Impact of High Food and Fuel Prices on Developing Countries—Frequently Asked Questions

What is happening with food and fuel prices in developing countries?

Why is this happening?

What are the implications?

Is there relief in sight?

What can and should be done?

What can the IMF do to help?

How is the IMF providing financial assistance?

Q. What is happening with food and fuel prices in developing countries?

A. A world-wide commodity price boom picked up pace in 2007, notwithstanding financial market turmoil and slowing growth in major economies:

• Food prices have risen by 45 percent since end-2006, mirroring earlier price run-ups in other commodities (Source: IMF Commodity Price Index).

• Many prices reached record highs in current US$ terms—including those for crude oil, tin, nickel, soybeans, corn, and wheat. The surge was led by some major food crops (corn, wheat, and edible oil), but has spread to other foods including, most recently, rice.

However, in real terms, prices of many commodities, particularly foods, remain well below their highs in the 1970s and early 1980s, with the main exceptions of crude oil, lead, and nickel.

Q. Why is this happening?

A. Prices have been propelled by a mix of permanent and temporary factors:

• Strong food demand from emerging economies, reflecting stronger per capita income growth, accounts for much of the increase in consumption. Although demand growth has been high for some time now, the recent sustained period of high global growth contributed to depleting global inventories, particularly of grains.

• Rising biofuel production adds to the demand for corn and rapeseeds oil, in particular, spilling over to other foods through demand and crop substitution effects. Almost half the increase in consumption of major food crops in 2007 was related to biofuels, mostly because of corn-based ethanol production in the US; and the new biofuel mandates in the US and the EU that favor domestic production will continue to put pressure on prices.

• At the same time, supply adjustment to higher prices has remained slow, notably for oil, and inventory levels in many markets have declined to the lowest levels in years.

• The policy responses in some countries are exacerbating the problem: (i) Some major exporting countries have introduced export taxes, export bans, or other restrictions on exports of agricultural products. (ii) Some importing countries are not allowing full pass-through of international prices into domestic prices (less than half a sample of 43 developing and emerging market countries allowed for full pass through in 2007).

• Drought conditions in major wheat-producing countries (e.g., Australia and Ukraine), higher input costs (animal feed, energy, and fertilizer), and restrictive trade policies in major net exporters of key food staples such as rice have also contributed.

• Financial factors: the depreciating US$ increases purchasing power of commodity users outside of the dollar area; falling policy interest rates in some major currencies reduce inventory holding costs and induce shifts from money market instruments to higher-yielding assets such as commodity-indexed funds.

Q. What are the implications?

A. To date, most developing countries have been able to absorb the balance of payments impact. Higher export earnings or inflows of capital and transfers helped finance the higher commodity imports.

The overall effect of the commodity price hike on the terms of trade has varied widely across countries. In about half the countries of sub-Saharan Africa, the negative impact has been offset by rising food and fuel export prices.

Higher food prices have been passed through to domestic markets in most countries, but the responses to fuel price increases have varied (the pass-through for oil-exporters averaged slightly over half of that for oil importers).

Concerns center on possible second-round effects on inflation and the poor:

• Headline inflation is up in many countries. This is a particular concern in developing countries where food expenditure shares exceed expenditure shares in other goods by a large margin. Food price increases accounted for almost 70 percent of 2007 headline inflation in emerging economies. Looking ahead, the impact on inflation of food price increases will persist through 2008 even without further price increases.

• External balances of net commodity importers have deteriorated. The first round effect on 2007 current account balances exceeded 1 percent of GDP in some developing countries. With most of the increase in prices of grains and oil in the 2nd half of 2007, external balances in some LICs may deteriorate significantly in 2008.

• The social implications of rising food prices can be severe for the urban poor. Some countries in Africa have recently had food price–related riots. In Burkina Faso, there have been demonstrations in two cities. In Cameroon, political unrest spilled over into protests over food and fuel prices. Niger has also suffered food-price-related riots, while in Indonesia there have been protests over soybean shortages.

At the same time, external balances of net commodity exporters have improved. The challenge for them is to maintain macroeconomic stability while dealing with rising foreign exchange inflows.

Q. Is there relief in sight?

A.
• Oil prices are expected to moderate once a global growth slowdown sets in, depending on how much this will affect emerging economies. Nonetheless, the decline in oil prices will be limited, as high prices reflect soaring oil production costs, and OPEC is likely to reduce quotas in response.

• The global slowdown is unlikely to provide much relief this year for food prices, which are expected to peak in 2008 and then ease gradually, with upside price risks in the short term. With normal weather conditions and indications of increased acreage for planting, supply conditions for wheat and corn should improve. However, this will only provide limited relief, as food demand is less cyclical than demand for other commodities and as the increase in food demand from biofuel production is largely policy-induced.

Q. What can and should be done?

A. Policy responses need to be tailored to country-specific circumstances:

• It is hard to tell the extent to which recent price increases are permanent: the speed and size of the price increases have been large.

• Temporary prices increases can be mitigated by temporary, targeted subsidies or increased aid to protect the poorest. Countries should avoid untargeted subsidies to lower domestic food prices, direct price controls or financing of production, and export bans—which tend to raise world market prices further, may be a disincentive for producers, fail to help the poorest and drain scarce resources. More permanent shocks may require adjustment of exchange rates or monetary and fiscal policies.

• Beyond the current price boom, the most effective response for developing countries is to seize the opportunity and step up efforts to encourage expansion of domestic agricultural production by improving infrastructure, distribution and storage systems; increasing competition; providing a stable regulatory environment and access to financing; and removing trade barriers. This will increase productivity and food supply.

• Multilateral policy efforts should ensure international free trade in commodities. Restrictive trade policies to protect the urban poor in net commodity exporters tend to have unintended negative consequences at the domestic level, and at the global level, they push up world prices even further and hurt net importers. From a global perspective, maintaining free trade in commodities while fostering incentives for production and using efficient policies to protect the urban poor (e.g., targeted cash transfers) is a priority. At the same time, less ambitious and more trade-friendly biofuels policies in the EU and the US would also lower pressure on food prices.

Q. What can the IMF do to help?

A. The IMF stands ready to give countries advice on appropriate monetary and fiscal policies, as well as financial assistance:

• The IMF is carefully monitoring the commodity price boom, and we are concerned with the impact of these price increases, especially on the poor.

• In the short-run, the IMF will help countries be accommodative. (e.g. through temporary, targeted subsidies).

• The IMF can provide financial support to those countries where the price shocks are having a significant impact on the balance of payments.

• The IMF supports any multilateral efforts that ensures open commodity markets and increases temporary relief to those most in need.

Q. How is the IMF providing financial assistance?

A.
• For low-income countries with a PRGF arrangement in place, IMF assistance is being made available by augmenting the resources available under the PRGF. A number of countries that experienced qualifying shocks since late 2005 had PRGFs in place and availed themselves of PRGF augmentations (Niger in 2005, Burkina Faso in 2006, Moldova in 2006, and Burkina Faso again in 2008; Kenya reduced access under a previously augmented PRGF arrangement in 2007).

• The Exogenous Shocks Facility (ESF) can provide policy support and financial assistance to low-income countries facing exogenous shocks.

• So far, no member has drawn on the ESF. This reflects (i) that many potential users had PRGFs in place and opted for augmentations; (ii) strengthened economic policies in potential users, with many LICs able to accumulate foreign exchange reserves as a first line of defense; and (iii) favorable global market conditions up to recently. Despite the increase in world oil and food prices, many LICs experienced improvements in their terms of trade (see question above), as the prices of their other commodity exports increased as well. This may change in the months ahead.