The impact of exchange rates and monetary policy on
competitiveness in agriculture:
A United States-European Union Comparative analysis
This paper intends to demonstrate that the monetary policy and exchange rates carried out by a country have a direct and significant impact on the competitiveness of its agricultural sector (I), and to measure such impact in the context of a comparison between the United States and the European Union for the years 2004 to 20091(II).
It brings out the fact that the impact of a monetary policy and of exchange rates on agricultural competitiveness did increase in the past few years due to an economic environment characterized by the combination of three factors: The farmers' and national indebtedness, the agricultural market liberalization and the growing market financialization.
The application to a bilateral comparison between the United States and the European Union clearly reveals that such impact varies from one year to the next, but remains meaningful.
The variables of exchange rates and key rates charged by central banks are thus representing two factors of a nation's agricultural competitiveness, factors that are even more unavoidable now than in the past 2.
by momagri editorial board
This paper is an excerpt from an analysis to be published in the mid-2011 by the think tank momagri. Prepared in the framework of its project to develop a rating agency for agriculture and its issues at stake, the analysis presents an indicator that measures the real nature of direct and indirect supports to agriculture.
1. The exchange rates and key interest rates of central banks:
Two growing factors on agricultural competitiveness
The escalating use of indebtedness by farmers and
the debt crisis give an amplified role to key rates set by
central banks in the economic stability of the agricultural sector
- The gradual liberalization of agricultural trade conveys an
increased influence to the geographic direction of trade flows
- The growing financialization of agricultural markets
Increases the reliance of agricultural supply and demand
fundamentals on the fluctuations of financial variables,
and more generally to financial markets.
2. An example: The impact of the euro/dollar exchange rate and of
the disparity in actual key rates charged by the American
and European central banks on the relative competitiveness
Of the two agricultural sectors since 2004
- The under evaluation of the US dollar versus the euro gives
American agriculture a competitive advantage valued
at US$17,8 billion in 2008 and US$14.4 billion in 2009
- The monetary policy implemented by the American
central bank––more accommodating than that of the ECB
since 2007––generates an added competitive advantage
for the American agriculture, advantage assessed at
- The technical terms and conditions of the Farm Bill subsidies,
Which are more sensitive to levels and fluctuations of
International prices than the European agricultural policy,
allow to maximize American farmers' and consumers' profits,
linked to an advantageous monetary policy and favorable
1. The exchange rates and key rates of central banks:
Two growing factors on agricultural competitiveness
While exchange rates and monetary policies implemented by the various central banks always had an impact on export competitiveness and investment level in agricultural activities, their influence has significantly intensified since 2005.
Most international experts are now in agreement on this issue and bring up three major causes:
- The escalating use of indebtedness by farmers and the debt crisis give an amplified role to key rates set by central banks in the economic stability of the agricultural sector;
The escalating use of indebtedness by farmers and the debt crisis convey an increased role to key rates set by central banks in the economic stability of the agricultural sector.
- The gradual liberalization of international agricultural markets and the expansion of traded volumes are conveying an increased influence to the geographic direction of trade flows;
- The growing financialization of agricultural markets since 2005 turns these economic and financial variables into key criteria of decision––particularly those regarding indebtedness––such as interest rates.
The subprime mortgage crisis has been followed by a debt and confidence crisis affecting practically all nations throughout the world. To confront it and revive economic growth, all central banks lowered their key rates. All economic sectors are involved, and particularly agriculture since:
- Most agricultural activities are supported by governments through specific public policies that are heavily funded and focused on targeted measures: The severity of the crisis challenges the resources allocated;
- Farms are increasingly resorting to short-term and long-term debt, with a view to investing in the literal sense (long-term) but also to getting temporary aid in times of crisis (cash-flow support).
The interest rates charged by central banks are playing a growing key role in the cost of debt incurred by farmers and in the preparation of national budgets for agriculture. Eventually, the competitiveness of agriculture is directly involved because:
- In the current context of slow economic growth, the growing indebtedness of farmers limits their future ability to invest;
- The massive debt incurred by governments––particularly in some agricultural powerhouses––can go hand in hand with an increase in current and future debt servicing in case of a lowering of the financial rating of the given country (as is the case of Greece for instance). This would affect its budgetary capacity accordingly, and thus the scope of any possible financial support to agriculture.
