Sovereigns facing elevated vulnerability comprise a number of small island economies and low-income, non-investment-grade states. They face the unfolding shock from a position of limited fiscal, external, and political buffers, often in combination with inherent structural or natural constraints that make countervailing fiscal or other adjustments difficult. Governments around the world are responding with short-term measures to boost domestic food availability and keep prices low.
While steps such as increased subsidies and export bans will contain political fallout, they come at a cost of additional fiscal and external pressures, which in many cases will be unsustainable. Moreover, such measures will stifle rather than stimulate the mechanism of a long-term supply adjustment that is needed to counter the apparent permanent shift in world food demand. Supply-side adjustments in the global foods market and within individual countries will lower prices in the longer term, but this will require significant investment in agriculture and infrastructure, which, for low-income sovereigns, could mean more recourse to borrowing or aid funds.
Until recently oil prices were policy makers' greatest source of vexation. Oil's economic importance and unpredictable jumps meant that it, more than any other variable, could see carefully calibrated fiscal plans rapidly become obsolete, pare back growth prospects, blow out current account deficits, and bring demonstrators to the streets. Well, given what has happened to global food prices in the past few months, one might say "those were the good old days".
As anyone either grocery shopping in the affluent UK or eating at a roadside stall in low-income Indonesia would attest, food prices have rocketed in the past few months. The rapidly escalating cost of food around the world has the potential to exert negative pressure on sovereign credit fundamentals û especially on sovereigns in the low-income group û as governments and consumers alike scramble to adjust to the new reality.
The International Monetary Fund's index of "market prices of non-fuel and fuel commodities" shows a 44.3% rise for food commodities in May 2008 compared to a year earlier. Within that category, prices for cereals, which constitute the staple food of the great majority of the earth's population, have increased by 83.2%, while wheat prices have risen by 68% and the price of rice by an astonishing 215%. These numbers give an inkling of the magnitude of wealth transfer that is likely to occur between net exporters and importers of basic food commodities, and of the inflationary impetus that is further stoked by the 85.8% year-on-year rise in energy prices that add to transport costs.
Data from around the world show that the overwhelming contributor to the recent spike in inflation is food, outweighing the impact of rising energy prices. For example, in the first quarter of 2008 food price rises accounted for more than 80% of overall inflation in China, Nigeria, Peru and Thailand, and for more than 60% in Chile, Hong Kong, Indonesia and the Philippines.
With the weight of food in the official consumer price index (CPI) basket in the sub-investment grade rating category ranging from 25% in Indonesia to 40% in Pakistan and 64% in Nigeria (see table 1), it is clear that mitigating food-price inflation is crucial for many governments. Beyond the immediate inflationary impact, however, food-price rises and the way in which authorities choose to deal with them could also exacerbate fiscal, external, and political pressures, and could even challenge governments of some exporting countries which, on paper, stand to benefit from the high prices of food commodities.
No quick fixes
To fully appreciate the likely impact on credit fundamentals in general, and of the appropriateness of sovereign policy responses in particular, it is important to understand that high food prices are not a transitory phenomenon, as they are primarily driven by structural shifts in demand and supply.
On the supply side, diverting crops and arable land away from food production toward biofuel manufacturing and urban use constitutes an inward supply shift that results in higher prices for any quantity of food demanded. Simultaneously on the demand side, the rising incomes of an expanding global population, together with changing dietary habits (toward more crop-intensive foods), are causing an outward shift in demand of a permanent nature. This means higher quantities are demanded regardless of prices, which pushes prices even higher. Governments therefore face a long-term adjustment problem and in the interim, credit quality may come under pressure from fiscal, external or political sources (or a combination of the three) as this adjustment process plays out in conjunction with the policy responses put in place to mitigate the effects of the sudden price shock.
Policy response linked to income levels
Is soaring food price inflation a monetary problem, a fiscal problem, or some combination of the two? The answer is neither immediate nor simple, with income levels and political stability being the key determinants of chosen strategies.
High per-capita-income sovereigns, which generally are politically stable, tend to adopt the monetary view, under which food price rises are fully passed through to consumers and inflation is tackled via monetary policy tightening (see European Economic Forecast: Central Banks Zero In On Inflation, published on RatingsDirect on June 30, 2008).
At the lower end of the income scale, however, both because the population is less able to absorb higher food costs and because of typically weaker political settings, a purely monetary approach is a luxury such sovereigns can't afford. For this reason, but also because maintaining strong growth momentum is the overriding policy goal of many emerging market sovereigns, fiscal and administrative measures are expected to make up the bulk of the policy response. Governments in many low-income countries, therefore, walk a tightrope, with political stability on one side of the balancing pole and fiscal and external sustainability on the other. Ruefully for them, no matter which way the balancing pole tilts, the implication for credit fundamentals is likely to be negative.
