The Weekend Economist "Quaerere Verum": The Food Squeeze
The Weekend Economist "Quaerere Verum"
Wednesday, July 25, 2007
The Food Squeeze
The "Food Squeeze" is a global phenomenon, it doesn't matter whether you like pasta, tortillas or rice, prices are up, and set to go even further. Basic food commodity prices have been moving up steadily for quite some time now. In France alone, grain stockpiles are down to the levels of the early 70's. Those were record lows by their own standards and therefore we are witnessing an unprecedented food squeeze. So far in Europe the effect has been dampened somewhat by the strong Euro and its relative trading strength.
There's also another, albeit, temporary cushion that lies in the use commodity based instruments and derivatives such as futures and forwards. Major food firms such as ADM, Cargil, General Mills, Kellog, Phillip Morris employ these hedging instruments to protect them against cyclical spikes associated with the volatility of commodity markets. For consumers it creates a delaying effect, which means that in many cases you don't feel the immediate hike in food prices; at least not as fast as energy prices.
However, bioflation is going to end up on everybody's plate at some point. Part of the food squeeze is coming as a direct result of the rapid industrialization of India and China. When agricultural laborers move into the city, their production output is lost from farms. Industrialization could theoretically mitigate these effects by further mechanization, fertilization, economies of scale and other capital intensive processes to ramp-up output. But that takes time and money. For now at least, laborers are choosing to go to the city rather than ramp up their own agricultural output. One would expect higher food commodity higher to incentivize higher production. But this is not expected to happen overnight, and things are further complicated by the bioflationary effect of a growing biofuel economy that links food prices with energy prices
Given the sheer size of the Chinese economy and its impressive growth rate, China consumes a significant and growing slice of world wide food production. This expected to increase in tandem with slowing food production. Net food output in China can no longer keep up up with demand. As China grows and develops, its citizens will have more income to dispose on food. This increased spending power is now resonating on world markets, for grains, meats and fish.
Food prices also have a stronger impact on developing countries rather than developed countries. In china, on average, 34% of disposable income may be spent on food. In the U.S this figure is less than half. Nonetheless, food prices are amongst the highest risers in core inflation figures for the U.S. On a macro scale, for now this only slightly affects demand for other goods. In developing countries it remains to be seen how adversely these price hikes will affect overall economic growth. For the worlds poorest, the news could be rather bad, as the U.N recently announced it could no longer afford to feed the world.
The production of food is really part of a larger structural problem. As you may/may not remember from economics 101. Food is an inelastic good, everybody has to eat, and substitution is really not an option. Given the trend of industrialization, lagging production, climatic challenges and other side effects of bioflation food prices are expected to stay in a strong upward trend.The chain is deeply inter-connected. I.e. grain is not only used in domestic consumption for bread but grain is also used to feed pigs, poultry and other animals. This means that as prices for grain go up so do the costs of producing meat and other related products.
With production not keeping up, inventories at record lows, the pain that occurs when China buys food "en masse" on the world market will be felt by everyone. Indirectly, this bioflation is going to add to global inflation and possible hamper growth and development. Additionally, with higher future inflation expected, the inflation targets of central banks world wide will most likely come under renewed pressure. This ultimately means higher interest rates, and thus more expensive capital. Just last week we saw what credit repricing did to world markets. It send shock waves throughout the financial world. If last week's "correction" was just a speed bump on the road to further economic growth (as predicted by most economists) then it would be wise to investigate what further bioflation will do to the world economy.
Posted by The Weekend Economist at Wednesday, July 25, 2007