Policies for coping with price uncertainty for Mexican maize : policies for maize price variability in Mexico

PONay R.swch | IPS1\ ZO WORKING,PAPERS, International Trade International Economics Department The World Bank March 1993 WPS 1120 Policies for Coping with Price Uncertainty for Mexican Maize Donald F. Larson More efficient, market-based policies should be inrduced for coping with uncertainty about international prices for maize in Mexico. Policy RwAisrhWoddngP1p=sdiuntietfindings of woalkin pig rn en0 getheexchngeofides among an saffand alothuintin deve1 opmnaailw.hesepam striuftedbytheResrachAdviswyStff,canythenamesoftheut ,rilnect aolytirviewsv.nddswhdbeaedandckedacrdiey.Thefindingnzo.tios,andon1uionsuatheauthoIsowniTheyshoudd not be asibuted to the Wodd Bank, its Board of Dinctor, its managanan, or any of its manbercounties.  Policy Reserch| International Trade| WPS 1120 This paper-a product of the Intemational Trade Division, Intemadonal Economics Department-is part of a larger effort in the department to improve the developing countries'.management of commodity price risk. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Dawn Gustafson, room S7-044, extension 33714 (March 1993, 27 pages). The three goals of recent agricultural pricing offer farmers an inexpensive way to provide in- policies in Mexico for maize have been to raise season price stability. But the farm sector can farm income and c op prifitability by boosting take advantage of these instruments only if the domestic prices through trade restrictions, to domestic distribution system is reformed - by provide some pdice certainty at planting time, liberalizing interstate trade, harmonizing stan- and to reduce year-to-year variations in maize dards and measures (including sanitation stan- prices. dards), and privatizing storage facilities. The govemment pursued all goals jointly, No market mechanisms exist to ease the using import quotas and a state marketing underlying year-to-year price variability for agency to implement a mandated pan-Mexico wheat and maize. But the benefits of govermment price for maize. Farmers benefited primarily intervention to smooth prices are small and, in from the price stippor , and very little from the themselves, do not justify using a price-band other goals. Maize policies were unsustainable mechanism. and enormously expensive, so the govemnment has decided to reform the sector. [The reforms Still, a price-band system might be consid- will be institutionalized in the North American ered as a transitional tool. NAFTA calls for slow Free Trade Agreement (NAFTA.1; liberalization of the maize market, but the Mexican government could liberalize its markets Larson shows that the same price enhance- more aggressively. Levels of transfer under ment and stabilization could have been achieved current policies remain high and the costs of at less cost by using variable border tariffs within adjustment may depend on the path of interna- a price-band mechanism. Moving immediately to tional prices during the transition. The advantage such a policy can lower costs yet produce the of the price-band mechanism is that relief is same effects as current policy. The multiple granted (transparently and automatically) to effects of policy on price can be measured consumers when prices are abnormally high and separately, and a variable tariff/price-band to producers when they are abnormally low. This scheme can be used to target both price levels would help forestall political pressures for ad and price variability. hoc measures. International markets in commodity futures and options (through millers and banks) could The Policy Research Working Paper Series disseminates the frndings of work under way in the Bank. Anobjective of the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy. Produced by the Policy Research Dissemination Center  Policies for Maize Price Variability in Mexico Don Larson  Table of contents 1. Introduction 1 2. History of maize and wheat prices in Mexico 4 3. Within-year price uncertainty and free trade 6 4. Measuring the benefits to producers from price variability reductions 9 5. Targeting price variability with a price-band mechanism 13 6. Simulating historic price distributions in maize 20 7. Hedging government revenue risk 22 Conclusions 25 References 27  1. Introdection Agricultural pricing policies often have several targets. First, they may attempt to increase farm income and ctop profitability by engineering a higher domestic price than international markets would dictate. An additional goal may be to provide an indication at planting time of the price farmers can expect to receive at harvest, providing a measure of within-year price certainty. Finally, pricing policies often attempt to smooth farmer incomes across years by reducing price variability, smoothing the peaks and valleys associated with internatioxial commodity prices. In the recent past, Mexican pricing policies for maize attempted to meet all of the targets described above. By setting domestic prizes for maize, defended by import restrictions and domestic interventions in the marketing chain, the government assured farmers a higher-than-international price for their product and a more stable price for their product, and offered a guarantee that, at least in nominal terms, the price that farmers expected at planting time would be the price they received at harvest. However, these policies have been implemented at tremendous cost to consumers and taxpayers. With the government's recognition of the unsustainability of these policies and the overwhelming benefits of reform, analysis was carried out to identify more effective