The world food market – it doesn’t make sense

Gulf states are planning to use desalinated water to grow wheat, whilst the US is already using corn to make biofuel does this really make sense? If such misallocation of resources continues, food prices are going to cause mass hunger and civil unrest worldwide.

The credit crunch is overshadowing the real danger no food

While the financial markets seem mesmerised by the credit crunch, trouble is quietly brewing elsewhere. As world markets have moved to price in recession in the US this year, the commodity markets appear not to have got the message.

Last month the President of the Philippines made a personal appeal to the Vietnamese Prime Minister, requesting that he promise to supply a quantity of rice. The Philippines is dependent on food imports and the President knows that if imports dry up, prices will skyrocket which will trigger widespread urban unrest.

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Half the world's population depends on rice, but stocks are at their lowest level since the 1970s. Securing adequate food supplies is policy priority number one for many developing countries. This political dimension means that there is plenty of mileage in the current food price boom.

Hunger sparks civil unrest

The link between food shortages and civil unrest is well known. In the year 2000 around 15m tonnes of America's maize crop was turned into ethanol, in 2007 that quantity was almost 85m tonnes, output that would normally be earmarked for food consumption. The rise in global maize prices caused 'tortilla riots' in Mexico in January last year. There have also been food riots in Morocco, Uzbekistan, Yemen and West Africa.

The truth behind Burma and China

Moreover, some episodes of civil unrest are not what they seem. Last autumn you may recall the bloody three-day crackdown on protesting monks in Burma. The media presentation of the story was quite simplistic, as if all of a sudden everyone suddenly woke up and demanded democracy.

What really kicked off the protests was a trebling of the price of rice. The reaction of ordinary people was to organise transport and secure supplies in the countryside. This led to a huge increase in demand for petrol, which the Burmese authorities subsidised at the time. But the government could not afford to subsidise the heightened level of usage, so it announced the end of the subsidy. Predictably, this didn't go down well.

In China, the annual inflation rate touched an 11-year high in January, on the back of an 18% rise in food prices. The last time food prices were a serious issue in China was 1988. Social disturbances, protests and civil unrest ensued, culminating in the Tiananmen Square revolt of 1989. The Chinese authorities are acutely aware of the dangers of food price inflation. China was a net exporter of corn, rice and wheat last year, but the government has imposed export quotas on grain in order to stem runaway food price inflation.

The reasons for rising food prices

The background influences behind the rise in food prices are well known. First the Asian middle classes are eating more meat and dairy products, creating higher demand for wheat, soya and corn for animal feed. In 1985 the average Chinese consumer ate 20kg of meat a year, now he or she eats in excess of 50kg per annum. Up to 13kg of grain are needed to produce one kilo of meat. One tonne of feed wheat, which cost £67.50 two years ago, now sells for nearly £180. Moreover, population levels are growing fast. An extra six million children are born every month.

Also, a succession of droughts in Australia has severely affected wheat production. In addition, the rising price of oil, which has been up to $110 per barrel, pushes up farmers' transport and nitrate fertiliser costs.

Finally, last year President Bush called for a massive increase in the use of ethanol in America over the next decade. The US now devotes more acreage to growing corn than at any time since 1944. Farmers planted over 90m acres in 2007, an increase of 15% on the previous year. If White House efforts to double ethanol production this year are achieved, in due course around 40% of the corn crop will end up in petrol tanks.

This is an unnecessary market distortion. It is old-fashioned government support of agriculture masquerading as a policy to increase energy security and reduce greenhouse gas emissions. The net result is a relative scarcity of food and higher prices. Indeed, the UN agency responsible for relieving hunger is drawing up plans to ration food aid in response to the spiralling costs of agricultural commodities.

Hedge funds not to blame

One other cause mentioned by financial commentators has been speculation by hedge funds and the like. Investor interest in commodities has increased. Inflows into commodity indices stood at $142bn last year compared with just $10bn in 1998. But if speculation was a decisive factor behind the rises in commodity prices, you would expect to see prices of commodities that cannot be easily actively traded by speculators, like rice and iron ore, lagging behind.

