduction of 30%.
Intra-year price risks can be hedged using futures contracts. A possible hedging strategy would work
as follows. The Coffee Marketing Board offers producers a price for coffee which is fixed for the entire year.
This price is set at the beginning of the year and is equal to the weighted sum of the prices of coffee futures
contracts which will mature at various months
throughout the coming year. The weights are determined by the
quantities of coffee available
for export in the months between each contract expiration.
For example, say in December 1988 the Coffee Board had wished to set a fLxed price for the crop year
1989. There are five expiration months on coffee futures contracts (March, May, July, September and
December) and in December 1988
each had a price for delivery
in these months in 1989. Based on historical
cxport trcnds the Board could have predicted fairly well
the proportion of the total exports
available
before each
of these delivery
months (e.g., January, February and March 10%; April and May 20%; June and July, 30%;
August and September 25%; October, Novcmber and Deccmbcr 15%). These proportions could have then
been used to obtain a weighted price for the coming year.
This strategy was simulated
using monthly data from 1980 to 1989 and the cffect
on intra-year variability
27
observed by comparing the CVs of various price series. The results are reported in Table 8.1. for the world
price, the threshold price (ten-year moving average), the domestic price A (the threshold price adjusted for
subsidies and levies calculated using the world price), the fixed price (the weighted futurcs price) and the
domestic price B (the threshold price adjusted for subsidies
and levies calculated using the fixed price, instead
of the world price, and assuming that the price band followed
the moving average).
-abl 8.J Intra-Year Meie Yariability 1921149. (CVsA
Year World Threshold Domestic Fixed Domestic
Pnce Price Price A Price Price B
1980 16.8 2.9 8.9 0.0 1.1
1981 6.2 2.0 4.1 0.0 1.0
1982 4.2 2.0 1.6 0.0 0.0
1983 5.5 1A 4.7 0.0 0.0
1984 2.7 1.6 1.9 0.0 0.0
1985 11.2 IS 7.4 0.0 0.7
1986 16.7 1.2 9.7 0.0 0.6
1987 83 2.5 3.9 0.0 0.0
1988 2.9 OS 2.5 0.0 0.2
1989 30.4 IA 16.0 0.0 0.7
Mean 10S 1.7 6.1 0.0 0.4
The inter-year CV of the world price is substantial, averaging 10.5% over the ten-year period. The
instability
in 1989 is clearly
captured by the CV statistic,
which reached 30.4% for that year. The domestic
price
A (based on the world price) also fluctuated throughout
the period. The results showed that under the existing
scheme the greater the intra-year variability
of the world price, the greater it was for the domestic price for
produccrs (e.g., in 1980,
1985, 1986
and 1989),
even with subsidies
and levies. In contrast, by using the futures
contract to lock-in an external price, the inter-year fluctuations in the domcstic price are removed almost
altogethcr. On average, the CV of the adjusted domestic price is 0.4%, indicating that produccrs are almost
entircly insulatcd from intra-ycar price instability. The impact of opcrating this hedging strategy on intcr-vear
price variability is reported in Table 8.2.
28
Tabl2 AeracE PIcesfor Stabilized
Coffee
Pre In pNO Us Dolams.
Year Wodd Threshold Domestic Fund Fixed Domestic Fund
Price Price Pice nsize Pri price size
1980 3466 2444 2953 68 4106 3273 73
1981 2869 2640 2749 82 2754 2697 95
1982 3088 2840 2964 87 2733 2733 96
1983 2911 3009 2898 89 2788 2788 96
1984 3189 3173 3157 91 3033 3033 97
1985 3231 3355 3203 91 2951 2985 96
1986 4295 3541 3897 104 3939 3740 100
1987 2S05 3421 2792 101 2792 3278 105
1988 3013 3257 3019 90 2926 2930 10S
1989 2387 3212 2684 85 2691 2791 101
Mean 3095 3089 3031 89 3120 302S 90
Std. Dev. 504.1 334.9 328.7 9.4 481.6 308.6 9.6
CV 16.2 10.8 103 10.6 H5A 10.2 8.9
The results show
that the introduction
of the hedging
program has very
little impact
of inter-year
variability
compared
to the stabilization
fund. On average,
the domestic
price
A (based
on the world price)
is $3,031
per ton, compared
to $3,025
per ton for domestic
price
B (based
on the fixed
price). The stability
of these prices
was
similar
with
coefficients
of variation
of 10.8%
and 10.2%,
respectively.
The impact
of the
hedging
strategy
on the fund size is also
shown
in Table 8. 2. On average
the mean of the fund with the
hedging
strategy
is larger
than that without
it, while
the
variability
of the fund
is lower. This
reflects
the lower
CV of the fixed
price
compared
to the world
price.
This
analysis
shows
that with
a simple
hedging
strategy
using
futures
contracts
the Coffee
Board
can
rix
the cxtcrnal
price it faces
for an entire
year at a time. This
stability
can be translated
into a very
stable
within-year
domestic
prices received
by producers. The clfcct
of implemcnting
this strategy
on intcr-year
variability
is
vcry
small,
however.
