Extreme droughts and abnormally high temperatures have devastated the grain-producing areas of the US, Brazil, Russia and the Ukraine, threatening to trigger the third global food crisis marked by low supplies, soaring prices and social upheavals in the past five years.

The epicenter of the latest instability is the US Midwest, the top grain producing region in the world. Thirty-one states were stricken by the driest conditions since 1956. Meanwhile, unlike the food crisis periods in 2007/2008 and 2010/2011, the leap in agricultural prices is happening when the global economy is in a downward cycle. Furthermore, price movements of grains are increasingly synchronized. All these heighten the sense of crisis.

In 2012,1 global grain production is predicted to decline 2.7% year-on-year due to climate changes, meaning that harvest will fall short of projected consumption by 40 million tons (1.7% of consumption).2 Wheat production is expected to drop 4.7%, corn 3.2% and rice 0.4%. In the US, corn production is predicted to plunge 12.8% and soybeans3 11.9%. Wheat production in Russia (third largest wheat producer) will likely decline 23.5%, 51.6% in Kazakhstan (eighth largest) and 32.2% in Ukraine (ninth). Production cutbacks will likely decrease US' soybean exports by 17.8% year-on-year in 2012 and corn exports 16.1%.

Amid supply volatility, speculative funds have flown into the grain market leading to a surge in their prices. The net long non-commercial position for corns has risen three-fold between end-May to August 21, and wheat 94-fold. Between end-May and end-August, prices of corn jumped 44%, wheat 38.2% and soybeans 31.1%.

Rising grain prices cause prices of poultry feed, meat and food to rise, triggering agflation. The climbing food prices affect emerging market economies more than developed countries because of significantly higher portion of their household spending going toward food. Price instability caused by rising agricultural prices will keep emerging market economies from implementing stimulus measures, prolonging their economic slowdown.

Meanwhile, rising grain prices can lead to political unrests in some developing countries as was the case in 2011 in the Middle East and North African (MENA) countries, which experienced civil uprisings (Arab Spring). This summer, Iran already has gotten a dose of what may escalate. In July, rising poultry feed prices caused the prices of chicken, an essential ingredient of the Iranian diet, to surge, triggering street protests.

In short, agflation and political unrest from rising grain prices will bear down on the global economy in the remainder of 2012 and through the first half of 2013.

II. Impact of Rising Grain Prices

1. Emerging market economies: high food consumption → rising grain prices → agflation

The latest food short supply comes at an especially inauspicious time for many emerging economies. The ongoing eurozone crisis is spurring depreciation of their currencies, making imports more expensive. Hence, they are getting whipsawed by both spiraling commodity and import prices. Given their sizeable household spending on basic food, there will be no escape from agflation pressures.

The emerging economies that have less fiscal firepower will be more vulnerable. Evaluation of the shocks and response capability to agflation and food problems shows that major emerging economies including India, Egypt and Iran will likely face increasing agflation and food problems.

2. China: high share of pork in inflation rising grain pricesg"pigflation"

In China, rapid economic growth and increasing living standards have increased meat consumption and thus consumption of animal feed. China is the world's largest consumer of soybeans, wheat and rice, and the second biggest consumer of corn, putting grain imports on a relentless upward trajectory. The country is the world's No. 1 importer of soybeans, taking up 63.8% of the world's total soybean imports. In addition, it has become net importer of corn in 2009, and its imports have jumped to 5 million tons in 2011 from 1.5 million tons in 2009.

Since the country imports corn and soybeans mainly for animal feed, an increase in corn prices could lead to surge in meat prices. Pork, the staple meat in the Chinese diet, has been the main culprit in previous bouts of food inflation, and a repeat episode of "pigflation" is expected in the second half of this year, raising China's consumer price growth by as much as 1.5 percentage points in early 2013.

