Exogenous factors: Assessing the role of government policies

As mentioned above, demand and supply of wheat are subject to several exogenous factors. In order to ensure food security (a primary need for their citizens) and for land and rural management, governments play an important exogenous role in affecting agricultural commodities. Government intervention into the wheat market has taken several forms over the years, from market price supports and incentives, to export programmes, to more neutral mechanisms such as support programmes based on arable lands and historical receipts (e.g. the new Common Agricultural Policy in the European Union). In a market that continues to become more global and open to trade flows, a single sudden decision to ban wheat exports – as Russia did after the 2010 drought – or to add a levy on imports can have significant repercussions for prices, at least in the short term. Due to their pervasive action, changes to subsidy programmes require a phased approach. Government intervention in wheat markets has been justified by the existence of imperfect competition in international markets (Corden, 1991), where monopsonistic STEs deal with an oligopolistic international trade market. In recent years, however, policies within the WTO have trended towards open global markets.

Governments have responded with accommodating policies, such as the privatisation of the Australian and Canadian Wheat Boards. The European Union has been decoupling payments to producers from payments linked to the production of a specific crop after the reform of the Common Agricultural Policy (CAP) in 2003. However, the size of this programme is still significant. The CAP budget, directed to all commodity sectors, amounted to $78.2 billion (€60.8 billion) in 2012, roughly double the value of EU wheat production in the same year ($41 billion). Even though this amount accounts for less than 1% of EU GDP, it is still a significant amount in agricultural commodities markets, where arable lands are 60% crops (Eurostat in 2007)¹²⁵ and production value is typically low in absolute terms. As a result, any additional decoupling in the European Union or reduction in US export subsidies could influence market developments. The EU decision to decouple payments from production quotas or direct price support (to be fully implemented with the new reform in 2013; see Box 8) together with the decision to increase support to the development of rural areas, may trigger interesting market developments. The OECD (2004) measured the effects of decoupling resulting in a reduction in arable land and a reduction in export subsidies, and found that consumers would benefit from greater competition. Markets are still internalising the long-term effects of this decision, resulting in a gradual reduction of export flows from Europe due to lower production subsidies. Direct government interventions on market prices have been decreasing over the years, but in the form of direct payments to producers they are still significant in many regions (see Box 8). As today, the European Union does not provide direct market support to wheat production, and the United States has reduced its support to roughly $1.1 billion. The implications of these rapid changes in subsidy programmes are still to be fully understood. Lower protection for farmers in the European Union does not only mean lower use of land (Hermans et al., 2010), but also consolidation at the local level led by greater competition among regional areas within Europe and beyond. This process may ultimately benefit final consumers, despite the potential for more volatile patterns as the market begins new developments.

The gradual reduction of harvested lands after the oversupply and quality problems in the 1980s, with subsidies based on the quantity of commodity produced (then taken over by quotas), is a broader phenomenon affecting both the European Union and the United States as a result of technological changes and consolidation of farms (Figure 147).

Figure 147. Arable acreages (kt)

Source: Author’s from USDA.

125 Available at http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/Agri-environmental_statistics.

As long as reduced acreage is offset by increases in yield and greater production, this process may be beneficial for consumers in terms of quality and cost. However, this is not a foregone conclusion; yields in Europe and the United States struggle to exceed those reached during the 1980s (5 and 3 tonnes per hectare, respectively).

Figure 148. Wheat production yields (tonne/ha)

Source: Author’s elaboration from USDA.

Subsidies and other interventions may also affect incentives to invest in agricultural infrastructure. Structurally low prices and high land values for prolonged periods can distort investment incentives. This is perhaps one of the reasons the EU has decided to build a second pillar of investment for greater development of rural areas. The US market-oriented programme does not explicitly tackle this issue yet. China, meanwhile, has been massively investing in agricultural infrastructure and has gained ground compared to western economies with respect to agriculture, with the ambitious intent to overcome significant obstacles (e.g. water supply and loss of agricultural lands) and become self-sufficient rather than a huge importer of agricultural products. Finally, the effects of state interventions depend in many ways on the incentives. Export subsidies, for instance, ensure high volumes but may have perverse effects on quality (Larue and Lapan, 1992). Overall, greater market-oriented supply and demand interaction improves income transfer and consumers’

welfare (OECD, 2004). However, following sudden exposure to market conditions, it can take several growing seasons for all market adjustments to occur, increasing volatility in the short term.