substitutes for these policies within a well- functioning market economy. Table 1 provides a summary of the different characteristics of current' price policies for maize in Mexico. From results reported later in this section and from the results of earlier research, especially 'Since this paper was written, the terms of the yet-to-be-ratified North American Free Trade Agreement were announced. Under the agreement, Mexico will convert its import licensing regime for maize from the United States and Canada to a transitional tariff-rate quota (TRQ). The TRQ will be in effect for 15 years. In the first year of the agreement, the US will enjoy duty-free access on 2.5 million tons of maize. The duty-free quota will grow at 3 % per year for the 15 years that tariffs are in effect. The initial tariff paid -in imported maize above the quota will be 215%. During the first six years of the agreement, an aggregate 24 % of the over-quota tariff will be eliminated and the remainder will be phased out over the rest of the 15-year transitional period. Mexico is free to pursue a more aggressive quota liberalization scheme. I  Table 1: Summary of price-policy effects. Components of prking policies Prke level Current pollale rise domestlo puica (by llilng imporu), thus gonerating increased producer incomes, welfare losso to consumen, and net transfers from government revenues. Price risks: - Within-year price uncertainty Since time passes between planting and harvesting, farmers are subject to unexpected price changes after planting decisions are made. Current policies provide an announced guaranteed price, removing this uncertainty to the extent that producers are confident that government resources are available to defend the announced price. - Price variabWty across years International market prices for some commodities are inherently unstable with significant year-to-year variations. Current policit s reduce this variability, but do so at high cost. In addition, the producer benefits generated may be small compared to policies that raise average prices. Levy and van Wijnbergen (1992) for maize, it is clear that large redistributions of incomes and welfare will come from reducing the wedges between domestic and international prices for maize and wheat. As these effects are treated in detail in other papers, they receive only passing treatment here. Rather, this paper deals with the benefits flowing from the two other price-policy effects: reduction of within-year price uncertainty and reduction of price variability across years. Results for wheat are presented along with results for maize to illustra, differences between these two markets. The conclusions of this paper are, first, that within-year price variability can be addressed inexpensively using futures and options markets, once a link between domestic producer and international prices has been established. Unfortunately, recent experiences with sorghum and soybeans indicate that the removal of trade restrictions in and of itself is not sufficient to establish such a link. Additional reforms along the marketing stream, including liberalization of transportation along state highways, harmonization of sanitation regulations between states as well as between nations, adoption of international standards in 2  grading and inspection, and privatization of storage are required before inexpensive market-provided hedging methods can be of use to producers. Secondly, although producers derive benefits from government policies that reduce the variability of annual prices, these benefits are quantitatively small compared to those deriving from policies that attempt to raise price levels. The present mix of policies - Import quotas and domestic management of storage and distribution - generates these benefits in an inseparable fashion. A tariff-based, price-band scheme is described which allows policy makers to separate price-level targets from price-variability targets. Although the average economic returns from reducing price variability in the short run may be small, the price-band system does provide a transparent and systematic method of responding to consumer and producer pressures during periods of abnormally high or low prices. The system is easier to administer than the current system, relying only upon variable border levies, and allows distribution to be determined domestically in response to demand and transportation costs. The remainder of the paper is organized in the following way. The history of Mexican maize and wheat prices is presented in section 2; in section 3, within-year price uncertainty and market instruments for risk are discussed; in section 4, the benefits of past policies in maize and wheat are estimated; section S demonstrates how a variable-levy price-band system can be used to separately target price levels and price variability; section 6 demonstrates that a price-band system could have been used to replicate the historic average level and variability of maize producer prices in Mexico while generating about $300 million in annual government revenues; section 7 discusses how government liability generated by a price-band system can be hedged using existing market instruments; and section 8 concludes. 