Catalog

Reasons to be Nervous: Commodity Prices and Inflation

Food and fuel are core elements in Asian household budgets. Rising prices pose serious economic challenges and risk spilling over into more general inflation pressures. In early 2008, prices of a raft of commodities have reached all-time highs in real terms. Figure 1.1.49 shows the path of real oil prices over the last 27 years. Commodity food price indexes are now also testing new heights (Figure 1.1.50). High food prices raise particular concerns about the circumstances of the urban poor and fooddeficit, poor rural households. Rising rice prices are of particular concern in developing Asia with countries such as Pakistan and Philippines being major net importers (Figure 1.1.51).

Though some of the factors influencing prices such as geopolitical events or weather-related impacts are likely to fade, there are also strong structural factors—both on the demand and the supply side—that are pushing up prices of food and fuel and these have some mutually reinforcing effects (Boxes 1.1.4 and 1.1.5). Oil prices have consistently risen by an average of about $10 per barrel annually in nominal US dollar terms since 2002 bringing its average price in the year ending in February 2008 to $95 per barrel. Rice prices in US dollars per metric ton, again in nominal US dollar terms, roughly doubled between December 2002 and December 2007 (from $188 to $372) but in early 2008 have exceeded $500 per metric ton.¹⁵ Though it is unlikely that price rises will be sustained secularly, the outlook for the next 2 years is for continuing upward pressure. There is also a risk that cost inflation may lead to demands for upward adjustment of money wages or increased fiscal outlays to subsidize food and fuel consumption. The subsequent monetization of the fiscal costs coupled with accelerating wage increases are potential triggers for an inflation spiral of prices and costs.

Inflation pressures, stoked by rising food and fuel prices, are building in much of developing Asia. Headline CPI inflation rates accelerated in 26 of Asia's developing economies in 2007 relative to 2006, remained constant in one, and decelerated in 17—for the bulk of the populace in the region CPI inflation rates have gone up. There is the prospect of accelerating inflation in 2008, despite administrative restraints that hold recorded numbers in check (Table 1.1.3).

Food prices make up a significant part of the weights used in the calculation of headline inflation and food price indexes show a strong positive correlation with the CPI indexes across developing member countries for which data are available (Figure 1.1.52). Food accounts for 59% of the CPI weights in Bangladesh, 57% in India, 55% in the Philippines, 33% in the PRC, and 42% in Viet Nam.

Empirical studies of the relationship between inflation and poverty and income inequality tend to support the view that poverty incidence and reduced shares of the bottom quintile in the distribution of household income are associated with high inflation (Blank and Blinder 1986, Cardoso 1992, Datt and Ravillon 1996, and Romer and Romer 1998). Without a doubt, rising food prices hurt the urban poor. It forces them to spend more of their income on food and less on other essentials such as education and health (Son forthcoming).

The relationship between food prices and rice prices in particular and the incomes of poor rural households is complicated by the fact that many marginal farmers produce rice. The impact largely depends upon whether households are net buyers or net sellers of foodstuffs or can source rice consumption directly from their own production and stocks. The ability of rural households to afford food may be positively influenced by higher farmgate prices for their outputs so that selling more homegrown rice makes them better off as they can sell high-quality rice and buy lower-quality rice or other substitute foodstuffs. However, data taken from expenditure surveys of rural households in India show that the lowest income decile's consumption of homegrown rice is less than 20% of its total consumption, so that people in that decile may well be worse off when food prices increase (Figure 1.1.53).

Precisely because of the potential social hardships posed by higher food prices, governments throughout developing Asia are considering various measures to restrain price increases and secure supplies. Import duties on food and cereals are being temporarily cut in some countries and in others exports are being taxed or indeed restricted to boost domestic supplies. Net food importers have been prepared to pay premium prices to secure supplies of staples such as rice. In a number of countries, such as the PRC, administrative price controls on foodstuffs have been introduced, after a sustained period of price liberalization (Box 1.1.6).

The fiscal implications of subsidies on food, fuel and, in some countries in developing Asia, on closely related inputs into food production such as fertilizer and electric power consumption for irrigation pumps, threshing machinery, and tractors are worrisome. For example, in Indonesia fuel subsidies alone ate up 12% of the central government budget in 2007 and it is estimated that the budgetary cost of fuel and electric power subsidies with oil prices at $100 per barrel would rise to almost $26 billion in 2008 (Kong and Ramayandi 2008).¹⁶ In India, the new fiscal budget for 2008/09 is assumed to run a deficit equivalent to 3.1% of GDP, though this omits the state budget deficits as well as the cost of fertilizer and fuel subsidies, which are thought to be substantial.

