Food Prices: what information and regulations to avoid extreme events – Key Policy Messages by Maximo Torero

Background – high prices versus volatile prices

  • High and volatile food prices are two different phenomena with distinct implications for consumers and producers. The major problem we phased in 1970’s was high prices but in 2007 onwards it was excessive levels of volatility.
  • High food prices may harm poorer consumers because they need to spend more money on their food purchases and therefore may have to cut back on the quantity or the quality of the food they buy, or economize on other needed goods and services. For food producers, higher food prices could raise their incomes—but only if they are net sellers of food, if increased global prices feed through to their local markets, and if the price developments on global markets do not also increase their production costs. For many producers, particularly smallholders, some of these conditions were not met in the food price crisis of 2011.
  • Apart from these effects of high food prices, price volatility also has significant effects on food producers and consumers. Greater price volatility can lead to greater potential losses for producers because it implies price changes that are larger and faster than what producers can adjust to. Uncertainty about prices makes it more difficult for farmers to make sound decisions about how and what to produce. For example, which crops should they produce? Should they invest in expensive fertilizers and pesticides? Should they pay for high-quality seeds? Without a good idea of how much they will earn from their products, farmers may become more pessimistic in their long-term planning and dampen their investments in areas that could improve their productivity. By reducing supply, such a response could lead to higher prices, which in turn would hurt consumers.
  • It is important to remember that in rural areas the line between food consumers and producers is blurry. Many households both consume and produce agricultural commodities. Therefore, if prices become more volatile and these households reduce their spending on seeds, fertilizer, and other inputs, this may affect the amount of food available for their own consumption. And even if the households are net sellers of food, producing less and having less to sell will reduce their household income and thus still affect their consumption decisions.
  • Finally, increased price volatility over time can also generate larger profits for investors, drawing new players into the market for agricultural commodities. Increased price volatility may thus lead to increased—and potentially speculative—trading that in turn can exacerbate price swings further.

Key factors creating price volatility

  • Among the key factors playing a role in creating price volatility are increasing biofuel production, the medium- and long-term effects of climate change, and higher levels of trading in commodity futures markets. Export restrictions in important food-producing countries also contributed to price increases and market jitters in 2010 and 2011.
  • Biofuel policies. With oil prices at an all-time high during 2011, and with the European Union and the United States subsidizing and setting mandates for biofuel production, farmers have shifted their cultivation toward biofuel crops, most of which are also used as food or feed, such as maize, sugar, and oilseeds. To comply with biofuel mandates, farmers have ramped up production of such crops, increasing the demand for land, water, and nutrients—and therefore the production costs of other food crops. Furthermore, the production of biofuel crops strengthens the links between the highly volatile energy markets and food markets, thereby increasing the volatility of food prices. With more countries, such as India and Peru, enacting biofuel mandates, food price volatility is likely to increase even further. Flexible biofuel mandates that will not contribute to food price volatility could represent alternative mechanisms to reduce the potentially negative impact of biofuel policies.
  • Extreme weather and climate change. Extreme weather events helped raise food prices and fuel price volatility in 2007–08 and 2010–11, and climate scenarios predict more variable weather events in the future. More intense and frequent natural disasters (such as droughts and floods) resulting from climate change could trigger significant yield losses and subsequent price increases and higher volatility. Indeed, simulations show that climate change is likely to push prices up, regardless of whether population (and thus demand for food) grows faster or slower. In contrast to the 20th century, when inflation-adjusted prices of staple grains declined, in the first half of the 21st century, these prices are likely to rise.
  • Commodity futures trading. One signal of higher price volatility has been the significant increase in the volume of agricultural commodity futures traded in the Chicago Board of Trade, a leading agricultural futures exchange. (Futures are contracts between a buyer and a seller that specify a current price for a commodity to be delivered on a certain date in the future. These contracts can themselves be traded by investors who do not physically own the commodity or plan to take delivery of it.). For example, from 2005 to 2006, the average monthly volume of futures trading for wheat and maize grew by more than 60 percent. In 2007, traded volumes again rose significantly for wheat, maize, rice, and soybeans. In fact, the average monthly volume of trading in soybean futures was 40 percent larger than in 2006. Futures trading continued to increase during 2010–11 for all commodities. Between March 2006 and December 2011, the volume of commodity index funds trading increased (in terms of the number of transactions of 5,000 bushels) by 157 percent, 200 percent, and 169 percent for maize, soybeans, and soft wheat at the Chicago Board of Trade and by 124 percent for hard wheat at the Kansas City Board of Trade. Investors have increased their trading of food commodity futures, but only 2 percent of these futures contracts have resulted in the delivery of real goods. For maize, for example, the volume of futures traded on exchanges worldwide is more than three times greater than the global production of maize. Changes in futures prices have been shown to lead to changes in day-to-day, or “spot,” prices. This pattern of increasing commodity futures trading and higher prices for commodity futures can create a vicious circle that exacerbates the volatility of spot prices for food commodities to excessive levels.
  • Other factors. Today’s agricultural markets have three characteristics that make the price responses to these challenges more extreme.
    • First, export markets for the main staple commodities—rice, maize, wheat, and soybeans—are either highly concentrated in a few countries or very “thin” (that is, only a small share of production is traded). Given these high levels of concentration, the world’s capacity to cope with shocks is limited. Any incidence of poor weather or other production shocks in these countries will immediately affect global prices and price volatility. Similarly, any policy changes—such as trade bans, customs taxes, or other restrictions on exports—in any of the top exporters will significantly affect the levels and volatility of food prices. Research suggests that such policies explained almost 40 percent of the increase in the world market price for rice during the 2007–08 food price crisis.
    • Second, the world’s stocks of maize and wheat are still low, although they have improved from the historical low levels in 2007. This situation leaves the world vulnerable to food price spikes and threatens the proper functioning of markets.
    • Third, appropriate and timely information on food production, stock levels, and price forecasting has improved since the creation of the Agricultural Market Information System (AMIS) but still there is significant need of improvement.