Box 8. The evolution of government intervention in agriculture in Europe and the United States

Government intervention into agricultural markets has played a significant role in the development of agricultural markets. In 2011, global support to agriculture reached over $252 billion (OECD, 2012), mainly concentrated in the two biggest subsidies programmes (by budget) by the European Union ($78 billion) and the United States ($74 billion).¹²⁶ Including indirect support through investment in research, marketing and rural areas, the amount of resources allocated to agriculture in OECD countries soared to over $400 billion in 2011 (34% of total production value; Figure 149).¹²⁷

126 Including support for rural areas development, research, marketing and indirect transfers (disaster relief, etc).

127 There are three aggregates of government subsidies used in the OECD statistics. The total support estimate (TSE) is the broadest indicator of support, representing the sum of transfers to agricultural producers individually (the PSE) and collectively (the GSSE), as well as budgetary subsidies to consumers. The general services support estimate (GSSE) measures the monetary transfers associated to public financing of services such as agricultural research and development, training, inspection, marketing and promotion and public stockholding.

Figure 149. Total support estimate (US$mn)

Source: Author’s elaboration from OECD Library.

Among the countries and regions most active in governmental support to agriculture, the European Union is the only one that has consistently reduced is support to agriculture, which dropped below $120 billion in 2010. Both China and the United States, the two biggest economies in the world after the European Union, have increased the size of their intervention in agricultural markets in absolute terms.

Figure 150. Total support estimate (TSE) by region (US$mn)

Source: Author’s elaboration from OECD Stats.

Only China appears to have increased its government contribution (direct and indirect) to the economy in 2010, both in relative (GDP) and absolute terms. The European Union, in contrast, has further reduced its direct and indirect contribution after the historical peak in 1998 (Figure 151). China has overtaken the European Union in size of total intervention, both in absolute and relative terms. Chinese intervention (direct market support) almost doubled in 2010, to $90 billion (from roughly $50 billion in 2009). Additionally, despite commitments towards a more market-oriented intervention, the United States has gradually substituted old direct support to producers (only $30 billion out of $147 billion) with indirect measures that may only partially reduce distortive effects on agricultural markets.

Figure 151. PSE (left) over the value of gross farm receipts and TSE (right) over GDP (%)

Source: Author’s elaboration from OECD. Note: The ‘total value of gross farm receipts’ is the sum of the value of transfers to producers (PSE) and the value of production (VP; farm production at farm gate prices), minus market price transfers to producers (MPS) as this is included in both the PSE and VP values.

The rationale used for government intervention are threefold:

 Ensuring food production under fair conditions.

 Promoting a sustainable use of resources.

 Preserving rural areas.

The achievement of these three objectives is considered a public good (i.e. goods that are non-rival where the use by one person does not exclude another’s use) and non-excludible (people cannot be excluded from using it). Under this line of reasoning, subsidy programmes have been activated to protect domestic prices from global trade flows, to promote environmentally friendly production practices, and to encourage investment in historical rural heritage. However, such interventions (in particular, volume-based incentives) may create significant distortions to market equilibrium and may adversely affect long-term investment incentives. As a result of significant distortions that have emerged over the years, subsidies to support output or to guarantee minimum prices are being used less and less by governments around the world

Today, such supports account for less than 30% of global subsidies. Such reductions have helped foster the development of a global and competitive market for agricultural commodities. The long-term objective is to remove obstacles and align domestic prices as much as possible with international ones.

Such a result would likely benefit emerging economies, but could offer new challenges to the more advanced countries that control most of the global food supply.

The European Union Common Agricultural Policy

The Common Agricultural Policy (CAP) was first introduced in a much smaller European Union (with six countries) in 1962. Since then, the CAP has expanded (as the European Union grew) and has been progressively modified since the late 1980s to adapt its programme to important market developments.

The CAP is still today the biggest item in the EU budget, but its relative weight has gradually decreased over time from over 60% to 32% of the EU budget in 2013. Total resources (including research and rural areas development) amount to $120 billion, of which $103 billion (€74 billion) are direct payments and $17 billion indirect support to agricultural markets (not to producers).

Figure 152. EU CAP expenditure (€bn)

Note: 2007 constant price.

Source: European Commission.

A multitude of interventions have been pursued over the years, but the most notable reforms started at the end of the 1980s when the distortive effects of subsidies based on volume of production or minimum market price caused oversupply and bad long-term incentives. In 1988, after the start of the 1986 WTO Uruguay Round, a ceiling on EU direct payments to farmers and a limit to quotas were introduced to help limit oversupply. This was the beginning of a more market-oriented CAP, the process of which will still take years to be completed. Exceptions still exist (e.g. fruits and some vegetables), but most of the market support subsidies have been gradually removed. From 1992 (with the MacSharry reform), the CAP introduced some adjustments to face the issues of overproduction and the problems with quotas. Measures to support prices or levels of production for specific commodities were cut and replaced by fixed payments based on land area and animals in 2002 (as the year of reference), and payments based on current planted area and animals (Figure 153).

Figure 153. EU CAP direct support expenditure ($mn)

Source: Author’s elaboration from OECD.

In 2003, the European Union decoupled subsidies from a particular production and linked payments to compliance with specific rules about the quality of product and the environment. The reform did not include sugar subsidies (of which the European Union is the biggest producer), which have been reformed in 2005 by reducing resources given for guaranteed prices.

