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ICO economic report: Not so volatile

From the August 2019 issue.

The International Coffee Organization says there is no evidence to suggest the international coffee price has become more volatile in recent years, yet explains why it remains a serious concern.

Since 2016, the coffee market has experienced a visible and continued downward trend, with the International Coffee Organization (ICO) composite indicator remaining below the 100 US cents per pound mark for most of the first six months of 2019. For this reason, attention of the global coffee sector has focused on the root causes of price levels and the impact on growers and their livelihoods.

Recent reports of frost in the southern producing regions of Brazil in June and July, however, briefly shook up the market, causing the ICO composite indicator to rise within days by more than 10 per cent. As such, growers and market participants were reminded of another critical market feature: price volatility.

While variation in prices is inherent to agricultural commodity markets, as a result of factors such as seasonality of supply, drastic deviations from long-term price trends can have a severe negative impact on producers and value chain actors. In particular, smallholders who lack access to price risk management tools, including formal mechanisms such as hedging in futures markets, remain exposed to significant market risks. If realised, the risks related to fluctuations of prices on international markets can have a devastating impact on household incomes and therefore on rural livelihood. The perceived risks associated with coffee production also affect the “bankability” of smallholders, resulting in an often binding credit constraint that hampers investment in coffee production.

This is why the ICO has launched a comprehensive sector-wide dialogue that seeks to identify short- and long-term solutions to address both price levels and volatility in a market-based environment. Price risk management and risk sharing along the value chain are among the key areas of discussion. To inform the development of, and agreement on, concrete solutions that help achieve economic sustainability of coffee production, the ICO carries out rigorous economic research on underlying sector and market trends as well as drivers of volatility. The results will be featured in the Coffee Development Report, ICO’s new economic flagship publication that will be officially launched on International Coffee Day in London on 1 October 2019. The theme of this year´s report will also focus on the economic sustainability of the coffee sector.

Trends in volatility
Some may argue that coffee price volatility today is higher than in the past, especially compared to the period in which the ICO system of export quotas was in place. Research on international commodity agreements suggest that the quota, while riddled with political and enforcement challenges, was to some extent successful in achieving one of its key objectives: price stabilisation. Hence, there is reason to believe that in the absence of this mechanism, volatility has increased since the 1990s. Other more recent factors such as the “financialisation” of commodity futures markets, that is the increased presence of financial investors, may have exacerbated price movements. Indeed, some studies on the causes of the 2008 surge in grain prices suggested that higher volumes traded in commodity markets were linked to heightened price volatility in the short term.

So what does the data tell us? The ICO’s analysis is based on an extensive series of daily observations of the ICO composite indicator price covering the period from 1970 to 2018. To examine the effect of structural changes in the market, three distinct regimes were defined: 1970 to 1989 when the quota system was in place, 1990 to 2000 – a decade of radical change in the sector following the liberalisation of the coffee market, and 2001 to 2018, which was characterised by the financialisation of the coffee futures markets. During this last period, the volume of futures contracts traded almost tripled in the Robusta futures market and rose six-fold for Arabica. Over the same time period, physical output of Arabica and Robusta grew significantly slower by 51 and 58 per cent respectively.

The results of the analysis show that the volatility of the ICO composite indicator increased from 20.3 per cent from 1970 to 1989 to 30.8 per cent in 1990 to 2000 (see Figure 1). This significant increase is often cited as an indicator that the quota system was effective in its main goal of stabilising the international price of coffee, and that free unregulated markets would become more volatile. However, volatility in the subsequent period from 2001 to 2018 was significantly lower at 21.1 per cent, statistically indistinguishable from the level observed during the quota period. Hence, the first conclusion of this research is that there is no evidence that the international coffee price has become more volatile in recent years.

Drivers of volatility
This finding may seem surprising. A possible explanation is that other structural features of the coffee sector that are correlated with price volatility have changed over the same time period, reducing overall volatility. For example, production in Brazil, the world’s largest producer and exporter of coffee, has moved progressively out of frost-prone areas. As a result, the incidence of frost damage reported in the Brazilian winter months – a known cause of market fluctuations between May and August – decreased.

On balance, the volatility-increasing effect of market liberalisation as well as the financialisation of futures markets may have been partially offset by the less frequent occurrence of weather shocks in major producing regions. In view of the impact of climate change and the increased likelihood of extreme weather events in the future, it is not clear if this trend will continue. Further empirical analysis is required to isolate and quantify the effect of individual factors driving volatility. The results may also be sensitive to how the regimes are defined. Additional factors such as co-movements of the coffee price with other commodities may be considered as well.

A comparison of the volatility levels for coffee with previous research in other tropical commodities reveals that, while coffee price volatility has not increased in relative terms, it remains high in absolute terms and broadly in line with other agricultural commodities such as cocoa, tea and sugar (see Figure 2).

This is a compelling reminder that farmers face risky production and livelihood choices. Building growers’ capacity to manage price risks and improving risk sharing among actors in the coffee value chain are fundamental to contribute to a living income.

This article is written by ICO Economists Dr. Christoph Sänger, and Dr. Marcela Umaña.

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