Actions and Proposals

  • The major proposed actions can be grouped by the objectives they try to achieve: (1) better information and more research, (2) easier trade in agricultural commodities, (3) larger food reserves and better-managed grain stocks, (4) more active use of financial instruments to influence agricultural commodity markets, and (5) stricter regulation of these markets. Scholars and policymakers are debating the merits, feasibility, and likely effectiveness of many aspects of these proposals.
  • Better information and more research. Continue improvement of AMIS is needed and also there is a need to keep improving on early-warning mechanism for identifying abnormally high price volatility in the futures prices of staple food crops on a daily basis. This information could help reduce the potential asymmetry of information between buyers and sellers and thereby help dampen price volatility. In addition these models are needed at the regional and country level for which high frequency price data at country level is needed.
  • Easier trade in agricultural commodities. In the 2007­–08 and 2010–11 food price crises, many countries responded by cutting exports or boosting imports in ways that worsened price increases. Some proposals therefore aim to facilitate trade to reduce risks in grain trading when supplies are low and to avoid disruptions in global grain markets. One proposal is for a food import financing facility that would help poor countries afford food imports at times of high prices, as well as an international grain clearinghouse arrangement to ensure the availability of staple food imports. This clearinghouse would guarantee contracts for grain deliveries, reducing the risk that exporters would renege on contracts when supplies are tight. In a different approach, other observers propose preventing export bans to avoid any disruption of supplies.
  • On reserves. The focus should be on emergency reserves linked to safety net programs, not on buffer stocks. At the regional or global level global or regional reserves could be a possibility but they will require a trigger mechanism that determines when to release stocks to calm markets in times of stress, and it is essential that such a mechanism be transparent. The proposed early warning system for price volatility, mentioned earlier, could be a solution.
  • Stricter regulation. Since late 2005 problems have plagued the futures and cash markets for maize, soybeans, and wheat. The main problem is lack of convergence between cash and futures prices. To address this issue, the US Commodity Futures Trading Commission, other agencies in the US government, and the European Commission, along with the futures industry, have moved forward with setting seasonal storage rates, imposing limits on the number of delivery certificates an entity can hold for noncommercial purposes, and putting out an additional issue of the Commitments of Traders report to increase transparency. For example, in October 2011 the US Commodity Futures Trading Commission approved caps on speculation in food, energy, and metals, restricting the size of positions to 25 percent of deliverable supply. If the structural changes put in place do not significantly improve the price convergence between futures and cash prices, then a cash-settled contract must be seriously considered.
  • More active use of financial instruments. a toolbox of market-based risk management tools. The toolbox would include mechanisms such as physical or financial commodity price hedges, insurance, and guarantee instruments, as well as countercyclical lending, which could help vulnerable countries mitigate the risks associated with excessive food price volatility.

About the Author

????????????????????????????????????Maximo Torero is the Division Director of the Markets, Trade, and Institutions Division at the International Food Policy Research Institute and leader of the theme on Linking Small Producers to Markets in the CGIAR research program on Policies, Institutions, and Markets. His major research work lies mostly in linking farmers to dynamic markets, solving the ongoing challenges of global food security, volatile food prices, extreme weather shocks, famine, and conflict and unrest, analyzing poverty, inequality, importance of geography and assets (private or public) in explaining poverty, and in policies oriented towards poverty alleviation of rural areas based on the role played by agriculture, infrastructure, institutions, and on how technological breakthroughs (or discontinuities) in agriculture can improve the welfare of households and small farmers. His experience encompasses Latin America, Sub-Saharan Africa, and Asia. Dr. Torero received his Ph.D. from the University of California at Los Angeles, held a postdoctoral fellow position at the UCLA Institute for Social Science Research (ISSR), and is a professor on leave at the Universidad del Pacífico and an Alexander von Humboldt Fellow at University of Bonn, Germany. He has won the World Award for Outstanding Research on Development given by the Global Development Network (GDN) twice.