March 16, 2009
Trying not to repeat history: China swine prices to piggyback on feed costs
By legislating swine price bands based on corn and piglet prices, Beijing may create the very market outcome it is trying to avoid.
An eFeedLink Hot Topic
by Eric J. BROOKS
The last three years have been very volatile for China's swine sector. Moreover, the government, chastised by the problems created by pork's cyclic volatility, has recently announced measures to tame it.
These measures, though quite commendable in principle, require considerable, permanent state intervention in China's swine sector. They may also create the very negative outcome they were created to prevent,
Moreover, they carry implications for the trade off between hog farmers, grain farmers and the misallocation of feed and livestock resources. To understand the government's unprecedented step to control swine market volatility and its implications, we should first review the events that led up to this point.
What brought us to this moment
High hog prices in the middle of this decade led China into inevitable overproduction, low prices and a mass sow slaughter in 2006. As is often the case, the sow culling turned out to be excessive, particularly in the face of rapid economic growth and rapid rises in per capita meat consumption.
By 2007, swine prices were well on their way to rising by 100 percent for that entire year. Moreover, thanks to the previous year's excessive sow culling, a shortfall of piglets made them unaffordable to many backyard farmers, thereby exacerbating shortages and inflation.
Then last year, a combination of high prices and recessionary conditions after mid 2008 resulted in unexpectedly low pork demand and a trend of mostly falling prices ever since.
Unlike in the west where low meat prices are now counterbalanced by equally cheaper feed, in China, the government, to protect grain supplies and pacify rural farmers, has kept corn, soy, rapeseed and cottonseed prices artificially high. This means that lower hog prices have not been completely counterbalanced by lower feed costs. As prices initially fell more quickly than feed costs, profit margins have fallen close to non-existent levels.
Moreover, with grain prices staying stubbornly near their government sanctioned floors, the severity of today's global recession is causing pork demand to fall. Hence, after the hyperinflation of only two years ago, prices could, over the next year, fall significantly below the cost of producing pork. Consequently, eFeedLink analysts stated that given the momentum of current market trends, without government intervention, hog prices could plunge in second half of 2009. This would then trigger a mass slaughter of sows, thus resulting in extremely high hog prices in 2010.
Learning from the past?
However, the government is determined to avoid re-living the wild 2006 to 2009 hog price cycle of overcapacity, overculling, hyperinflation, shortages and deflation followed by a return to overcapacity and culling. Beijing's seriousness can be seen in the fact that six Chinese ministries; the National Development and Reform Commission, Ministry of Finance, Ministry of Agriculture, Ministry of Commerce, State Administration for Industry & Commerce and General Administration of Quality Supervision, Inspection and Qurantine recently issued a comprehensive joint policy designed to tame future swine market price volatility.
Price ratios for hogs to corn, piglets to pork
Henceforth, hog prices and piglet prices will only be allowed to fluctuate within flexible price ranges. The hog price band will fluctuate with hog feed prices while the official piglet price band will go up and down with pork prices.
The new policy sets an ideal hog to corn price ratio of between 6:1 and 9:1, with the profit/loss break even point estimated to be around 5.5:1. When the hog to corn price ratio rise near 9:1 or falls to near 5:1, the government will intervene in the market in order to bring the hog to corn price ratio back into the favoured 6:1 to 8:1 price range.
For piglets, the government considers a piglet to pork price ratio of 0.7:1 the break even point for piglet rearing. As is the case with hogs, when the piglet to pork price ratio falls to 0.7 or rises significantly above it, the government will take steps to bring piglet costs back into line. The plan also aims to keep hog and fertile sow inventories above 410 million heads and 41 million heads respectively.
Hog to corn price policy particularly problematic
This policy has all the shortfalls and contradictions inherent in any price control mechanism operating in a supposedly open market. However, it is the price linkage between swine and corn that is particularly problematic. As we shall see, it implies all sorts of trade-offs and distortions of the feed and swine sectors can be accomplished through fiat policymaking initiatives.
