Can we contain the global inflation crisis?

Amidst all the furore regarding the Labour administration's embarrassingly mis-managed tax shortcomings, the cries of those in the UK warning of a growing humanitarian crisis in the developing world have been lost.

Rising raw material prices, in particular rising food prices, are now causing real hardship and what represents a cause for shoppers in developed economies to grumble is a matter nothing short of life and death for the millions less fortunate around the world. This note considers what many emerging countries are doing and why their actions, far from alleviating the problem, are actually making matters worse.

Lord Mark Malloch Brown is a junior minister in the current Labour administration. He has a reputation for being forthright and often puts his colleagues' hackles up. He is also the former deputy secretary general at the United Nations and an acknowledged authority on global issues of critical concern. His recent comments regarding the growing food crisis are significant both because he has identified some of the root causes and because he has taken steps to raise the matter where some of his more craven colleagues dare not.

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Lord Malloch Brown describes, somewhat unoriginally, the confluence of factors he sees as serving to cause food prices to rise as a "perfect storm". These factors are: a series of poor harvests in Australia, the incremental demand for improved diet caused by the newly prosperous parts of China and India, coupled with the now wide-spread process of biofuel "flag planting" on land previously devoted to the production of food stuffs. We would add a few additional factors, on which more below.

Bang on cue, the United Nations secretary general Mr Ban Ki-moon has warned that, if allowed to escalate, permanently higher food prices could not only damage global growth but also, possibly, global security too.

Rightly, the secretary general has stuck to the UN's remit by indicating that an environment that has seen wheat prices double and the price of rice explode higher could seriously put back the process of global poverty elimination. "If not handled properly, this crisis could result in a cascade of others (including the imposition of quotas and the banning of exports) and become a multi-dimensional problem affecting economic growth, social progress and even political security around the world".

The biofuels debate is interesting from a number of angles. Firstly, it is not absolutely true to say that the commitment of land to the production of biofuels automatically reduces food production everywhere (although that hardly makes the European Union's full-on encouragement of plant-derived fuel right).

Supporters of biofuels tend to use the Brazilian experience as justification for the dash to plant-derived fuel alternatives, not that that country's success should detract from the fact that there are a lot of other places where land which would otherwise have been used to grow food for human consumption has now been given over to the production of biofuel to feed machinery!

The EU could, for example, call a halt to its pre-announced intention to derive 5.75% of petrol and diesel to be manufactured from plants, although we understand the EU's difficulties given growing stresses in the oil market too.

The developed world has hardly covered itself in glory on this matter either. In particular legitimate questions might be asked of Western countries' commitment to what has become known as the "Washington Consensus". Part of the reason why a number of African countries are now back on the verge of starvation is that developed nations, through their International Monetary Fund (IMF) conduit, actively encouraged many African governments to cut farming subsidies and focus instead on producing cash crops for export and by so doing, open up their previously closed economies.

That the plan has backfired is made obvious by the fact that many countries are now struggling to grow sufficient to meet basic levels of domestic demand. Whilst the UN falls back on its World Food Programme to raise sufficient funds to feed starvation zones, what is really required is greater research and development, improved credit facilities and ultimately a "green revolution" similar to that which took place in parts of Asia, not that the Asian experience is without its own pressure right now.

From the point of view of global economics there has always been a gulf between the "haves" and the "have-nots". Generally speaking, the larger a country is, the greater the likelihood that it will be richly endowed with natural resources. The fact that not even the largest countries are so well endowed in every scarce resource is reflected in the fact that imported inflationary pressure has become a global issue. Indeed, some of the world's largest and most populous countries are those with the greatest dependency on imported raw materials.

Estimated top global countries by resource production

The chart shows resource wealth, calculated using the most recent production data for energy, basic resources and agricultural products using average prices achieved over the previous quarter. Against this is plotted a countries' wealth on a per capita basis, to show that some countries are likely to benefit significantly more than others. On this basis, Saudi Arabia, Canada, Australia and Russia stand out. The second chart (below) compares the global share of a country's estimated resource wealth against its share of global population.