Political and social instability can swiftly eclipse a government when staple foods experience sudden price increases. In theory, countries can choose to mitigate the negative fiscal impact of high food prices by opting for smaller subsidies (or foregone revenues) and a higher level of political discomfort. In practice, however, few governments ever lean toward shouldering more political pressure for a smaller fiscal burden, aware that the price of bread had as much to do with Louis XVI's untimely demise as the peoples' yearning for liberty, fraternity and equality. Thus, well before multilateral agencies, such as the Organisation for Economic Cooperation and Development (OECD) or IMF, rang the alarm bells, governments across the income and rating spectrum, from Cambodia ($500) to Korea ($19,700), scrambled to establish measures for controlling food price rises.
In low-income economies in particular - notably Egypt and the Philippines - the price of staple foods such as rice and wheat is directly related to political stability. In both cases the governments have been proactive in controlling prices and ensuring adequate supplies. But as long as global food prices remain elevated, political and social unrest remains a risk in countries that are either too slow to react, or that mismanage their response.
The political credit an incumbent government holds with its citizens will make a great deal of difference. For those already on a weak footing because of deep-seated unpopularity or an unstable coalition, a widespread food riot could act as a galvanising force just strong enough to tip the government over. Pakistan's unstable coalition government and unpopular administrations in Cameroon and the Philippines come to mind, but even the entrenched politburos in China and Vietnam could be rattled if the ever-increasing urban populations suddenly feel they can't afford basic food items.
Speculative-grade sovereigns are going to be disproportionately affected. With a few notable exceptions, per capita incomes in this rating category tend to be low, with $3,560 projected for the 'BB' median in 2008 and $1,900 for the 'B' median. The lower the per capita income, the higher the proportion of that income that has to be spent on basic necessities.
Aside from income levels, inherent domestic production capacity is another key determinant of how a sovereign will weather food price inflation. Clearly, low-income countries that are also net food importers are worst placed to withstand the shock. According to figured from the United Nation's Food and Agricultural Organisation (FAO), the food import bill for the 84 countries it classifies as low income, food deficient countries (LIFDCs) rose by 37% last year, and is forecast to jump by another 40% in 2008.
The list of vulnerable sovereigns is, however, by no means limited to low-income, net food-importing countries. Per capita GDP figures often mask a significantly skewed distribution of income, suggesting that in many investment grade or food surplus countries û notably Russia, the Ukraine and South Africa û food price inflation could ignite social unrest; or conversely, measures to control food price rises could negatively affect credit fundamentals.The main immediate impact for vulnerable sovereigns will be on external liquidity. The FAO's forecasts starkly underline this fact, stating that the cost of the annual food import baskets for the group of lesser developed countries and LIFDCs combined, could in 2008 be quadruple that in 2000. Looking only at the 24 S&P-rated sovereigns among the 84 LIFDCs, 13 have current account deficits based on projections for 2008. Belarus and Georgia, with external deficits of 9% and 15.9% of GDP, respectively, stand out as having the least favorable starting position in the face of rising import bills.
Most of the large deficits (in excess of 5% of GDP), however, are among African sovereigns that also have much lower incomes and less-developed, narrower economic profiles than Belarus or Georgia. This means sovereigns such as Mali, with a current account deficit of 5.7% of GDP, Burkina Faso (10.7%), Ghana (8.1%), Madagascar (16.2%) and Mozambique (9.2%) are not only among the most vulnerable sovereigns in terms of external accounts, but they are also likely to find the long-term structural adjustments most difficult.
The other main pressure point will be on fiscal balances, and is likely to come from both the expenditure and revenue side. Subsidies for staple foods are common in many sovereigns in the lower- and middle-income ranges, and in many cases governments derive significant revenues from sales taxes and import tariffs on food. Higher food prices will therefore result in higher subsidies expenditure, while foregone revenues from reduced or discontinued taxes and import tariffs on food will further compress revenue bases that often are already narrow.
Removing import tariffs or lowering/eliminating value-added tax on various food items has been a common response by governments in countries such as China, Mexico, Panama and Sri Lanka, as well as a number of sub-Saharan countries. Many can ill afford higher subsidies or revenue losses, as they are facing this fiscal shock from an already precarious position of large deficits and narrow underlying revenue bases. Ghana, Sri Lanka, India, Pakistan and Egypt stand out, with general government deficits of 5.6%, 6.4%,
5.9%, 6.5%, and 6.9% of GDP projected for 2008. Sri Lanka, India and Pakistan all have revenues at less than 20% of GDP. Incidentally, all these sovereigns fall into FAO's LIFDC designation, which, as the organisation points out, will be hardest hit by the rise in food costs.
Among the 24 S&P-rated countries in this group, only Cameroon, Nigeria and Papua New Guinea are facing the food-price challenge from a position of fiscal surplus, although admittedly, largely on account of soaring oil export receipts.