To keep prices and inventories of sows and piglets within their respective price bands, intervention at all points of the supply chain is possible, with great flexibility implied. As we shall see, this flexibility can be used not only to implement policies in different ways but to actually reverse outcomes from their stated policy objectives.
If for example, the hog to corn price ratio exceeds 9:1, the government could bring this ratio back into line by selling hogs or pork from national reserves. That would keep grain prices constant but lower hog prices until the hog/corn price ratio was again below 9:1.
On the other hand, if it felt that the greater threat was not from high hog prices but low grain prices, it could buy up corn until feed prices rose.This would keep swine prices constant but increase grain prices until the ratio fell below 9:1. In both cases, the profitability of swine would deteriorate. The question then becomes, 'are we trying to keep pork cheap or make grain more expensive?' Both are possible, depending on what side of the corn/pork equation is manipulated to keep price ratios within policy guidelines.
Policy's flexibility results in ambiguous execution, ambiguous policy objectives
Conversely, if the hog to corn price ratio fell below 5:1, the government could restore this price ratio by either buying hogs until their prices increased or selling corn until its price decreased. In that case, regardless of whether it bought hogs or sold corn, the profitability of hogs would improve. Under this scenario, we must reverse the above question, as it now becomes, 'are we trying to keep pork expensive or make grain cheap?' Both are possible, depending on what side of the corn/pork equation is manipulated to keep price ratios within policy guidelines.
Yet, it is this policy's very flexibility, particularly the ratio between hog and corn prices, that can be its undoing. As demonstrated above, while it is ostensibly designed to safeguard pork prices and supplies, the policy is ambiguous to the point of confusing. The above example can be manipulated so that instead of safeguarding pork prices, it can also be used in a reverse fashion -that is, to safeguard corn prices and corn inventories -at the expense of the swine sector.
Hence, in a fast moving chaotic feed and livestock markets, it is not just the hog/corn price band's policy execution that can be reversed. Policy objectives can also be changed from protecting hogs to protecting corn growers, without informing either of the two industry's stakeholders!
In conclusion, the new hog to corn price band appears to protect China's pork producers but carries several inherent risks within it. The obvious one is that, even if properly executed, it safeguards against potential losses and producers from shortages -but at the cost of lowering farmers' profits in good times and keeping consumer pork prices artificially high in bad times.
The second risk is that of policy hijacking. For example, without making any official pronouncements until it had been obvious for several months, China's government recently went from putting a ceiling on corn prices to putting a floor underneath them. The first policy helped keep meat prices artificially low; the second policy is now keeping the cost of chicken and pork higher than it should be. Much market speculation will now shift towards speculating if the government is favouring the high or low end of the swine/corn price ratio, or if it is secretly controlling corn prices while using the hog price's relationship to corn costs as a cover.
Potenital for ironic, unintended outcomes
Consequently, under the new hog to corn price band ratio, we can never be sure if it is corn or swine prices that are being manipulated. As demonstrated above, a given price objective can be executed by either selling hogs or corn. What is not stated is that while these price ratios can be manipulated to control pork prices at the expense of corn raising profits, they can also be used to control corn prices at the expense of hog farming profits!
Hence, this policy announcement has the potential to create considerable confusion within China's corn and swine sectors. In the worst scenario possible, both hog and corn farmers will be left scratching their heads, wondering if policymakers favour the higher or lower end of their price band. Should policymakers quietly decide to abandon swine price stability and instead defend corn prices at the expense of pork, it will have the scope to create even more market upsets.
Hence, while the recently announced price band has laudable goals, its ambiguous execution and objectives may undermine its effectiveness. At the very least, it will tempt policymakers to use their market intervention power to favor a pro-pork outcome over a pro-corn outcome or vice versa. In the long run, this may result in a serious misallocation of grain, feed and meat producing resources. That would be ironic, as this policy was ostensibly formulated precisely to prevent such market imbalances.
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