Share of global resources plotted against share of world population

The threat of protectionism

Protectionism is a word that will strike fear into the hearts of supporters of global free trade. It is, however, alive and well and indeed thriving in the prevailing environment for food and energy where higher prices are exerting a particularly severe squeeze on consumers in emerging markets. In turn, those same consumers are pressing for higher wages, which in turn is having a negative impact on regional inflationary pressure.

Inevitably, Asian governments are acting to try and limit this inflationary pressure but, as ever, the tools at their disposal are limited and in the case of export duties / quotas and subsidies on imports, particularly blunt instruments.

Food is, of course a highly emotive issue in the region and often weak administrations have experienced a sharp increase in public demonstrations against higher prices over the past two quarters. We anticipate that this is something we will see more of as the Beijing Olympics draws near.

In attempting to protect domestic markets from exogenous inflationary shocks many countries are closing their borders and / or restricting trade in the commodities in which upwards pricing pressure has been most severe. But export barriers reduce the global supply of scarce commodities and serve to push prices even higher. Not only that; it is our suspicion that what we are seeing is not some transitory effect but something that could well last for some time, particularly if the globalisation process reverses.

In due course the cost of maintaining subsidies and reducing exports could have a marked negative effect on many countries current accounts, limiting the scope to use currency strength to limit rising cost pressures. In addition, by subsidising local producers to keep prices down, governments are essentially dis-incentivising industry and limiting the attraction of producing more, again serving to drive prices higher.

At the same time, these measures often act to limit the scope for foreign investment, often a necessary pre-condition for industry development in developing economies. The end result is the same, reduced production and higher prices.

The following table, reproduced with the kind permission of UBS, reveals recently imposed agricultural trade restraints by country.

The role of oil prices

Just as agricultural product prices are rising, so is the price of oil on world markets. This should come as no surprise since government action to interfere with the price of oil on the world markets has been in place for over a century.

It is hardly a surprise, in the prevailing environment, that industry watchers are alert to criticism regarding producing countries attempts to derive increased royalties, impose higher taxes and raise local ownership to benefit more fully from the seemingly inexorable rise in prices. At the same time it should come as no surprise that oil consuming countries are redoubling efforts to improve oil efficiency and alternatives.

Two additional developments have occurred further to muddy the water. Firstly, upstream oil operations are being increasingly denied access to local resources and where access is granted it is becoming more costly to acquire.

Secondly, local governments are increasingly giving up on the idea of local subsidies on oil consumption, thus removing the historical protection local populations have hitherto been afforded from the vagaries of the international oil price.

This is not an issue for the major oil exporters of course and petrol still costs less than $1 per gallon in countries such as Saudi Arabia and Venezuela, but it is increasingly a matter for serious concern in countries such as India, Thailand and Indonesia where local subsidies have been halted, and may become an issue in China although oil imports are still relatively modest when set against the overall size of the country's population.

Conclusion

Although we continue to argue that for developed Western economies inflationary pressure is a lagging indicator, not a leading indicator, we fully accept that, in the round, inflation and the authorities' reaction to it is becoming the primary driver of macro economic policy measures. As a consequence the outlook for growth has become much less assured.

In the United States it is estimated that the combination of higher gasoline prices, coupled with the ongoing deleveraging process following the credit crunch is at least twice as powerful as the coming temporary fiscal stimulus. In Europe, inflationary pressure has been rising and given a relatively limited exposure to the first round of the credit crisis so far, the European Central bank has kept regional base rates on hold at 4.0%. The Bank of England has been more pro-active but overall regional growth is beginning to slow appreciably. Elsewhere, the outlook for growth is even worse. Sustained inflationary pressure is now apparent in Latin America, Africa, Australia, Japan and elsewhere around East and South Asia.

Inflation is rapidly becoming a crisis that policymakers in both the developed and developing world are not well equipped to deal with. How well the lessons from previous inflation shocks are learnt and acted upon will determine how persistent and severe the current crisis proves to be.