Small island economies most exposed
The negative consequences of an adverse terms-of-trade shift arising from food price rises would, however, likely be most acutely felt by small island economies, such as Barbados, Cook Islands, Fiji, Jamaica, Grenada and the Seychelles, even though none of these are in the low-income category. Per capita GDP ranges from $4,000 in Fiji to $14,500 in Barbados, which in most cases would suggest some degree of fiscal and political buffer. Balance-of-payment profiles generally are what expose such sovereigns to rising food prices, although some, such as Jamaica and Grenada, are fiscally vulnerable, too.
The vulnerability stems from their economic structures, with an overwhelming reliance on tourism as the main foreign exchange earner, against a high import content of domestic consumption due to inherent physical limitations. By and large, such sovereigns have limited scope to pass on rising import costs, be it food or energy, to the tourism sector, while scarce or no arable land precludes any domestic supply response in food availability.
Jamaica, Fiji, the Seychelles and Grenada have projected 2008 current account deficits of 11%, 21%, 23%, and 38% of GDP, respectively, while the Cook Islands has a trade deficit of 41.5% of GDP. These nations face a structural adjustment of a different kind. As the inherent natural constraints allow for little if any adjustment of domestic food production, the increased food bill can only be mitigated by generating additional export earnings from different activities and trying to mitigate the terms-of-trade shift by increasing per capita receipts from tourism.
For the majority of sovereigns in both the above groups of countries (LIFDCs and small island economies), external liquidity (as defined by the ratio of gross external financing needs to current account receipts plus usable reserves) is already relatively weak. Ranging from about 100% to 170% and combined with mostly very narrow export profiles, it again underscores the external vulnerability of such countries.
Breadbaskets can slip up too
It is also worth pointing out that the "breadbaskets" of the world are not immune to potential negative effects of global food price rises, especially in terms of domestic inflation and possible political or social instability.
A case in point is Argentina, a country poised to be one of the foremost beneficiaries of the soaring food prices given its position as one of the preeminent food-exporting nations. The Argentine government's apparent redistribution efforts via increased export taxes on various food commodities (and the revision of the export tax formula that will capture any upside potential for the government), are vehemently opposed by the farming sector. It pits the rural population and exporters against the government and urban dwellers, and most ironically, threatens food shortages as a result of strike action by farmers.
Moreover, as the farmers' actions drag on, they threaten to turn the issue into a broader political problem for the Fernandez de Kirchner administration, bringing into question its management ability and style of governance. Three months into the conflict between farmers and the government, the president's approval rating was down to the low 30% range, from 52% before the protests began, aptly illustrating the potency of the food issue to inflict great political damage even to governments that in this new world of high prices should be celebrating a bonanza.
Beware of 'starve thy neighbour' policies
Spooked by the sudden rise in food prices, a number of major food exporters, including the the Ukraine, Kazakhstan, Vietnam and China, have limited or altogether banned exports of various food commodities. These measures will improve domestic food supply and hence keep prices down for at least the short run. However, in the longer run, and given the increased integration of global commodities markets, such policies will be self-defeating. The collective action of large food producers banning or restricting exports will further tighten global supply, and keep prices high. This then will feed back to domestic producers who, because their potential gains are reduced, will try to divert production to exports and will have reduced incentive to invest in the sector. The ultimate effect, therefore, will be depression of domestic availability of food, contrary to the aim of the export-ban policy.
Aside from not improving food supply in a sustainable manner, such policies are likely to have negative consequences for fiscal and external balances as well, as governments forego export earnings and tax revenues. For example, the Ukraine, where almost 10% of exports are agricultural products, has caps on both wheat and sunflower oil exports. These export controls are projected to reduce the value of the Ukraine's exports by 1.5%-2% of GDP during 2008, which will exacerbate its already substantial current account deficit of nearly 8% of GDP.
Similar results are to be expected from the policy response taken by Venezuela (one that could be followed by like-minded governments) whereby some food distributors and producers were recently nationalised. State-owned firms can operate at lower or no profit and thus keep prices low, but with no private investment in the sector and reduced efficiency, the desired long-run supply shift is unlikely to materialise.
The Argentine and Ukraine cases highlight several points. The global food-price rise causes wealth transfer from urban to rural populations in both net-food-exporter and -importer countries. Policy measures that try to reduce or prevent this transfer will be resisted by producers, potentially exacerbating divisions between rural and urban populaces, and leading to smuggling or product diversion that ultimately result in more shortages and higher prices. If the policy response is miscalculated or mishandled, the resulting political and social instability could be more than what an already weak or unpopular government could handle.
We have seen that soaring global food prices constitute a negative exogenous shock for numerous rated sovereigns. We conclude that although a rise in the price of food is itself unlikely to be the direct cause of a negative rating action, ongoing high food costs will significantly increase overall susceptibility to negative rating movements for many sovereigns. Governments who face this era from positions of limited fiscal, external, and political buffers, often in combination with inherent structural or natural constraints, will be especially challenged.
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