3  2. History of maize and wheat prices In Mexico For the last three decades maize prices for producers in Mexico have been both higher and less variable than th, price of internationally traded maize (see Figure 1.) In recent years, the high domestic prices paid to producers have been achieved through a state monopoly which limits imports to defend a guaranteed price. The benefits transferred to producers through the higher prices are in effect paid by rural consumers in the form of higher food prices and by taxpayers. The state-subsidized commodity-marketing agency, CONASUPO, buys a significant portion of maize output from producers at national guaranteed prices and imports maize at inwernational prices2. CONASUPO then sells the maize to regional millers at differing prices with a substantially lower price granted to millers in the Federal District. Transportation and handling expenses are absorbed by the agency. These are substantial since the uniform domestic price which CONASUPO is required to pay does not reflect regional differences in transportation, storage, and marketing costs. The current regional wholesale maize and tortilla prices are given in Table 2. Maize prices 1980 pesos per ton 6. 500 8. 000 5. 500 S. Soo I 5. 000 4, 500- 4, 000- 3. 500- 3. 000- 2.5019161 i696 196i 197i 197-7 1981 1985 1989 1963 1967 1971 1975 1979 1983 1987 -Dormestic price -~ US price of border Figure 1: Comparison of maize prices, adjusted for transportation. 2Some poultry pr--Aucers are allowed to import maize at international prices. 4  Table 2:Wholesale corn and retail tortilla prices. Location Maize TortiUa pesos per ton Federal District 510,000 750,000 Veracruz 900,000 1,150,000 Nuevo Leon, Coahuila, Durango 865,000 1,100,000 Rest of Zountry 800,000 *1,050,000 Source: World Bank As illustrated in Figure 2, the differences between international and domestic wheat prices have been fairly small after accounting for transportation and varietal differences. Over the period 1981-90, domestic wheat prices have ranged above and below international prices. However, the average spread between domestic and international prices was positive (about 12%) during this period and domestic prices were less variable. Until recently, CONASUPO handled the ,narketing of wheat in much the same way as maize is currently marketed; however, with liberalization in wheat trade, ASERCA now has responsibility for facilitating wheat marketing. Wheat farmers still enjoy a measure of price protection Wheat prices 1980 pesos per ton 7.500 1 7 000 6,5000 6, 00 5, 000 IA 4. 500 4. 000 ,kTA4t 3. 500 3. 000 1961 1965 1969 i973 1977 1981 1985 1989 1953 1967 1971 1975 1979 1983 1987 -- US price at border Domestic price Figure 2: Comparison of wheat prices, adjusted for transportation S  and ASERCA must resort to subsidies in order to market the wheat in the presence of wheat flour imported under low tariffs. It is an indication of the price distortions generated under current pol'ties that ASEkCA recently found it cost effective to subsidize the use of wheat as animal feed In northwest Mexico rather than transport it to urban centers and subsidize Its conversion to flour. 3. Within-year price uncertainty and free trade Under current policies, Mexican producers know that the price announced prior to planting is the price they will receive at harvest. While this provides a benefit to producers, it is a benefit which could be readily and inexpensively provided by private markets for hedging - primarily international markets for futures contracts and options on futures. It is not necessary for the individual farmer to understand and participate directly in such markets since it is often in the interest of intermediates such as millers or banks to offer the hedging to farmers. For example, a wheat miller close to an urban center may have a transportation-cost advantage over competitors if local wheat can be secured. Figure 3 provides an illustration of how a miller anxious to secure local production might bundle hedging services in his price offer to local risk-averse farmers. Another example of how market forces might provide for hedging services is that of a bank already lending to local farmers. Such a bank might offer the same type of program to reduce the chance of default on farm loans. For example, the bank might purchase a put option (which gives the owner the right to sell a certain amount of a commodity at a specific price) in Chicago to protect a customer/farmer at the beginning of the crop year from an unexpected price decline at harvest. The bank would loan the producer the cost of the put along with the balance of the loan and recover the costs at the end of the crop year. Should prices unexpectedly fall, the value of the put would increase in a compensating manner, protecting the producer from an income loss and, indirectly, the bank from a default on the loan it extended to the farmer. Protecting the farmer against downward price risk is in the self interest of the bank since it also reduces the likelihood of producer default and increases the bank's recovery rate. 6  Chicago closing priCes: ODeember 4, 1991 tutrt opt IOwE ,Juiy '92 mail. .luly 92 put with 82 . 60 atrike prIc 82 . 6075 i bu. S 0 `13 / bu. buyS put / Miler 12 . 50 - transport Coats - 8 . 13 if price goes up, ferivar caaoults but .waa mre than miller 'a offer If Orice goes down, miller obiigated to wY U . 60, b;jt 1 coe,enasted by Increased val ua of opt ion Figure 3: Private market hedge for guaranteed maize price. International markets for hedging instruments for many commodities are readily available and inexpensive. For example, the cost of a six-month forward put in Chicago for maize at 'expected' prices, as indicated by the futures market, was slighty more than $5 per ton on December 4, 1991 - about 5% of the spot price. Physical distance is usually of little consequence in hedging commodity price risk. The Cocoa Marketing board in Ghana actively hedges cocoa prices and has an office in London to do so, while copper producers in Peru n-Aake use of markets in New York. However, it is vitally important that the links between one location and another be efficiently made. The removal of trade quotas is a necessary condition for such a link to be established but is not, by itself, sufficient. Recent experience in the Mexican soybean market tjest additional reforms along the marketing chain are required before Mexican producers have access to inexpensive markets to hedge within-year price risk. The producers themselves will not undertake the hedge; this is more effectively done by intermediaries such as central storage facilities, millers, exporters, or banks. 