Goodbye to cheap oil and cheap food

By the Economist

Currently two serious external shocks are affecting the balance of payments, inducing a spate of inflation and causing severe hardships to people. The oil price hike has been sharp and serious. Price of oil has more than doubled within 24 months and is on a continuing uptrend. Soaring food prices have caused havoc in developing countries. Prices of wheat, corn, rice, barley and dairy products have all increased significantly since 2005. The London Economist characterised the phenomenon of high food prices as a permanent one in the title of a cover story last year: “Good Bye to Cheap Food’. In fact it is “Goodbye” to cheap oil and cheap food. The April 17th issue of the Economist reconfirms this with respect to food prices: “Agriculture is now in limbo. The world of cheap food has gone. With luck and good policy, there will be a new equilibrium. The transition from one to the other is proving more costly and painful than anyone had expected. But the change is desirable, and governments should be seeking to ease the pain of transition, not to stop the process itself.”

The high oil and food prices are here to stay. This is indeed bad news for the Sri Lankan economy as we need to import all our requirements of oil and a significant amount of basic food items. Wishing that the price hikes in oil and food would pass away is a futile exercise as structural changes are underpinning these price escalations. Any idea that oil prices and food prices may slump is optimistic. Both oil and food prices will remain at high levels though they may come down slightly from their current prices for short periods of time. What this means is that countervailing policy responses are needed to cope with these external shocks. Our national economic policies require adjusting to these changes to make their impact less adverse.

There are fundamental and structural reasons for both the oil price rise and the food price escalation. These cannot be reversed. All what a small trade-dependent economy such as Sri Lanka could do is to adjust to these shocks that have large costs and some benefits. Sri Lanka’s trade dependent economy has always been vulnerable to international price movements. We have been bombarded by external economic shocks ever since independence. There have been also spells when we have benefited from international price escalations as during the Korean War when rubber prices skyrocketed. Even the current oil price escalation has had some benefits. These include the high prices for rubber, increasing demand for tea from oil producing countries and employment opportunities in countries benefiting from higher incomes from oil.

The reasons for this phenomenal price increase are to be found in both supply and demand sides. On the supply side, climate changes have led to reduction of crops and dairy production. There has been a shortfall in grain production around the world and especially in the large grain producing countries like Canada. While the Canadian wheat crop has declined by about 20 percent, rice production in Australia has declined by nearly one half. New Zealand’s milk production has fallen to low levels resulting in a reduced exportable surplus and soaring prices. The sharp increases in petroleum prices has led to not only a rise in the costs of agricultural production, but also resulted in prime agricultural land being converted from food production to bio-fuels. On the demand side, there has been a substantial increase in food consumption especially in the fast growing large countries of China and India. In China the increased meat consumption has meant a reduction in grain availability as several times more grains are needed for conversion into meat. India that was self-sufficient in grains finds the level of demand outpacing its supply. Russia, benefiting from the high prices of oil has led its more prosperous population to consume more grain and meat. All these factors are likely to lead to a continuous increase in food prices.

Agricultural production has been on the decline for a number of years. Yield levels have fallen sharply since the 1980’s to reach a plateau so much lower than they were two decades ago. This is so particularly with respect to rice, wheat and maize in developing countries. Low prices of wheat and rice in the past decade has resulted in farmers taking their land away from grain production. The shift has been to other crops as is the case in Australia, where lands cultivated with grains have been converted to more profitable grape production for wine. The price hikes when depicted graphically appear like the take off of a missile, while yield levels appear as a sudden fall of an aircraft to low altitudes. The rise in oil prices has two important impacts. First, the cost of production of grains has risen owing to increased costs of inputs and tractor costs. The other insidious impact has been the conversion of good agricultural land for bio-fuels. Both these factors have also been responsible for the reduced supply of grains.

In the case of oil, the increased price of oil is due to increasing consumption, disruptions in production and cartel type reduction of output to derive higher prices. This is in an emerging situation of declining stocks of known and available oil supplies. Temporary factors, especially the turmoil in the Middle East and uncertainties in supplies, have added to the fluctuations within a trend of increasing prices. There should be no illusion. Oil prices would not come down once the political problems are resolved as the reducing stocks of international oil on the one hand, and the huge increasing demand for oil from newly industrializing countries of Asia, on the other hand, are at the bottom of the oil crisis.

The implication of all this is that Sri Lanka has to accommodate these changes and adjust the economy to cope with them. External shocks require internal adjustments. In the case of food prices the path is clear. The country must put more resources for the improvement of yields. Research should be better funded; the extension services revamped to be effective in conveying best practices to farmers; institutional credit has to be expanded to reach more farmers; marketing and storage facilities have to be improved; irrigation facilities have to be expanded to increase the cropping density on land; rural infrastructure has to be developed; and reforms of the agrarian structure have to be undertaken. These are the vital changes that are pre-requisites for improving agricultural productivity.

In the case of oil price increases, the response has to be two-fold. There is a need for conservation in the use of an expensive imported resource such as oil and alternate sources of energy require to be developed. Even with sharp price increases of oil, there is inadequate curtailment of demand. This implies adoption of more effective policy measures that would ensure a reduction of consumption. Alternate energy sources would include small hydro plants, wind power, coal power generation and use of Dendro and bio-fuels for power generation. Unless countervailing measures are adopted to cope with these external shocks they could become the stumbling blocks to development.