Futures
with
longer
maturities
or rolling
over
futures
may
be used
to managc
this inter-year
price risks.
29
9. Cmdushb
This paper diswsed some of the financial
instruments available to PNG for managing its external
risks
and illustrated their potential
benefits. Given the importance
and benefits of risk management, PNG should
consider undertaking a risk management program. This could
involve establishing a national
financing and risk
management strategy
(authorized perhaps by PNG's
National Borrowing Advisory
Committce). Furthermore,
the MRDC
needs to be strengthened by establishing rules regarding not only the size of its participation
in ncw
projects, but also the type of external rnancing it uses (e.g.,
more commodity indexing
features) and its risk
management strategy.
In the past, the MRSF has been
well managed given the financial
tools available. Howcvcr,
the MRSF
should now
take advantage of the recent
innovations in international capital
markets by using instrunlenis
stic h
as commodity swaps to hedge
its commodity price-sensitive
tax revenues. This would allow
stablc cash-llows
to be passed on to the general budget, independent
of commodity price movements.
Other comnmioodity risk
management
techniques can also
be introduced in managing the MRSP.
With the expected expansion of the mineral and energy sector,
PNG should look for ways
to rcduce
the variability of its economy through
fmancial instruments, and,
given its high international credit
standing, is
well placed to take advantage
of longer-term commodity-linked
instruments.
30
Coopers and Lybrand, (1989), Mining and Petroleum Taxation: A Guide for Operators and Cotractrs.
Brogan, B. and J. Rewenyi, (Ed.), (1987),
Commodity Price Stabili7ation
in PNG - A Work-in-Progress
Seminar.
Australian Centre for International Agricultural Research, January.
Coleman,
J.R. and Y. Qian, (1991),
'Managing Financial Risks in PNG: Optimal Debt Portfolio," In review for
PRE Working Paper Series, World Bank.
Gemmill, G., (1985), 'Optimal Hedging on Futures Markets for Commodity-Exporting
Nations", Europen
Economic Review 27, pp. 243-61.
Gilbert, C.L., (1990), "Domestic Price Stabilization
Schemes for LDCs,"
mimeo, IECIT, World Bank.
Guest, J., (1987), "Problems in Managing the MRSF",
Bank of PNG Quarteriv Economic Bulletin June 1987.
International Monetary Fund, (1990), 'Request for Stand-By Arrangement and Compcnsatory Financing of
Export Fluctuations under the Compensatory and Contingency Financing Facility," March.
Kolb, R.W., (1985), -Understanding Futures Markets, Scott, Foresman and Co. (London).
Masuoka, T., (1990), "Asset and Liability Management in the Developing Countries. Modem Fmancial
Techniques. A Primer," PRE Working Paper No. 454, World Bank.
World Bank, (1989), Panua New Guinea OpDortunities and Challenges for Accelerated Development, Report
No. 7707-PNG,
April.
World Bank, (1990), Papua New Guinea Strategy for Adjustment and Growth, Report No. 8518-PNG, April.
31
Debt Rntigp szm ~rggno C0Mggsitioin 0f PNG
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989
PRlWCZPL RATI03
Total £xternal Debt (I)
EDT/XGS 66.1 121.9 175.9 195.9 197.3 203.0 168.2 158.5 130.5 161.5
EDT/GNP 29.2 49.1 72.3 77.0 81.7 90.5 77.6 77.0 66.5 74.2
TDS/ MS 13.8 19.0 25.1 30.1 40.1 32.7 26.8 24.6 26.6 34.3
IHTMX0S 8.6 10.0 12.7 13.8 15.8 13.5 11.3 11.1 10.0 11.2
INT/GNP 2.9 4.0 5.7 5.4 6.6 6.0 5.3 5.4 5.1 5.1
Cancessional/EDT 12.2 9.7 8.6 12.0 14.0 16.3 20.4 24.1 19.3 19.1
1980 1981 1982 1963 1984 1985 1988 1987 1988 1989
CURMBWC'Y
CCFEOSITrON OF DEBT OUTSTANDINO
(PFfCERI)
U.8.Dollcrs 35.0 27.9 39.0 48.4 45.5 39.0 35.7 29.2 28.9 31.9
Mixed Currency 27.4 41.3 36.2 31.1 29.0 28.9 28.0 27.6 29.9 31.0
Japanese Yen 4.4 3.7 3.4 3.0 8.4 14.2 16.1 18.0 20.8 23.0
Deutsche Mark 5.2 3.9 3.1 1.9 2.0 2.1 2.3 2.3 1.8 1.8
French Franc .0 .0 .0 .0 .2 .4 ,3 .3 .3 .2
Pound Sterling 2.7 2.3 2.4 1.7 1.2 1.3 1.9 2.1 2.0 1.5
Swiss Franc 25. 4.5 3.4 2.5 4.2 7.2 9.5 10.3 9.6 6.1
Other Currencies 19.6 16.4 12.4 13.4 11.7 9.4 9.0 13.3 10.2 9.6
Exchoane Rate Val Effects /a 0 -12 -20 -13 -20 40 87 140 -44 -50
Notes: a/ IDP. debt valuation effects are shown from 1985 onward, millions of dollars.
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