Eliminating Drastic Food Price Spikes

A three pronged approach for reserves

Joachim von Braun, Justin Lin, Maximo Torero

The 2007/08 international food price crisis caused hardship on a number of fronts. The steep rise in food prices led to economic difficulties for the poor and generated political turmoil in many countries. The crisis could also result in long-term, irreversible nutritional damage, especially among children. There is a global interest in preventing such events from recurring. This episode highlights the need to modify the architecture of international financial and agricultural markets to address the problem of price spikes, especially their effects on the livelihoods of the poor.

Although a set of guiding principles for regulating agricultural and commodity futures markets should be developed and recent inappropriate trade policy instruments such as export bans should be reviewed, these actions are not sufficient to avoid extreme price spikes and to ensure that the world can respond to emergency needs for food. We propose three global collective actions to meet these goals.

  • First, a small physical food reserve should be established to facilitate a smooth response to food emergencies.
  • Second, a new international coordinated global food reserve should be established to minimize the risk of individual countries trying to achieve grain self-sufficiency by rebuilding their own public reserves which could result in a very inefficient global production system, a large total global reserve, and a very thin global grain market.
  • Third an innovative virtual reserve should be set up to help prevent market price spikes and to keep prices closer to levels suggested by long-run market fundamentals like supply and demand without putting at risk the coordinated global reserves.

This note offers some specifics on implementing this proposal to stimulate further discussion.

Price instability is a general feature of agricultural markets. The proposals made here are designed not to stabilize prices generally, but to prevent damaging price spikes and the collapse of confidence in the international grain market. The proposed actions will entail costs, but the modest costs of the required organizational elements must be balanced against the benefits of more effective international financial architecture. These benefits will include prevention of economic hardship, improved market efficiency, stronger incentives for long-term investment in agriculture, and prevention of political instability.

The Proposed Global actions

The three global collective actions we propose—a small, independent physical emergency reserve, a international coordinated global grain reserve and a virtual reserve and intervention mechanism backed up by a financial fund—would avoid the collapse of confidence in the international grain market, with many countries now trying to achieve grain self-sufficiency and rebuild their own public reserves while ensuring that the world can respond to emergency needs for food and prevent extreme price spikes.

The independent emergency reserve. A modest emergency reserve of around 300,000–500,000 metric tons of basic grains—about 5 percent of the current food aid flows of 6.7 million wheat-equivalent metric tons—would be supplied by the main grain-producing countries and funded by a group of countries participating in the scheme (The Club). This decentralized reserve would be located at strategic points near or in major developing-country regions, using existing national storage facilities. The reserve, to be used exclusively for emergency response and humanitarian assistance, would be managed by the World Food Programme (WFP). The WFP would have access to the grain at pre-crisis market prices to reduce the need for short-term ad hoc fundraising. To cover the cost of restoring the reserve to its initial level (that is, the difference between the post-crisis price and the pre-crisis price times the quantity of reserves used by WFP), an emergency fund should be created and its level maintained by the participating countries. The fund should be accompanied by a financing facility that the WFP could draw upon as needed to cope with potentially increased transport costs, as experienced in the 2008 crisis. This arrangement could also be defined under a newly designed Food Aid Convention.

A new international coordinated global food reserve. The end result of the recent grain crisis is the collapse of confidence in the international grain market, with many countries now trying to achieve grain self-sufficiency and rebuild their own public reserves. While the motivation of each country is justifiable, the result will be a very inefficient global production system, a large total global reserve, and a very thin global grain market. In this case, if a country encounters an unexpected shock to its demand or supply which is larger than its public reserves, not only will its domestic price surge, but also any attempts to import grain from a thin global market will cause the global market price to surge. A food crisis akin to the recent one may not be avoidable by individual country action alone. It is imperative, therefore, to find a way to coordinate each country’s efforts and to restore confidence in international grain market.

While the specific features for a new international coordinated effort could be further discussed we propose that there should be an agreement under the auspices of the United Nations that each member country (from The Club) will hold a certain amount of public grain reserve in addition to the pipeline stock that the private sector holds for commercial operations. Although the exact amount of public reserve that each country holds is a subject for study, it will not be too large as a percentage of its domestic grain demand annually. These reserves would be drawn upon by the high-level technical commission only when needed for intervention in the spot market.

