China could upend price complacency

According to the China National Grain and Oils Information Center, China holds 120m tonnes of maize in reserves, which is more than 50 per cent of annual domestic consumption and half of all reserves held globally.

So why does the Chinese state bother to hold so much grain, when storage costs and wastage are so high?

With a myopic focus on self-preservation, the Chinese ruling class has a longer memory than most. Famine is implicated in the collapse of the Ming dynasty, the Taiping Rebellion, the Boxer Rebellion and the Great Famine, which killed an estimated 40m people in the early 1960s.

Hunger is the single biggest risk to Communist Party rule, and it knows it.

This matters because agricultural commodity prices are currently at the marginal cost of production and investors are looking for catalysts to lift returns in the sector. China’s policy on maize reserves and imports could help reignite this space.

The country does not produce enough food to fill its 1.4bn mouths. It imports millions of tonnes of staple foods and protein and is no longer producing enough maize to satisfy domestic demand.

This maize deficit looks set to widen, and it is only the strategic reserves buffer and import quotas that are delaying another step up in demand in world trade for agricultural commodities.

Previous step changes include the import of soyabeans into China – currently 78m tonnes – accounting for 90 per cent of the crop grown in Brazil. In addition, the introduction of US biofuel mandates has resulted in 40 per cent of all US maize being turned into ethanol.

To anticipate this rise in demand, investors need to estimate when these maize reserves might run out. Unfortunately, given the strategic importance of these stocks, the real grain reserves number is a state secret.

The Food and Agriculture Organization of the United Nations’ estimate of Chinese maize stocks is much lower than the official number, at 95m tonnes, and the US Department of Agriculture’s estimate is lower still at 92m tonnes.

However, the current policies are increasingly unsustainable and distortive. Any policy adjustments could have a dramatic effect on domestic maize balance, and the changes could squeeze the reserves number more rapidly than market participants predict, bringing forward imports into China.

The country’s farmers get a guaranteed price of Rmb2,250 (£231) per tonne for maize – equivalent to $9 (£5.90) per bushel, more than double the global price. Rather than buy domestic maize from the state at these prices, pig farmers are importing all the foreign maize the 7.2m-tonne quota will allow, and substituting domestic rations with cheap imported alternatives wherever possible.

There is no import quota on sorghum, for example, and imports have moved from less than 1m tonnes three years ago to 10m tonnes this year.

Policy distortions explain why both maize reserves and imports are rising at the same time, and why the costs of this programme are spiralling. The government is subsidising inefficient maize production by placing the harvest into the reserves – where it rots – while Chinese farmers feed their animals cheap imported maize substitutes instead.

The Ministry of Agriculture says it is looking at market-based pricing mechanisms. Domestic maize production would fall if costs were cut or guarantees abolished, while demand would jump if quotas were introduced on substitutes. Both changes would widen the maize deficit and reverse the recent expansion of reserves, bringing future imports forward.

It could take a couple of years to adjust reserves sufficiently to scrap import quotas, but given the context, China could act as one of several catalysts to lift the sector.

There have been two excellent harvests back to back and agricultural commodity prices have fallen steadily in the past three years. Prices are at marginal cost for some of the most efficient producers in the world and, unlike oil, there are short lead times and no large sunk costs or international politics to consider.

If farmers don’t think they will make a profit on a bit of ground, they won’t plant it. The supply response takes a year, and that response has begun.

We are at a floor in agricultural commodity prices and only a small change or disruption could bring the sector to life again. Production is as volatile as the weather. Consumers and investors have become complacent about low food prices and this complacency provides opportunities for active investors.

Hugo Rogers is a manager on the structural opportunities team at Liontrust