Food Bells? Ringing the Risks of Food Prices

Food prices continue to ride a rollercoaster. In the first quarter of 2011 the food price index of the United Nations’ Food and Agriculture Organization set new records in real and nominal terms. While food prices haven’t been the cause of the wave of unrest sweeping the Middle East and North Africa, a City analyst concludes privately, “Prices and scarcity have certainly been factors in destabilizing Tunisia, Egypt and possibly Libya.” Egypt was self-sufficient in food production in the 1960s; now one-third of its food is imported and it’s the world’s largest importer of wheat. So Egypt imports political risk from the potential impact of drought in China, and exports food supply risks given the volumes of food transiting the Suez Canal. No wonder futures markets show sharp spikes.

Why higher spikes? Start with supply and demand. Population increases and more affluence increase direct demand and leveraged demand as a larger global middle class switches to more resource-intenSuresive “western” diets. Overall, the World Bank expects demand for food to rise by 50 percent by 2030. Further, policies change demands on agricultural land.

Competition for land is intensifying, partly due to rising demand for meat and biofuels, but also from land uses like conservation, carbon sequestration and the world’s growing cities. Supply is constrained by deteriorating soil quality, land degradation, desertification, poor infrastructure, and post-harvest losses due to inadequate logistics.

Finally, food supply growth has attenuated as the productivity gains of the “green revolution” run out of steam. Water scarcity, too, is already a major issue and higher oil prices mean higher food prices, by raising the costs of fertilizer, on-farm energy use, processing and transportation — as well as increasing demand for biofuels.

Perhaps we are at an inflection point on land prices. Has land been historically undervalued, and is it about to be re-valued sharply upwards as the world hits the wall where there is no easy way to increase land supply? Some analysts think so.

Food shortages, food prices and long-term food security are issues of huge concern worldwide. So far, governments have often made matters worse through short-term actions or narrow pursuit of national interest without regard to broader consequences. Import-dependent Middle Eastern countries have engaged in panic stockpiling, forcing prices still higher. Others set price controls that keep demand high and remove incentives to farm. Western farm subsidies and food aid lead to supplies being almost randomly dumped on local markets, further undermining local farmers. Meanwhile, exporter governments prove all too ready to introduce export bans for domestic political reasons, adding to global instability.

Some government leaders call for price controls on the physical and derivative markets. While there is evidence that financial flows can have temporary influence at the price margins, there is little to suggest that speculation is really altering supply and demand fundamentals. Food prices are going up, and becoming more volatile, for reasons rooted in the real world. Badly designed controls could create more risk, deny finance a vital part in dampening food problems, and starve future investment.

Commodity markets are an important initiator of financial investment in agriculture. Hard-nosed finance has the potential to fund improvements in logistics for greater efficiency, point out that unsubsidized biofuels are uninvestable, seek improved land rights, invest in yield productivity, fund further research in agricultural methods and pool global risks to smooth local problems, i.e. insure.

At the same time, “good guys” — farmers, food producers, supermarkets — hedge, buy or sell forward to meet unexpected demands. With hedging comes speculation: the two are different sides of the same coin. Policymakers need to recognize that smoothing prices through fiat does nothing to resolve the underlying causes of food inflation and volatility, while creating a host of unintended consequences. So, what’s a poor insurer to do?

First, keep a closer eye on commodity markets than previously; price volatility is the best risk indicator. Second, think the unthinkable about hungry people: food pirates seizing ships at canals or ports, terrorists targeting food, cascading waves of resource nationalism. Third, make the case that markets are not just pricers, “canaries in the food mine,” but the source of the finance that will build a more robust future food chain.

Topics Agribusiness