Sunday, January 16, 2011

What is causing food price volatility?


Changing petroleum prices, crop yields, food stock levels, and exchange rates are the main culprits, but trade policies and a lack of reliable, up-to-date data are also driving the volatility.

In what is potentially an even more worrying trend, implied volatility—which represents the market’s expectations of how much the price is likely to move in the future and can only be inferred from the prices of derivative contracts such as options—has been increasing steadily since the mid-1990s. The implied volatilities of three key staple foods—soybeans, maize, and wheat—show a clear upward trend, indicating a steady increase in uncertainty.


So argues Hafez Ghanem, Assistant Director-General of the Food and Agriculture Organization. Specifically, volatility in four variables—petroleum prices, crop yields, food stock levels, and exchange rates— significantly increases food price fluctuations.

Causes:


First, petroleum price volatility—which tends to be high—translates to food price volatility through transportation costs and fertilizer prices. The link has become even stronger with the advent of biofuels, which require food crops as inputs and can therefore change food prices.

Second, because the demand for food is inelastic, small changes in supply can lead to big changes in prices, meaning that even limited crop yield volatility can have large effects on food price fluctuations. The role of crop yield variability is only expected to rise as extreme weather events become more common.

Third, food price volatility is inversely related to the level of food stocks—as stocks fall, price volatility rises. Both public and private actors have lowered stocks in recent years. This trend may be reversing itself, however, as countries are revising their reserves policies in response to recent bouts of volatility.

Finally, changes in exchange rates, especially of major exporting countries, translate to changes in international food prices. Thus, as macroeconomic factors lead to more volatile exchange rates, food price volatility also rises.

[…]an additional cause of price volatility: the lack of reliable, up-to-date information on crop supply and demand, stocks, and export availability.

[…]it is possible to argue that increased speculation contributed to higher food price volatility.

[…]real factors such as production shortfalls in key exporting countries—and not speculation—triggered the two recent bouts of volatility (in 2007–2008 and 2010).


Solutions:

  • Yield-enhancing investments (R&D in infrastructure that promote irrigation as well as drought-resilient crops and their hybrids)
  • Trade policies (completion of the Doha Round of negotiations so that trade distorting subsidies can be reduced, and perhaps include tighter rules on export restrictions)
  • Improving market transparency (information about both the real market and related financial transactions)
  • Reforming policies for grain-based biofuels (introducing call options for biofuels—a market-compatible instrument—would guarantee that producers shift grain from producing biofuels to providing food during crises—a mutually beneficial outcome)
  • Review stock policies (adequate emergency food stocks, or strategic reserves, must be maintained at the national, regional and global levels)
  • Financing instruments (institutions need to act ex ante and provide import-financing or -guarantees to alleviate credit and foreign exchange constraints)
  • Commodity exchanges (regulatory frameworks governing commodity exchanges must also be reviewed to reduce speculative behavior and thus limit volatility)