My Grain Headache...

Although financial asset inflation has been making headlines recently, for emerging market ('EM') nations it is the rate of food inflation that provides the greatest cause for concern.

A statement by the World Bank on the 21 st April outlined fears that the world's largest rice exporter, Thailand, would follow the lead of India and Vietnam and place restrictions on exports. This followed a wave of export and purchase limits imposed on staple foods from other producers such as Egypt, Indonesia and China in order to placate domestic urban consumers and keep prices down, as rice, corn, wheat and soybean prices have all hit record highs this year. (see first illustration)

This phenomenon has been labelled the 'silent tsunami', and 'silent famine' it is estimated that it will cause a global increase of 150m in the number of people who can no longer afford to feed themselves. The entirety of this figure will be residents in the developing world. In the same report the World Bank identified 33 countries that face political uncertainty over food inflation, including some of the largest constituents of EM indices such as Mexico, Indonesia and the Philippines.

Bio-fuels have been shouldering most of the blame for this increase in food commodity prices, but price rises are also a function of meat becoming an increased part of diet in the populations of a more affluent China and India. Whatever the main culprit, the World Bank concerns, coupled with producer export tariffs, indicate that there is, or will be, a supply or availability problem within the 33 countries. This means that the high prices and problems associated with it are likely to persist due to the seasonal pattern of grain harvests. There will inevitably be a lag between the re-allocation away from bio-fuels and cattle feed of any domestic grain production. People can quickly eradicate more expensive food items from their diet such as meat, but, they cannot immediately harvest more grain.

Hunger is the greatest political motivator, as people cannot simply afford to let spiralling food inflation wash over them and in the process slowly starve to death. Political unrest can manifest itself in many ways, including demonstrations, strikes, violence and rapid changes of government. As an EM bond investor, we are greatly concerned with a government's ability to pay its bond coupons on a timely basis. However we should not lose sight either of the possibility of a lack of compunction to honour debt obligations.

Great strides have been made in both the transparency and credit quality of EM government bonds. However, these countries are classified as 'EM' for a reason. This often means that the domestic politics are developing in much the same way as the economy, and they can often be very fragile through single party political dominance or military dictatorship. Therefore, in the face of political turmoil caused by potential starvation, if a government wishes to remain in power it usually faces one of two choices. Either it can adopt populist rhetoric, and implement a rapid distribution of wealth through taxes or price controls, or it can abandon the democratic process entirely and militarise the government. Either choice results in a marked deterioration in transparency owing to increased black-market activity and the absence of democracy. Most previous EM government bond defaults have been immediately preceded by a change in the government or power structure.

Structural reforms, stronger currencies and more assertive central banks have been instrumental in bringing down the level of EM inflation (see second illustration). However, exports are becoming a decreasing share of GDP as domestic demand has grown faster than overall GDP (see third illustration).

Therefore, we should not be surprised to see aggressive interest rate cuts from the newly assertive central banks to protect their domestic economies. This would undoubtedly place the local currencies in a very precarious position as the yield 'carry' versus the major currencies would be eroded and would lead to widespread repatriation of foreign exchange ('FX'). This could be further exacerbated in commodity-scarce EM countries by forced selling of FX reserves to prop up domestic currencies and prevent spiralling inflation of dollar-denominated commodity prices and FX debt obligations.

Export tariffs and price controls which, have been used increasingly to deal with price inflation problems, are rarely an effective solution. Venezuela, for example, has implemented strict price controls on over 50% of the CPI basket. Yet this has done nothing to prevent it having the highest year-on-year inflation in the northern hemisphere currently 29.1% (Source: Bloomberg). Another problem caused by increased government intervention is that it requires a larger civil service to keep check and implement increased policy intervention. This is counter-productive to the successful implementation of structural reforms and improvements that have been widespread among EM governments. The increased government expenditure associated with an overly large civil service would represent a further erosion of investment fundamentals.

Obviously these scenarios cannot be applied to all EM governments, and it is often harsh to make such broad statements. However, some of the governments that could be affected in this way worryingly represent quite sizeable contributors to EM government benchmarks. This suggests that the problem of contagion across the asset class would be very real, presenting great buying opportunities of EM debt whose governments have maintained sensible fiscal policy and structural balance. In the short term the asset class could experience real volatility, which is why we believe an overweight position in short- dated, high-yielding, commodity-rich government bonds would be a preferred position.