Financial Risk Management Needs of Developing Countries: Discussion

Commodity-linked bonds afford important advantages in the external financing of LDCs relative to the traditional alternatives of foreign currency-denominated general obligation borrowing or direct foreign investment. They entail state-contingent obligations that enable LDCs that are overexposed to particular risks relative to the world economy to shift these risks to world capital markets on an ex ante basis. General obligation financing, in contrast, also shifts risk but only on an ex post basis through nonperformance with its attendant deadweight penalties. Such ex ante risk shifting clearly is pareto efficient. In contrast to direct investment and other forms of penetrating finance that also shift risks on an ex ante basis, commodity bonds-because they are linked to observable, exogenous outcomes-do not require the same degree of costly monitoring or intrusion of foreign forces in domestic decision making. The puzzle is why such bonds have not found any significant acceptance in practice. The papers in this session are important for two reasons. First, they underscore the potential efficency gains of employing commoditylinked financing. Second, they provide insights into why such financing has not been adopted, as well as how it could be implemented. The issues addressed can be grouped in three levels: (a) those that apply to commodity-linked finance whether or not the borrower is a sovereign with the related limitations on contract enforceability, (b) those that apply to a sovereign with a clean financial slate, and (c) those that apply to sovereign borrowing in the presence of an existing debt overhang. Myers and Thompson focus on the first level, computing commodity hedge ratios for a country facing variance in the quantity as well as price of its commodity exports. Their use of vector autoregression is an important extension to the typical one-period mean-variance framework because it can capture variations in both export patterns and departures from random walks in commodity prices. More discussion of the relative impacts of these two types of departures from statistical stability on the robustness and of the estimated hedge ratios, however, would have been helpful. Further, it would have been useful if hedging had been examined in a multiperiod context as well. How well, for example, would a dynamic hedging strategy employing rolling short-term hedges have performed relative to a strategy employing longer-term hedges? The calculations for Costa Rica are informative, both in terms of the commodity positions required and the resulting risk reduction. A useful extension of this analysis would have been to compute optimal hedge ratios with appropriate international risk premia for various commodity risks as well as a range of arbitrary cross-border penalties to reflect the costs of and constraints to cross-border risk shifting. Theoretical and empirical work on international equities by Cooper and Kaplanis (1986 a, b), for example, shows that relatively small cross-border penalties offset the benefits of international risk spreading for many countries, whereas for others the barriers would have to be extremely large. Such an approach could be used to identify those countries that suffer most from the incompleteness of international markets for specific risks. The Wright-Newbery paper makes important contributions at the first two levels. At the general level, without reference to limits to enforceability, it quantifies the magnitude and welfare costs of export revenue variance for characteristic countries with concentrated exports and both analyzes and quantifies the relative performance of reserves management versus commodity hedging in reducing fluctuations in its foreign income. These estimates of the costs of variance and the potential for risk Donald R. Lessard is a professor, Sloan School of Management, Massachusetts Institute of Technology