The virtual reserve. The virtual reserve would be implemented as a coordinated commitment by the member countries (the Club). Each country would commit to supplying funds, if needed, for intervention in the futures market. The fund would normally consist not of actual budget expenditures, but of promissory, or virtual, financing by the members. These funds would be drawn upon by the high-level technical commission only when needed for intervention in the futures market (much previous evidence has shown a link between futures and spot markets). This intervention would consist of executing a number of progressive short sales (that is, selling a firm promise—a futures contract—to deliver the commodity at a later date at the specified price) over a specific period of time in futures markets at market prices at a variety of different future positions until futures prices and spot prices decline to levels within the estimated price bands. This increase in the supply of short sales will reduce spot prices and should make speculators move out of the market—in other words, a backwardation will be created (the situation in which, and the amount by which, the price of a commodity for future delivery is lower than the spot price or a far future delivery price is lower than a nearer future delivery price). Moving speculators out of the market will minimize the potential second-round effects of this intervention given that spot prices will return to being consistent with fundamentals, and therefore the lower spot prices should not result in the accelerated use of available supplies.

The innovative concept behind the virtual reserve is the signal that it gives to markets, including speculators. Its presence alone is likely to divert speculators from entering this market. Nonetheless, the commission must be ready to trade grain when necessary and to assume the costs if in the future it must buy back contracts at a higher price than it sold them for.

Preliminary estimates show that for the virtual reserve to be a credible signal, the fund should be US$12–20 billion. A fund of this size might cover 30 to 50 percent of normal grain trade volume. Determining the exact size of this fund will require further analysis, however, because commodity futures markets allow for high levels of leverage.

Required Institutional arrangement

The three global solutions proposed require a new institutional arrangement with four major components.

  1. The Club. They would be implemented as a coordinated commitment by the member countries of the Club, which may consist, for instance, of the G8+5 plus some other major grain-exporting countries (such as Argentina, Thailand, and Vietnam). Each country would commit to a specific amount of public grain reserve for the emergency reserve fund, a certain amount of public grain reserve for the global coordinated grain reserve, and in supplying funds, if needed, for intervention in the futures market under the virtual reserve. Agreement on the arrangements for the Club will not be easy and may require a high-level United Nations task force to analyze the way forward.
  2. The global intelligence unit. The global intelligence unit, to be established by the Club on a permanent basis, would have three main roles:
    1. Forecasting prices in the medium and long run. The unit will forecast prices by combining an assessment of the fundamentals component (supply and demand factors) with a medium-term to long-term financial model in which the spot price of a commodity at a certain time is decomposed into stochastic factors. The unit would pay special attention to key indicators of how well commodity exchanges are functioning, such as divergences between spot prices and futures prices. Using models that capture fundamental forces in price determination as well as stochastic factors, the unit will incorporate the impacts of market intervention policies.
    2. Designing the optimal level of public reserve that each country will hold for the international coordinated global food reserve.
    3. Designing and maintaining a dynamic price band system. The unit would design a fairly widely defined price band based on the forecasting model.
    4. Triggering interventions of the virtual reserve. The unit would trigger the alarm to the high-level technical commission that prices are significantly outside their estimated price band (that is, the upper price limits approaching a bubble) based on the dynamic price band system. The high-level technical commission would then decide whether to approve sales in the futures markets or release physical stocks in the spot market until a speculative attack is largely eliminated. The recommendation of the intelligence unit would include the price at which sales of futures or spot market should be made and the duration and frequency of the operations.

The intelligence unit would be part of an existing multilateral institution with a small team of full-time staff. Ideally, the intelligence unit could be built within an institution that already has the long- and medium-term modeling infrastructure for price forecasting. It would also draw on existing analytical capacity in specialized organizations (such as FAO, the U.S. Department of Agriculture, IFPRI, and the World Grain Council).

  1. The high-level technical commission. The high-level technical commission, which would be appointed by the Club on a permanent basis, would make the official decision to intervene in the futures market once the triggers are activated by the intelligence unit. This commission will need to have full decisionmaking autonomy.

Final Considerations

Past efforts on stabilizing grain prices at a certain level by some individual countries have generally been unsuccessful. However, the purpose of this global agreement is to avoid the excess price surges caused by hoarding and speculation. The above agreement will restore the confidence of global grain markets; allowing the market to perform well without prohibiting its function of guiding resource allocations in response to fundamental changes in supply, demand, and costs of production. Such an agreement is a win-win solution for both consumers and producers as well as for the exporting and importing countries. This system would also help prevent the kinds of harmful ad hoc trade policy interventions, such as export bans, high export tariffs, and high import subsidies that have been both a cause and an effect of the recent price crisis.

Neither the poor nor governments can afford excessive speculation in food markets. There is clearly a need for global collective action to facilitate well-functioning grain markets. In addition the likely impacts of climate change on grain supply and demand in the coming years make action imperative!

About the Authors

Joachim von Braun (j.vonbraun@cgiar.org) is director general of the International Food Policy Research Institute (IFPRI), and Maximo Torero (m.torero@cgiar.org) is director of IFPRI’s Markets, Trade, and Institutions Division. Justin Lin is Senior Vice President and Chief Economist of the World Bank (Jlin@worldbank.org).

In Press