In the Summer of 2010, wildfires raged throughout the Russian Steppes, ravaging a precious wheat crop shortly due to harvest. Racked by food shortages in the recent past, Russia arguably faced the worst domestic drought since 1972. The government placed a temporary ban on exports in grains and other agricultural goods until the end of the year. While the ban was intended to avoid spikes in domestic food prices, the global marketplace digested news of both the drought and subsequent export ban badly. With tighter supply prospects and inelastic global demand, prices on wheat and related grain futures dramatically rose in response. By some measures (e.g. Future contracts on The Chicago Board of Exchange) wheat has seen a 30% increase year-to-date with many substitutable grains following suit. Chief among these is corn, a crop that Chinese farmers will depend more heavily upon to support increased meat consumption within a burgeoning population.
As with most other tangible goods, China hoards an incredible amount of grain. The People’s Republic currently (alleged. One can’t even be sure of GDP estimates over there) has the world’s largest wheat and soy reserves, yet still makes sizeable purchases to help counter-balance an annual consumption equal to US and Russian wheat stocks combined. With so much skin in the game, its no wonder that China would have sufficiently bungled panties over this summers price rally. The Chinese, however, chose to unwedge those panties in a very unprecedented way.
There were two announcements that came out of the PRC on the week of November 8th. The first involved selling domestic soy stocks to the global marketplace, thereby increasing international supply of grains and lowering the price on soy and close subsitutes. Additionally, the impression that the Chinese can afford to reduce domestic stockpiles signals a weakening of demand and therefore exacerbates the price decline. The second, and more important announcement, involved an intent to raise domestic interest rates by .25%. Some speculate that, in the short term, an interest rate hike would lead to a sell-off of loss-incurring Yuan denominated bonds, making the Chinese currency weaker and imports relatively more expensive. The combined effect of selling domestic stockpiles (increasing global supply) and raising interest rates (reducing domestic demand) should naturally decrease the global equilibrium price of grains such as soy beans.
And decrease it did. On Friday, November 12, December wheat futures plunged 6% within 3 hours, Corn and Soy dropped 4% within a similiar time frame. Both contracts ended the day stop-down. Fundamental commodity traders were aghast at the moves, unable to comprehend how Chinas announcements could roil grain markets so royally. Yet anyone who had followed technicals throughout the summer (chart below) could see that the sustained rally could not last forever. Most speculators were just looking for a reason to justify grain prices coming off their highs. China’s announcement had provided that catalyst.
Certain market-watchers cried foul. While China may have the largest grain reserves in the world, their stockpile-to-use ratio is almost double the world average. As such, the need to maintain current supply levels is more pressing than it may be in other nations. With margins so tight, many questioned the validity of a domestic sell-off. Anything the Chinese sold would have to ultimately be replaced by imports from the US and South America. Secondly, interest rate manipulation as a policy tool is somewhat unprecedented in the Mecca of Market Socialism. The fact that the Chinese are even discussing raising rates is news in itself. The fact that the market priced the hike in so rapidly may have been a slight over-reaction.
The confusion over Chinese policy moves didn’t last for long. After the grain prices plummetted to limit down-levels, several large buy orders came through the tape. Chief among these was a large single order from The Louis Dreyfus Group, a french-based private company that is involved in the global processing, trading and merchandising of agriculture commodities. Louis Dreyfus works very closely with China on agriculture trade deals and had been discussing corn purchases on behalf of China for months. The reasoning for such a move would be clear; shake investors confidence with talk of price dampening, allow that dampening to manifest itself via speculation, and strike a deal when its cheap to do so.
Could it be that the Chinese announcements were nothing more than a tool to facilitate a large grain purchase at a discount? Analysts are not sure, but the fact that “Louis Dreyfus was a buyer of corn limit lower on Friday helped add volatility to the rumours of Chinese buying,” US Commodities said. Regardless of whether the trigger was actually pulled on purchasing, the drop in grain prices was good news for the Chinese Politburo. Just by wondering aloud about raising interest rates and selling soybeans stocks, the Chinese can drive grain prices down in the short run. This information is invaluable for a country with a pressing need to maintain supply levels and prone to big purchases of agricultural commodities. We may hear more of these “surprising” announcements going forward.