7  Recently, ASERCA asked Merrill Lynch to investigate the use of futures markets for soybeans which are currently freely traded. The chain of markets between a soybearn producer in Mexico and Chicago can be segmented in the following way. The future price of soybeans in Chicago in SUS plus forward Chicago-to-border transportation costs in $US times the future peso/dollar exchange rate plus local transportation costs should equal the local wholesale price; otherwise, arbitrage opportnities exist. Forward markets exist for the peso as well as for sea transportation from the United States. However, Merrill Lynch found that the variability over time in local transportation costs was so large that the benefits of using the Chicago markets to hedge domestic price risk in Mexico were lost. Put another way, Merrill Lynch concluded that the primary uncertainties faced by the Mexican farmer were not the variations in international prices, international transportation, or exchange rates, but were associated with domestic marketing costs. Two physically separate markets will be linked as long as there are ways in which unwarranted price - 'fferentials can be arbitraged away. Ultimately, this requires the opportunity for physical goods to be anoved from one market to another. Several bottlenecks occur in the local marketing system which must be addressed before the ability to arbitrage distant markets can be established and full advantage taken of the opportunities available to hedge the prices. These include: 1) the liberalization of transportation along state highways; 2) the harmonization of sanitation regulations both among the Mexican states and between the United States and Mexico; 3) the adoption of international standards in grading; and 4) the privatization of storage. The following examples illustrate the difficulties that remain with lingering regulation even as most sectors in Mexico are being rapidly deregulated. At one time, freight rates were regulated along both state and federal highways. While freight regulations on federal highways have beer. dropped, not all state regulations have been eliminated. As a result, transportation costs may be substantially different 8  from one locale to another. In addition, some state governments have been accused of using sanitation regulations as a barrier to interstate trade. In order to arbitrage markets, some certification is required to demonstrate that the good is of sufficient quality to trade on both markets. Generally, issues of inspection and certification are handled routinely either by government or private Institutions. However, when a central agency has monopolized international trade as has CONASUPO in Mexico, the existence of such institutions cannot be taken for granted. Finally, much of domestic storage is government-owned in many parts of Mexico and, according to anecdotal evidence, not properly priced. During harvest periods, storage may be rationed, forcing a larger quantities onto the local market than would be justified if storage costs and supplies were market-dictated, thereby depressing local prices. Without adequate access to markets for commodity price risk, trade liberalization will unnecessarily impose further costs on those farmers and intermediaries who would desire to be hedged at market prices. While efficient domestic markets for storage, transportation and marketing are necessary to take advantage of international markets for commodity price risk, they are also essential for the efficient allocation of resources within the domestic economy. Though raised here in connection with the use of hedging instruments, reforms in domestic distribution networks have important implications for the entire economy. Addressing such issues early during trade liberalization will greatly ease the costs of transition. 4. Measuring the benefits to producers from price variability reductions While the benefits to producers of receiving a higher price are obvious, the benefits of a more stable price are dependent upon how farmers view risk. To the extent that producers prefer stable incomes to unstable incomes, additional benefits accrue over the life of a price stabilization program 9  based on the efficacy of the program in reducing income variability by reducing the variability of the price component of producer income. Newbery and Stiglitz (1981) derived a quantifiable measure of the value of the income stabilization achieved based on assumptions concerning the relative risk aversion for producers. Assuming that producers can be treated as a single aggregated agent whose utility can be represented by a Von-Newman Morgenstern Utility function of income U(Y), average benefits relative to income are defined as: _ i Y _ I(f/0_2 B Y,-o 2 1 y 0 2R('o)[o271(Y/Y)2-o2rO] 1 where B is the money value of the stabilization benefits; YO, Y, represent income without and with a stabilization program, respectively, and a bar over a variable represents the variable's mean; a2y is the square of the coefficient of variation for the income Y; and R is the coefficient of relative risk aversion given by: R u -y.rL(n