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.