Food subsidies are also costly. Using data from a rural household expenditure survey, estimates can be made of the cost of rice and wheat subsidies in rural India (Tables 1.1.4 and 1.1.5). Together, rice and wheat subsidies cost Rs23.5 billion in 2004/05.¹⁷ The amount of the outlay in the central government budget expenditure in 2007/08 to maintain the same level of subsidy will without a doubt be far greater as rice and wheat prices are now considerably higher.

The supply response of farmers globally and in developing Asia will eventually relieve the pressure, but only if markets are allowed to work and weather conditions and energy prices, which have a critical influence on fertilizer costs, accommodate the response. Efforts to accelerate technical progress and improve productivity through infrastructure, especially irrigation systems, and institutional support through credit markets and extension services, will also be important.

Movements of primary commodity prices are also thought to have important macroeconomic effects. They are leading to a dramatic shift in the commodity or barter terms of trade—in favor of oil and cereal and other raw material exporters and against those exporters of manufactured goods that also rely heavily on commodity imports (such as Korea, Pakistan, and Sri Lanka). The G3 countries that are large importers of mineral fuels have also experienced terms of trade reversals as a result of rising commodity prices. Table 1.1.6 shows which countries are net food and fuel importers and exporters and provides an indication of which countries may gain—and which stand to lose.

On balance, only Indonesia and Kazakhstan appear unambiguously to benefit from recent price rises as net food and oil exporters, and Indonesia only marginally so. Even though several Asian countries are net exporters of food, the oil bills they face are more than swamping the positive effects from net food export gains. Malaysia has net positive balance-of-payments effects from the movement in prices as its net oil exports vastly exceed its net food imports.

Trade price indexes for a selection of countries in developing Asia are shown in Figures 1.1.54 and 1.1.55. Constructing these indexes for a broader sample of countries was not possible due to data limitations. These data suggest that significant transshipment centers have seen a much more modest recent decline in their terms of trade, as they are cushioned from any adverse movements against domestic exports. Thus in Singapore, with about a 3% decline in 2007 (Figure 1.1.54) and Hong Kong, China, with about a 4% loss (Figure 1.1.55), the changes are modest. In contrast, large commodity-dependent East Asian economies are suffering far more serious consequences. Korea has seen an almost 50% deterioration since 2002, again with a sharp decline in mid-2007 that has likely worsened. Taipei,China shows a slightly more moderate decline of around 20% over the past 3 years.

Persistence of high and rising commodity and energy prices may force some tightening in monetary and fiscal policy in order to avoid inflation consequences even as income growth decelerates in the coming year.

Though few reliable data are as yet available, the likely deterioration in the terms of trade in those economies in developing Asia that are reliant on food and fuel imports and that are exporters of labor-intensive manufactured goods—Cambodia, Nepal, Pakistan, and Sri Lanka—are likely to be severe and may add further downward pressure on income growth just as the rise in import prices puts further upward pressure on the CPI. India, in contrast, has a favorable export basket featuring iron ore, precious gems, and foodstuffs.

Southeast Asian economies that export a mixture of commodities including oil and gas along with manufactures are likely to be less exposed to terms of trade losses. The impact on the PRC is uncertain but is likely to be negative as well.

In summary, inflation pressures are mounting throughout the region (Table 1.1.3 above). Surges in food, fuel, and raw material prices are a result of both structural and cyclical forces, as well as unanticipated shocks. These are pushing up costs to firms and households and may soon elicit demands for higher wages. If costs escalate, firms will eventually have to pass them on in higher prices. Appropriate macroeconomic responses to accelerating inflation are likely to include tighter monetary policy and some exchange rate appreciation. Resisting appreciation by tracking global interest rates down would only aggravate inflation pressures. Though governments may be tempted to resist commodity price increases through administrative measures, these are likely to come with a high fiscal price tag, which may add to future inflation. Artificial restraints on prices and inflation today that blunt market incentives are only likely to lead to higher prices in the future. Carefully targeted direct income support for the poor, within strict budgetary limits, might better alleviate stresses, and at much lower cost.

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