As Food Prices Fall, A Change in Policy Coming for China?

At a Glance

  • Market forces are propelling China to speed up market liberalization for some crops
  • Corn expected to be immediate focus of reforms

 

China has a practice of embracing market forces on its own terms, particularly when it comes to commodities, where it is often the world’s largest buyer. This is especially the case with agricultural commodities, where the government also needs to balance its responsibility for feeding 1.3 billion plus people with price stability and efficiency.

But now Beijing’s flagship food security policy of encouraging home-grown production through a domestic price support scheme is facing a fast growing challenge: as international agricultural prices fall to multi-year lows, it has been left with vast and expensive mountains of food.

 

Stockpiling Food

The government is now facing the hangover from this policy, including some unintended market distortions that have come about as a result. This is propelling China to speed up moves towards market liberalization, at least in some core crops. Such developments merit close scrutiny as they could have a significant impact on international prices, as well as providing new opportunities for foreign exporters in the world’s largest food market.

In the past decade China has had significant success boosting domestic crop production by offering its farmers a minimum guaranteed price. This was designed to satisfy a desire for food security so that 95 percent of its wheat, rice and corn needs were domestically produced.

But as international agricultural prices have slumped dramatically below China’s domestic price, the government has been left accumulating ever larger and more expensive stockpiles of everything from grains to cotton and edible oils. In March 2015, the budget for stockpiling assorted crops was upped by a third to $24.7 billion. Some reports suggest reserves of corn, wheat, and rice have exceeded 50 percent of China’s annual consumption.

The current policy is now under pressure as it leads to bloated warehouses, overproduction, smuggling and land degradation. The case of corn has been particularly problematic, as the inflated prices have fed through to downstream food production.

The guaranteed corn price paid by the government has risen to an average 2,250 yuan per ton while current import prices after tax are just 1,600 yuan per ton, according to data from BMI Research. And as corn is used as an animal feed, livestock producers have no choice but to buy the more expensive domestic corn to feed their herds, leading to higher meat prices and thus making Chinese consumers pay more for their groceries.

Because of these wide price distortions, corn is expected to be the immediate focus of agricultural reforms. In its place should come a more market-driven regime with some liberalization of corn production and pricing policy.

So what could likely happen? We could potentially see a similar transition that the United States experienced with its grain  markets two decades  ago when authorities moved from buying the commodity directly to paying a differential between the market price and the guaranteed price. This moves a step closer towards a market-driven mechanism by taking the government out of direct buying.

 

Entering the Global Supply Chain

Analysts believe a policy change will most likely come now that the fall corn harvest is complete, leading to subsidies being favored over direct buying, and pricing moving closer to the import price.

Such a shift is a positive step on the reform road as there is less direct intervention and producers are now selling in the open market, rather than directly to the government.  It also means there is no longer “double-handling” before the commodity ends up with the end-user and also avoids the need for storage, which tends to be inefficient and costly to administer.

But most importantly, it means that every season’s production now enters into the global supply chain, stored, shipped and utilized by real users, as opposed to being piled up in nondescript warehouses only to become a burden to the taxpayer and the state, and risk being rendered unusable by time and the elements.

 

Reserves and Import Quotas

Further afield, this policy of building reserves not only has a domestic impact, but also a global one. Cotton and milk are probably the two best examples. At the time China ended its buying of cotton for its reserves in 2013, it had already amassed some 60 percent of the world’s stock and prices subsequently fell steeply as markets around the world came to the realization that China was not intending to continue building its reserves.

Milk tells a similar tale. Many countries had dramatically expanded production to meet Chinese demand, but after China stopped stockpiling and increased domestic production, this led to a glut in milk products and steep price falls.  Dairy farmers from New Zealand to the UK have felt the fallout, while there have even been reports that Chinese farmers had been pouring milk away due to price declines.

In a convoluted sense, in these two examples, government intervention ironically resulted in the worst possible financial outcome, where reserves are built up while prices are high when it should be the exact opposite.. However when it comes to China, a positive financial outcome is not necessarily the most important end result.

Another policy tool employed by the Chinese government is the use of import quotas, managed by the National Development and Reform Commission (NDRC).  Under Beijing’s World Trade Organisation (WTO) pledge, annual wheat import quotas are set at 9.6 million tonnes, corn at 7.2 million tonnes, rice at 5.3 million tonnes and cotton at 894,000 tonnes. That said, Beijing has come under pressure to increase quotas in recent negotiations and allow for higher limits. According to a study by the US Wheat Associates and the National Association of Wheat Growers, China currently supports 47 percent of the value of its domestic wheat production, far exceeding its agreement of 8.5 percent under the WTO.

China is neither the first nor the last country in the world to impose import quotas, many developed countries do too to protect their markets. The use of import quotas helps to wall off domestic markets from international ones, and thus not subject onshore markets to offshore supply and demand forces. While this might seem an elegant tool to manage domestic production, prices and consumption, it does have major drawbacks, chief of which is the lack of competitive pressure creating a disincentive to become more productive. This will, through a spiral effect, lead to inefficient production, leading to higher prices, leading to further import protections, which ultimately leads back to even greater inefficiency.

 

Food Security Policy = Social Policy

All these policy tools, are being used with the noble goal of attaining self-sufficiency in production. However, as we have seen, they each come with their own set of problems. Foreign analysts, who do not know China any better, might laugh this off by saying that the policies are archaic, and perhaps even unnecessary. Let the free market reign, they say.

However, for China, any combination of policy tools will need to take into account the reality that food security policy also contains elements of social policy, where there is a desire to ensure adequate income levels and employment for rural farmers.  Agriculture accounts for around 11 percent of GDP and more than 40 percent of employment, meaning the industry remains an important contributor to the economy.

We believe that China is firmly committed to the path of structural reform to their agricultural sector. However, any change will be incremental in nature, with each step building on the previous one, towards the final aim of creating a framework that is progressive, efficient and resilient. We can only hope that China does not flinch at the pain structural reforms will bring, and refuse the medication. In this sense, reforms are much like traditional Chinese medicine, where the treatment is long and the herbs bitter, but in the end the patient finds himself whole again.

Nelson Low is Executive Director of Commodity Products, Asia for CME Group.

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