3. Middle East: High food imports → rising geopolitical risks → oil price hikes

MENA countries import most of their food. Egypt is the world's No.1 wheat importer and the fifth largest corn importer. Iran is second largest importer of rice in the world and the ninth for corn. Along with high food imports, the share of food in consumption is also very high, making these countries especially vulnerable to inflationary pressure from rising grain prices. In the summer of 2010, Russia imposed a ban on grain exports, and caused widespread dissent in Middle East and North African countries, which depend heavily on imports of wheat from Russia. Due to the 2011 Arab uprisings and 2012 international economic sanctions on Iran, geopolitical risks remain heightened. If grain prices rise further under these circumstances, political unrest in these countries could become severe and threaten to disrupt oil production. That, in turn, would push global oil prices higher.

4. World economy: agflation, pigflation, oil price hikes → limiting economic stimulus → delaying economic recovery

Agflation, pigflation and oil price rises will heighten the global inflationary pressure. Supply setbacks of the two necessities of food and oil will further burden the global economy that is already reeling from the eurozone debt crisis. In particular, if inflationary pressure heightens in China, the world's factory of industrial products, the global inflationary pressure will further aggravate.

With growing inflationary pressure, countries have less room for economic stimulus, which would prolong the economic sluggishness. Major emerging economies, confronting fallout from the eurozone debt crisis, have responded with various economy boosting measures, including rate cuts. However, significant agflation will put them in a bind; they won't be able to hike interest rates to tame inflation but they can't slash rates further to prop up their economy from external risks.

In contrast, developed economies are under less threat. The sting of higher prices would be less painful because a smaller share of their household spending is on food. Also, deflationary pressures are in play in the advanced countries, which will cushion the effect of agflation.

III. Implications

Industrial goods prices are relatively stable in Korea and domestic demand remains sluggish, so overall inflationary pressure will be muted. However, the nation's high dependence on grain imports will lead to higher pressure on food prices. Meanwhile, exports, the pillar of Korea's economy, are teetering, and trade conditions could worsen given the flagging conditions of emerging and advanced economies.

Under these circumstances, the Korean government needs to devise both short and long term measures to restrain inflationary pressure stemming from grain price rises and to increase supply capacity. Micro measures like stabilizing supply and demand should be promoted, while taking preemptive measures to lighten inflationary pressure from higher grain prices.

Priority should be on supporting low-income classes with high Engel's coefficient (meaning their portion of income spend on food is high) and thus more vulnerable to agflation. The government already announced plans to lower import tariffs on grains, expand grain reserves and strengthen support for poultry feed and livestock farms. It plans to use dormant lands to develop farmlands while also promoting policies to expand production of wheat and organic beans to satisfy rising demand.

In the private sector, companies need to set up a system that can respond flexibly to various scenarios in Korea's major export markets. Developing high value-added products and making inroads into niche markets that are relatively less affected by agflation are also necessary.

Finally, new opportunities should be explored even amid the potential food crisis. Agricultural companies should be aggressively fostered to take advantage of the repeating food crisis into creating new values and promoting new businesses. Farm businesses like seed businesses reduce uncertainties in farm production, and generate stable and high returns. Monsanto, DuPont and Bayer in the US have transformed into agricultural companies from chemical companies via M&As and make stable profits.

Leveraging information and communications and electronic control technologies, which Korea boasts of global competitiveness, will also be needed in advancing into agricultural businesses.

Finally, with the possibility of food crisis occurring more frequently than in the past, it is crucial to actively response by increasing investment in and fostering the agricultural industry. To this end, it is crucial to foster the seed industry into a global high-tech industry through public-private alliance as is the case with the government's "Golden Seed" project.

Note

1.2012/2013 market year (the period refers to grains that are produced in 2012 are consumed and distributed before harvest in 2013).

2.USDA (August 10, 2012) World Agricultural Supply and Demand Estimates, WASDE-509.

3.Soybeans are classified as an oilseed, not grain, but they are a key agricultural product traded at the Chicago Board of Trade along with wheat and corn.