Since the 2003 reform, the amount of decoupled payments is almost 70% of all direct support provided by the European Union to agricultural producers (Figure 153). The decline in support prices has reduced the gap with world market prices and the exportable surplus in some commodities; the European Union has become a net exporter of beef, for example (EU COM, 2009). It also caused a slight drop in production for all crops in the European Union in 2009-10, while consumption kept growing. This may have contributed to price spikes and volatile patterns.

The CAP today is therefore radically different from what it was in 1962, and the 2013 reform aims at changing its nature even further. Besides the cuts to total expenditures, the reform is going to strengthen the second pillar, i.e. investments in development of rural areas, and complete the phasing out of the direct market support programme. From 2019, the basic payment scheme will introduce a uniform payment per hectare (capped to €300,000 per year), which will be supported by additional resources for those that comply with ecological practices and organic production procedures (known as ‘greening’).

Additional resources would be also set aside for areas with natural constraints, young and small farmers (to balance the strong consolidation process in act), limited coupled payments, and cross compliance (e.g.

with environmental rules). Finally, the ‘new’ CAP would promote further investments in rural development, among other innovation, low emissions, and ecosystems. The standard 50% EU co-funding would be increased to 85% in less developed areas.

The US subsidies programme

The subsidies programme has been developing in the United States since 1934, through the constant reform (every five year) of the original farm bill. The 2008 Food, Conservation, and Energy Act is the current farm bill applicable to agricultural markets, which should be reformed by the end of 2013. After several reforms over the years, today the programme includes direct payments based on pre-determined rates and historical production (since 1996), guaranteed minimum prices (with support to exports), counter-cyclical payments, and yield and revenues insurance.

Figure 154. US direct support expenditures ($mn)

Source: Author’s elaboration from OECD Stats.

The programme also introduces grants for production of biofuels, which can cover up to 30% of the cost of developing refineries for production of advanced biofuels, and tax breaks for producers of cellulosic biofuel. In addition, in 1985 the US Department of Agriculture (USDA) introduced the Export Enhancement Programme (EEP) to support with cash payments exports to specific countries at competitive prices. Support was limited in terms of disbursement and tonnage after the Uruguay Round and ultimately halted in 1996 (but only officially cancelled in 2008). On top of these direct interventions, there are investments in research and marketing, investments in rural areas, and additional programmes for indirect support to the agricultural industry. The yearly budget in 2011 was $147 billion, of which $31 billion was direct payments (Figure 154) and $116 billion indirect payments. The funding of indirect payments includes $40 billion directly from taxpayers (minus $5 billion back to consumers) and $75 billion from the government for marketing, research and infrastructure (such as direct aids, loans, insurance, disaster relief, etc.).

Direct payments are below 10% of the total production value, but when including indirect support the share rises to 39.4%. Interventions have been redistributed with general programmes (such as disaster payments) and subsidies for specific commodities production, such as corn, wheat, cotton, rice and soybeans.

Figure 155. US agricultural subsidies, 1995-2010

Source: Environmental Working Group.

In the last decade, direct support has been focused on commodities that are indispensable for food and energy production (roughly 55% of US agricultural subsidies; Figure 155). As a consequence, subsidies (and so prices) have a dual policy for agricultural products sold in domestic markets and abroad, with potential distortive effects in international markets.

Conclusions

The acknowledgement by governments of the direct and indirect impact of subsidies policies on long-term investment incentives have gradually shifted the focus of these programmes over the years from pure market support to indirect producers’ income and revenues support with fixed payments, crop insurance and disaster relief, among other interventions. More time, however, is needed to understand the full spectrum of effects that government interventions generate in these markets. Most notably, direct market price interventions in an open market model with international trade are unable to create incentives to tackle underlying problems of market structure. When the fiscal capacity of a country is reduced, the market has to face sudden adjustments in the flows of commodities (e.g. oversupply) with highly volatile patterns, especially for agricultural commodities for which the opportunities costs of the land are generally higher in relation to other commodities markets.

Another issue is that most of global production is priced against the US dollar in international markets, which can expose producers and merchants to exchange-rate risk. As suggested by the empirical data, the strength or weakness of the dollar is a key driver of price formation in wheat. The dollar, then, becomes an additional vehicle to channel the effects of expansionary monetary policies on commodities markets that have been generally considered anti-cyclical.

Table 56. Key exogenous factors

Government intervention Main other external factors

Medium Weather, exchange rates, oil prices, fertilisers, lands value Source: Author.

Finally, crude oil prices have become an increasingly important factor in agricultural markets.

The widespread use of petroleum-based fertilisers and the impact on incentives to produce energy from agricultural production (e.g. from ethanol) have increased the importance of oil prices in the discovery of prices for several commodities. The price of agricultural commodities may be increasingly correlated to oil prices in the short run. The more oil prices increase, the more wheat and other related crop prices could rise as this increases fertiliser costs and the incentive to produce biofuels.