Sg)7 L C/ oy, Research,and ExternalAffairs WC PAPERS Debtand International Flnance Public Disclosure Authorized InternationalEconomics Department TheWorld Bank August1 991 WPS749 Hedging Public Disclosure Authorized Commodity Price Risks in Papua New Guinea Public Disclosure Authorized Stijn Claessens and JonathanColeman With increasing awareness of commodity price risks and with Public Disclosure Authorized 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 pipemstany 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 iLtsmember countries. i Policy,Research, and ExternalAffairs Debtand Inte;,iationalFinance WPS 749 'Ibijispaper - - 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 hlecintpat of fluctuations in comtnodit) prices, Tle lcessons leIarIIe(dIItc 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 takerl 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 cominmodity swaps) exist for hedging export management. ea1nin1gs over long periods. For agricultural I'IhC PRE Workinig Paper Setiie dissmniinales the f-indings of uNorkunder way in the Bank's lPolicy, Rcsearch. and External Al faiis Complex. An ohjeclivc ftiiescries is to ge thetsc findings out quickly, cven irpresentalions 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 ExternalRisk Managementto the PNG Economy .1 2.1. Importanceof PrimaryCommodities to the PNG Economy .2 2.2. Nature of PrimaryCommodity Value Fluctuations .4 23. ProblemsCreated by Commodityand Other Price Instability .6 3. ExistingCommodity Risk Management Mechanisms . .7 3.1. Mineraland EnergyPrice Risk .. 7 3.1.1. Taxationand MRSF .7 3.12. MineralResources Development Corporation (MRDC) Rules .9 3.2. PrivateCorporations .. 10 3.3. AgriculturalCommodity Boards .. 10 4. Impactof CommodityPrice Fluctuationson EconomicStability 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. Financialinstruments to Manage Risk .. 17 6.1. Commodity Futures.17 6 Commodityt.2.Options .18 6.t3. CommoditySwaps .18 7. Mineraland EnergyPrice RiskManagement Strategies .19 8. Agricultural Stabilization Funds.26 9. Conclusions........ ................................................................... 29 R eferences ...................................................................................................................................................................30 Appendix . .... 31 Thc authorswould like to thank Ron Duncanfor his vcry usefulcomments and World Bank staff in AS5CO for their contributionsto this paper. 1. Q IIDf Papua New Guiuea (PNG) faces substantial exposure to price fluctuations of its major primary commodityexports. Existingcommodity risk managementschemes provide limited protection against the impact of commodityprice fluctuations,have high cost, and are not able to provide protection over long time periods. (e.g., the agricultural stabilization funds are effectivelyexhausted). This paper shows that financial instruments available in developed capital markets are better suited to manage the external risk of PNG than existingschemes, 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 commodityprices. 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 overviewof 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 1970sand 1980speriod thcsc markets have bccn highly volatilc, with 2 large intra-year and inter-year fluctuationsin prices, and thus a major source of instabilityin 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 economyis 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.nutoil, and palm oil decliningsince the mid-1980s. Thbeimportance of primary commoditiesin 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 1990-1992period. 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 1990speriod. The minerals sector makes a large contribution to governmcnt revenues through corporation income taxcs, dividendwithholding taxes, and dividendsfrom 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. Contnbuionof Maior PrimaryPgmModiyEWs to Total Emrt pamin.NG. t. Commodity 1985 1986 1987 1988 1989 1990 1991 1992 Percent