No, and not just because Russia’s decision to exit the Black Sea grain export deal, or India’s decision to impose a ban on its rice exports. And while long term phenomena such as climate change or population growth are most certainly intertwined with volatility in food prices world over, the persistence of food inflation in Pakistan is unique and one that won’t go away any time soon. Here’s why.
Exactly four years ago, Pakistan’s began its slow journey towards a market-based currency exchange rate. Although the transition from a managed to market-based exchange regime has not been one without its set of challenges, it has almost universally been heralded as a much-needed prescription for removal of the anti-export bias from Pakistan’s macroeconomic order. A market-based exchange rate enables exporting industries to fully exploit economy’s comparative advantage by accessing resources such as raw material, labor, or capital at competitive cost, while raising the cost of imports for domestic consumers. But as reforms go, it is not only incomplete, but is also symptomatic of the deeper malaise in Pakistan’s food commodities markets, and the persistent inflation therein.
The preceding words have been chosen carefully. The market-based exchange rate is symptomatic, but not the cause of persistent food inflation witnessed in the country over the last four years. In fact, Pakistan has recorded double-digit increases in food inflation for 45 of the last 48 months, with 12-month moving average now closing in on 40 percent per annum nationally. No single food commodity has witnessed a rise in demand, output shortfall or supply chain disruption – whether due to crop failure, floods, or poor profitability – commensurate with, or significant enough to drag annual rate of food inflation to this level. In fact, monthly food price index is closing in on 40 percent at a time when headline inflation has dropped back to 28 percent, and perishable inflation – that is, vegetables and fruits which were worst affected by super floods last year – is underperforming headline CPI and recorded below 24 percent.
So, what gives? The market-based exchange rate. In simple terms, ever since the transition took place, Pakistan’s commodity markets have slowly been dollarized, with daily changes in market prices not only reflecting demand and supply position, but also the effect of exchange rate depreciation. And as the loss in currency value has picked up pace – from average annual depreciation of 16 percent in FY19 to 40 percent in FY23 –so has the rate of increase in price of food commodities, especially the ones most tradable. In fact, the higher the tradability in form and storability, the greater the rise in prices.
Don’t buy it? Consider how average prices in the basket of perishables have increased at less than headline CPI, even though production of fruits and vegetables uses more of, and thus are more impacted by rising cost of imported seeds, pesticides, and chemicals. However, rising on-farm production cost is not fully passed through, as post-harvest supply position has a greater influence on market prices than average cost of producers. Higher perish ability, along with predominantly localized demand, means that producers are by and large held captive to domestic buyers. Thus, there is little sense in dollarizing the prices of perishables. This allows market prices to witness high and reversals based on the prevailing availability and demand, rather than recording fresh peaks every few months.
The markets for cereals, grains, and other storable commodities have taken a 180-degree different route. Over the last four years, local market prices in many of these commodities have become dollarized, moving not only in tandem with international prices, but also reflecting the daily changes due to exchange rate depreciation. In any other economy, this would be business as usual. But should it also be business as usual in a country where foreign trade – both import and export – of most grains is either highly restrictive or downright prohibited?
Consider for example, wheat or sugar, where export is completely banned periodically. Or maize and rice, where local producers are protected against imports, which face a minimum of 40 percent custom duties. As foreign trade in these commodity markets is either restricted or faces prohibitive barriers, should domestic market prices only reflect local supply and demand, or trade in tandem with the international market?
A harmless question, but one Pakistan never had to battle with during the days of overvalued exchange rate. When the currency market is managed and the exchange rate artificially overvalued, producers trading in commodities facing trade barriers or import/export bans have no incentive to peg prices with the international market. Thus, even though a fixed exchange rate regime instills a sense of stability in commodities market prices, domestic market prices remain higher in dollar terms (or uncompetitive due to the overvalued Rupee), offering little incentive for outward export (if permitted). If a country has porous borders, however, there is every incentive to flood the local market with cheaper imports (due to the undervalued dollar) in case of a shortage.
But the moment exchange controls are removed, the tables turn. Foreign trade may very well still be restricted as it is in Pakistan today, but porous borders enable a gold rush of traders trying to make the most of the currency arbitrage while it lasts. Meanwhile, the incentive to smuggle inwards is curtailed, removing the supply of imports made informally in the past, back when the Pak Rupee was still undervalued.
Throw into the mix various market disruptions such as minimum support prices, price control on final retail rates, a value chain mostly operating in informal or undocumented sector, and a large cash economy, and you have a recipe for disaster. On one hand, non-perishable food commodities such as sugar have become a store of value, especially for those operating in Cash-is tan. On the other hand, porous borders all the way from Isfahan, Tashkent to Astana ensure that traders get the international market rate for their risk and efforts.
No doubt, this would be routine business in any other economy where the free flow of goods – both exported and imported at the same time – would ensure that the domestic market never runs short or witness runaway inflation in a short period of time. But not in an economy rife with the scrooges of under-reporting of volumes – which begins on-farm and goes all the way to Customs - or the menace of porous borders/smuggling, cash-economy, and price controls imposed at every stage, from inputs such as fertilizer, to retail market rates set by district administration.
Market-based exchange rates are essential. But as reforms go, they are incomplete. In fact, where governance is broken and markets distorted due to excessive regulatory ingress, they can sometimes even backfire: manifesting themselves in the form of loss of confidence in local currency, as has become the case with Pakistan’s food commodities market, in particular non-perishables.
Is the prescription then to roll back market-based exchange rate until governance is fixed? Of course not. Instead, remember a basic principle: the currency market is inextricably linked to the goods market, as the former reflects transactions taking place in the latter. Therefore, you can never have a successfully functioning currency market for as long as the goods market is controlled. To reap the full benefits of market-based currency, allow trade of goods to flow freely first. One cannot happen without the other.
Until then, brace yourself for persistent food inflation. At least in the commodities market.
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