This is not the case. If speculation was an overriding influence on prices then stocks and inventories of foodstuffs would not necessarily be tight. But they are. This suggests that the fundamentals of supply and demand are the principal driving force behind rising commodity prices.

It's not just a matter of quickly adjusting supply

In the past it has paid to be quite relaxed about rising food prices, because the supply response is much quicker than in other commodity cycles like energy and metals. It takes time to increase mining or energy production capacity in response to higher prices, but with some agricultural commodities like grains, output can be increased as early as the following year through increased plantings.

But there are influences in play that suggest that agricultural prices will stay firm going forward. Oil prices continue to increase, which not only increases farmers' costs but also encourages more acreage to be earmarked to produce corn for biofuels. An even more important factor is the growing evidence that the political impetus for governments to secure scarce food supplies is mounting. The World Food Programme now thinks that a third of the world's population lives in countries with food price controls or export bans. This leads to a massive resource misallocation.

Governments make the market irrational

Let me explain. If the world today were a rational economic place, then regions such as the Gulf, which are energy rich but are food production constrained, would be investing their petrodollars in agriculture. On the other hand, the US is the world's biggest agricultural supplier, but has enormous energy demands. The rational solution would be for Saudi Arabians to buy farms in the mid-West. At the same time America would secure its energy needs in the most efficient manner by sending teams of Texans to Riyadh.

But in practice, numerous controls prevent Saudi Arabians buying Mid-West farms and Americans owning Saudi oil wells. So the law of comparative advantage is not allowed to work its magic. Instead, mutual mistrust is rising. Gulf leaders are considering plans to desalinate sea water to plant wheat in the desert, while at the same time the US and Europe are trying to turn corn into fuel. It's the economics of the madhouse, but alas, these measures make sense in terms of narrow domestic politics. And the consequence of this surge in economic nationalism? Even more food price inflation.

Russia and the Ukraine's narrow vision

The politicisation of food supplies is illustrated graphically in Russia and the Ukraine. At the moment some 23m hectares (an area almost as large as the UK) of prime crop land is unused. Both countries have erected export barriers to secure domestic food supplies and cap domestic prices, so the grain farmers have no incentive to maximise their output. This effective hoarding of food production capacity is a new blot on the rural landscape. Governments used to fret about the need to subsidise farmers and protect them from cheap imports, but now rather than keeping cheap food out, they are trying to keep cheap food in.

Politically inspired barriers to trade are a blight on the world. Consumers are crying out for more cereals, and yet countries like the Ukraine are missing out on an opportunity to meet this need. This looks like a terrific investment opening. However, an investor or entrepreneur cannot buy farmland in Ukraine. A law passed in 2001 prohibits the transfer of farmland to anyone, be they foreigner or Ukrainian. This was a misguided attempt to preserve the nation's rural heritage. But there is a way around it.

BRIC is not a block

There are interesting developments in the major emerging economies known as BRIC (Brazil, Russia, India and China). These are important markets. Last year each of the markets raised more money through IPOs than France, Canada, Italy or Japan. The boom in emerging markets last year was fuelled by aggressive easing of rates by the Federal Reserve. The MSCI index of emerging markets rallied by 25% in the six weeks following the Fed rate discount in August 2007.

But from then on, the markets went their separate ways; the Shanghai market is now over 30% down from its October peak. The economy has been hit by rising inflation, where food prices account for a third of consumer spending. In particular environmental degradation, lack of fresh water, disease and a harsh winter are damaging food production.

Like Buffet: back the commodity exporters

In contrast, the Brazilian stock market still remains incredibly responsive to Fed attempts to flood the world with liquidity. In the six and a half months after the Fed started easing in mid-August, Brazil's Bovespa index was up nearly two-thirds. Brazil enjoys an enviable combination of abundant fresh water, enormous capacity to produce agricultural commodities and secure supplies of energy.

So the trading rule appears to be that when the Fed cuts rates, funds buy into countries that are commodity exporters and exit those that import them. The legendary investor Warren Buffet certainly seems to think so. In his recent 22-page letter to Berkshire Hathaway shareholders he revealed a large holding in the Brazilian real, whose value against the dollar has soared over the last five years. And characteristically, he invests for the long term.

By Brian Durrant for The Daily Reckoning