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Are high prices a remedy for high prices? This possibility is often overlooked in the ongoing debates on spiralling food...

Are high prices a remedy for high prices? This possibility is often overlooked in the ongoing debates on spiralling food and oil prices. The UN summit in Rome that concluded on June 5 was no exception. The rhetoric ranged from the optimism of policy reform in developing countries geared to higher public investment in agriculture, modernisation of agricultural technology and its diffusion, and sustainable use of land and water, to the despair over unchanging lifestyles in the USA and other affluent OECD countries, and their reluctance to dismantle agricultural subsidies. In particular, subsidies for biofuel production in USA continue to divide large segments of the developing world from others, with the former exaggerating the distortions and the latter its potential benefits. Underlying these debates is the presumption that drastic policy changes in the developing or developed world would act as a magic wand in containing spiralling inflation.

A recent report, OECD-FAO Agricultural Outlook 2008-2017, released on 29 May, 2008, argues persuasively that high food and fuel prices are likely to persist during the next decade. In a broad-brush treatment of supply and demand factors, it elaborates that, despite record wheat and coarse grain crops in 2007-08 and a sustained moderate rise in production thereafter, grain markets are expected to remain tight up to 2017. Rising per capita incomes, dietary changes with significantly higher shares of meat and dairy products, and developing food markets have resulted in global demand outpacing domestic production capacity. Besides, growth in grain-based ethanol industries in USA and Europe as well as feed requirements from thriving livestock industries in developing countries are likely to exacerbate the imbalance.

Compared to the average for 1998 to 2007, nominal prices projected for the period 2008-2017 will on average be around 20 percent higher for beef and pork, 30 per cent for sugar, 40-60 per cent for wheat, maize and skim milk powder, more than 60 per cent higher for butter and oilseeds, and over 80 per cent higher for vegetable oils. In real terms, however, the decade-over-decade increase is lower but substantial for crops and dairy products. Besides, several factors are likely to render market prices more volatile. These factors include low stock to use ratios, changing weather patterns with more frequent droughts, growing industrial demand for agricultural commodities, and massive flow s of commercial funds in agricultural futures markets for speculative gain. In fact, billions of dollars have poured into the commodity futures market 8212; from pension funds, endowments and a host of other institutional investors 8212; through the new conduit of commodity index funds. Views, however, differ on whether such speculative financial flows could fuel inflation for long.

Food price inflation benefits the producers but harms net buyers of food 8212; such as agricultural labourers. A recent and somewhat alarming estimate of the impact of soaring prices on poverty by the World Bank, for example, is that about 100 million people in developing countries are likely to be pushed into deeper poverty, 30 million in Africa alone. So the case for protecting the poor from the ravages of spiralling inflation in the short-run is unexceptionable. Although the UN Summit in Rome drew pointed attention to the imperative of much larger investments in agriculture for raising productivity, it did not emphasise the role of high prices in raising yields in the short and medium- run 2-5 years.

Research conducted by us, in collaboration with Katsushi Imai and Ganesh Thapa, focused on the transmission of rising global prices to domestic prices, and shows significant differences between China and India. The extent of adjustment in the short and medium-run is generally larger in China than in India. However, the adjustment is larger for wheat, maize and rice than for fruits and vegetables in both India and China. Also, while most of the domestic commodity prices move in tandem with global prices, the transmission is partial because of distortionary government interventions like input subsidies.

A related issue is the responsiveness of crop yields per hectare to higher prices. Based on a detailed econometric analysis of RBI data on crop yields, and wholesale prices over the period 1970-2007, there are significant supply responses of higher prices. For an increase of 1 per cent in the wholesale price, rice produced per hectare is higher by 0.40 per cent; the corresponding wheat supply response is slightly larger 0.47 per cent; the coarse cereal response is of a similar magnitude 0.44 per cent; but that of pulses is relatively weak 0.11 per cent. These results are further corroborated by the strong supply response of foodgrains in the aggregate 0.45 per cent. Indeed, the long-run supply responses are considerably larger.

So in conclusion, a strong supply response induced by high food prices may help contain spiralling inflation more effectively than adhoc policy changes like higher interest rates, lower import tariffs and export curbs.

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Raghav Gaiha is Professor of Public Policy at Delhi University8217;s Faculty of Management Studies University of Delhi. Varsha S. Kulkarni is a visiting scholar from the University of Wisconsin