Poonam Munjal: The global food threat

The likely impact of global food inflation on domestic prices will significantly add to the challenges of maintaining macro-economic stability.

At the global level, a poor harvest coupled with rising demand has led to an overall increase in food prices. Unfavourable weather conditions in parts of Europe and North Africa, together with the worst ever drought to have hit Australia, have put stocks of major food crops, especially wheat, at record low levels.

Tight supply pushed up the prices of wheat to unprecedented heights, significantly affecting food inflation across the world. In order to boost sagging agricultural production, the demand for fertilisers from developing countries rose, pushing up their prices as well.

High energy prices, particularly for natural gas, a major input into the production of fertilisers, further added to the surge. This has recently led to lower utilisation of fertilisers and hence, to a decline in crop productivity, further affecting already spiralling food prices. Record high international freight rates made bulk food imports extremely expensive. Increased fuel costs, port congestion and high demand for food and feed products from importing countries have been the underlying factors that led to an escalation in freight costs.

For the last few years, a number of countries have heavily invested in the production of green fuels or bio-fuels. Global warming and the rising prices of crude oil have been the main driving factors. A number of food and feed crops, meant for consumption, are now being used for bio-fuel production, further worsening the global food situation.

The US has increasingly been using corn for the production of fuel ethanol. In 2006-07, more than 20 per cent of the corn crop was used for ethanol production, which was nearly twice the amount used for ethanol in 2002-03, and the figure is expected to double again in the next two years.

In response to escalating ethanol demand, both corn futures and corn cash prices have increased rapidly in the international markets. The firming prices of corn, the primary animal feed, have further resulted in the increased prices of livestock and dairy products.

Food-based fuel production is also rising in other parts of the world. Brazil, the world's largest sugar producer and exporter, is now converting half its sugar harvest into fuel ethanol, eventually leading to a surge in international sugar prices.

In Europe, the emphasis is on producing bio-diesel using edible vegetable oils. Among the Asian countries, in China, apart from corn, grains like wheat and rice are also used for the production of bio-ethanol. Thailand is concentrating on ethanol from cassava, while Malaysia and Indonesia are investing heavily in additional palm oil plantations and new bio-diesel refineries.

In India, ethanol is produced largely from sugarcane. Other than the fact that a number of food crops are being used to produce bio-fuels, there is a significant shift of acreage from essential crops to fuel crops, the inflationary consequences of which are increasingly visible.

Figure 1 shows the year-on-year variation of international food prices, plotted with that of wheat prices. The year 2002 ended with the food inflation jumping to over 14 per cent, largely because of the record low world wheat stocks resulting in steep rise in its prices. This period corresponds to the severe drought in Australia and North Africa.

However, the situation improved with higher than expected wheat harvests in Russia and most of the Asian countries. Subsequently, the year 2004 saw acceleration in food inflation even higher than in wheat. This was the beginning of the increased use of food crops in the production of bio-fuels. This period is marked with unparallelled price rises of corn, soybean oil, palm oil and rapeseed oil, depicted in Figure 2.

In short, the recent escalating trend of food inflation is the consequence of a combination of global dry conditions and the ever-increasing use of food crops for fuel production, reinforced by rising disposable incomes of countries like China and India, who spend more than half of their growing income on food, contributing to surging demand.

In India, a fairly good monsoon and the policy measures taken by the government have so far helped in containing the food inflation within the range of tolerance. But the risks are high, given that traditionally self-sufficient India has now become a marginal importer of food grains. Although the rabi harvest for the year is expected to be above the normal level, the production of other crops like pulses, rice and oilseeds has not been able to keep pace with rising demand.

The first half of 2007-08 witnessed record growth in the imports of pulses over the same period last year. The more we are dependent on imports, the heavier is going to be the impact of soaring world food prices on domestic food inflation. The surging prices of fertilisers in the international market are also posing a threat to both inflation and agricultural productivity.

Another matter of concern for India is the rising use of vegetable oils for the production of bio-fuel in various countries, as India is a large importer of vegetable oils. The domestic supply of vegetable oils, which is more or less stagnant, is insufficient to meet the rising demand, resulting in rising prices. The prices of soybean oil rose by 8 per cent in 2007-08, those of rapeseed oil by over 10 per cent, and those of imported edible oils by more than 11 per cent.

Recognising the global food threat, the government has made several policy moves to contain food inflation by increasing domestic supply. These include reduction of import duty on a number of food items and prohibition of exports of wheat and rice. To increase production, acreage devoted to wheat was increased considerably during this fiscal year.

However, if the next monsoon is not up to the mark and if the demand exceeds production, making dependence on imports inevitable, spiralling world food prices would have dire consequences for domestic food inflation. With the current rate of inflation already facing pressure from international oil prices, the inflationary effect of food prices will significantly add to the challenges of maintaining macroeconomic stability.

The author is Economist, CRISIL