#116 - Food Fight

We Can Never Do Merely One Thing

Mar 20, 2022

Hi 👋 - In the aftermath of Russia’s unprovoked invasion of Ukraine, CDS spreads on Egyptian government bonds blew out. That’s because Egypt is a large importer of wheat. This week, a look at economic interconnectedness and the first law of ecology. Thanks for reading.

“When we try to pick out anything by itself we find it hitched to everything else in the universe.” - John Muir

LIBORing

Finance is full of intimidating acronyms: LIBOR, EBITDA, WACC.

LOL.

Another acronym is CDS, short for credit default swap. A CDS is like an insurance policy for bondholders, protecting against default risk. One counter-party is buying credit protection while the other is selling it. The buyer pays the seller a premium (or spread). If there’s a default, the seller makes the buyer whole. If not, the seller pockets the premium.

Source: Market Business News, Credit default swap - definition and meaning.

The riskier the asset, the more expensive buying protection is. For example, the spread on JP Morgan will be lower than the spread on Russia's sanctioned Sberbank. Changes in CDS spreads are a barometer of risk assessment. Increasing spreads imply that investors think the risk of default is increasing.

In early March, CDS spreads on Egyptian government bonds went parabolic, an unintended casualty of Russia’s brutal, unprovoked invasion of Ukraine.

Alex Good @goodalexander

Egyptian Credit Default swaps have gone parabolic. The Egyptian government heavily subsidizes bread for its people (there were riots famously in the late 70s) and is often the world’s top wheat importer - heavily from Russia / Ukraine. Wheat rose more than 10% today.

Egypt produces only half of the wheat that it consumes, making it one of the world's largest importers of wheat. Like many other countries in the Middle East and North Africa, most of Egypt’s wheat imports, nearly 70%, come from Russia and Ukraine1.

Source: The Economist, How the invasion of Ukraine will spread hunger in the Middle East and Africa, March 12, 2022.

Skyrocketing wheat prices could stress Egypt’s coffers, hence the ballooning spreads. Bread is a staple of Egyptian diets and wheat is bread’s main ingredient. With approximately one-third of its 102 million citizens living below the poverty line, Egypt’s government heavily subsidizes bread. Its 2021 bill was $2.9 billion2. These subsidies are a political third rail. Subsidized bread prices haven’t been raised since the late 1980s. However, in recent weeks the price of unsubsidized bread has increased 50%3.

Source: The Financial Times, Wheat Front Month Futures (Wc1:CBT), March 18, 2022.

Unintended Consequences

Egypt isn’t alone. Russia’s invasion of Ukraine threatens shortages of key food commodities globally, as war disrupts planting and harvesting and raises the prices of key agricultural inputs. The ramifications could be far reaching, particularly for developing countries where a larger share of household income is spent on food.

Russia and Ukraine are top producers and exporters of agricultural commodities. The two account for one-third of the world’s wheat, one-quarter of its barley, and three-quarters its sunflower oil4. One in eight calories exported globally comes from Russian and Ukrainian fields.

Source: The Wall Street Journal, Ukraine War Stokes Insecurity in the World’s Food Supply, March 15, 2022.

In Ukraine, men and women who once tended fields are now tending trenches and machine guns. Shortages of fuel, which is being diverted to military use, and fertilizer, which requires Russian potash could also crimp farm activity. Shipping in the Black Sea, a key trade route for agricultural commodities, has become uninsurable due to the Russian Navy’s occasional targeting of civilian vessels. Commercial activity in Ukraine’s ports is frozen. While Russian food exports are not yet subject to sanctions, Western banks are reluctant to lend to traders. Countries like Australia have surplus wheat, but congested supply chains and tight shipping capacity might prevent export5. As a result, grain-based products like bread are likely to get more expensive, constraining household budgets and putting upward pressure on inflation. A second order effect is that pricier grain makes it more expensive to raise animals, increasing meat prices6.

In addition to food, Russia is also a top exporter of natural gas and potash, two key ingredients for fertilizer. Belarus, Russia’s BFF, is also a large potash producer7. The cost of energy and fertilizer are rising fast. A lack of fertilizer would reduce crop yields.

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The First Rule of Ecology

Nothing happens in a vacuum. Egyptian CDS spreads blowing is an example of the first law of ecology: everything is connected to everything else. In his excellent book Filters Against Folly, ecologist Garrett Hardin rephrases this as:

We can never do merely one thing.

In other words, there will be unexpected consequences. Always. For example, higher natural gas prices are crimping fertilizer production in Norway8:

Last week, Norwegian fertilizer giant Yara International said its European ammonia and urea production is running at less than half of normal capacity because of record-high natural-gas prices in the region.

We can never do merely one thing.

Nine Meals Away From Anarchy

To state the obvious, food is a necessity. Along with shelter, it’s the base of Maslow’s Hierarchy. Napoleon Bonaparte said, “an army marches on its stomach.” There are only nine missed meals between civilization and anarchy, according to Alfred Henry Lewis, an American muckraking journalist9.

Historically, food insecurity and inflation have sparked political unrest. For example, higher food prices in 2008 and 2009 sparked the Arab Spring and more recently helped topple Sudan’s government10. Today, countries in the Middle East and North Africa, like Algeria, Morocco, and Turkey, are big importers of Black Sea wheat. Ukraine is a major exporter of sunflower oil, a staple in West Africa. History has a tendency to repeat itself. According to The Economist11:

Pricey wheat will blow up budgets in the Middle East, perhaps forcing subsidy cuts that leave citizens hungry. In sub-Saharan Africa, higher oil prices will strain economies that are already creaking. All this may lead to unrest.

The Food and Agriculture Organization of the United Nations food price index, or FFPI - another acronym - tracks the monthly change in prices of a basket of food commodities. The hit an all time high in February 2022, with food prices up over 20% y/y12.

Source: Food and Agriculture Organization of the United Nations, FAO Food Price Index, March 3, 2022.

Food inflation will likely get worse before it gets better. Food makes up about 40% of the consumer-price basket across sub-Saharan Africa. Prior to Russia’s invasion of Ukraine, food inflation was already running double-digits due to rising energy, fertilizer, and transportation costs13. Surging commodity prices will exacerbate inflation. Food inflation creates hard tradeoffs between food and other necessities like housing, education, and medicine.

The Economist, War in Ukraine will cripple global food markets, March 12, 2022.

Past spikes in food and energy prices have caused widespread misery, particularly in developing countries. The World Bank estimates that food cost surges in 2007 and 2010 tipped 155 million and 44 million people into extreme poverty. The current bout of food inflation could push 40 million people into extreme poverty, according to analysis from The Center for Global Development14:

Although immediate concern has been for the bilateral export destinations of Russian and Ukrainian cereals, particularly Egypt, the impact of the shock will be felt widely, as importers switch their sources of supply, pushing up prices. Attention should be paid to countries most dependent upon imported wheat and corn: at least 24 low and lower-middle income countries imported more than 50kg of wheat or corn per person in 2018, according to FAO data (a significant level: assuming ~3500 calories per 1kg of grain, this is equivalent to depending upon imports for almost 500 calories a day).

Vladimir Putin started a war by sending his army across Ukraine’s borders. The impacts of his aggression will be felt well beyond Eastern Europe. He’ll leave a devastating wake.

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