The gradual liberalization of agricultural trade conveys an increased influence to the geographic direction of trade flows.
The recent period is characterized by the combination of two effects that intensify the influence of exchange rates. The first reflects the ongoing growth of international trade flows––in value as well as in volume––generated by the generalized lowering of border tariffs, especially since the 1994 conclusion of the Uruguay Round3 (liberalization effect). The second is marked by a consumers' standardization movement leading to h\the formation of large regional––even global––markets for numerous agricultural or agribusiness products (globalization effect).
For the past 15 years, the combination of these two effects has deeply altered the competitive conditions that prevailed on international markets and gave increased magnitude to both Quality4 and price variables. By doing so, exchange rates became one of the key factors in international competitiveness of a given sector since, at unchanged face value, under-valuating a currency versus another allows:
- To limit foreign agricultural imports and stimulate national agricultural exports (volume effect);
This ongoing movement had a strong impact on agriculture, in spite of remaining non-tariff trade stumbling blocks (particularly regulatory and sanitary hurdles). In fact, The WTO indicates that agricultural and agribusiness exports increased by five percent in volume between 2000 and 2008, despite the trade contraction generated by the 2008 economic crisis. This theoretical and fixed thinking must be toned down to include the temporal scope. In fact, the geographic direction of trade flows will differ depending on whether the recorded volatility of exchange rates is significant or not, and long lasting or not. The two effects mentioned (volume and value) are not occurring at the same time. Prices adjust in the short term while volumes adjust in the mid-term5, due to the necessary time to implement new production capabilities or curtail imports to be partially replaced by local products of substitution.
- To drastically cut the purchasing power of national consumers for foreign agricultural products (value effect).
Today more than in the past, exchange rates are a more decisive variable in the direction of short-term and long-term trade flows––including agricultural trade flows. The long-lasting exchange rate volatility or the prolonged upholding of an under- or over-evaluated currency can go hand in hand with a durable variation of trade flows by discouraging some exportations or importations, thus resulting in an indirect shelter for local producers, allowing them to develop and increase their competitiveness6.
The rapid and growing financialization of agricultural markets makes them very responsive to changes of financial variables.
Financialization can be measured by the growing use of financing through indebtedness by various market players. The evaluation of the various assets is therefore made through financial markets. And these are increasingly responsive to the international economic environment and to the fluctuations of extremely varied economic indicators.
This financialization of agricultural markets is a recent but very vigorous phenomenon. As shown in the chart below, the amount of traded commodity contracts has sharply grown since 2005 to peak in 2008 at over five times7 the average indices observed for other economic supports, such as interest rates, stocks or precious metals. One of the explanations is a structural one: Agricultural futures markets are very narrow and most transactions are carried out through negotiated contract markets8, which amount to unregulated gray markets. It is estimated that, in early 2008, 80 to 90 percent of transactions on these markets do not develop into physical deliveries. They can therefore be considered as purely speculative operations.
According to many experts, this growing financialization of agricultural markets has, as shown on the chart below, played an undeniable role in raising price levels––particularly those concerning grain––as well as strengthening the observed price volatility.
Several Princeton University experts9 thus have recently showed that agricultural markets were now widely financialized, and therefore quicker to respond to financial market variations than in the past.
In fact, these economists point out that:
- Since 2004, commodity index10 returns reacted more to the World Equity Index and oil prices than commodity returns that were not listed in these indices;
Consequently, futures market investors played an increasing role in the recent volatility of agricultural commodity prices by altering typical market behaviors of the various players (producers, cooperative entities, speculators, and governments)11.
- The correlation of traded volumes between the different commodities grew stronger since 2004, and agricultural commodities, oil and financial assets have now become narrow substitutes for investors on financial markets.
As a result:
- By increasing financing modes and supports,
the growing financialization of agriculture strengthens the role of key interest rates and exchange rates as crucial variables of investment trade-off, investment returns and economic reality, and consequently of the eventual competitiveness of agriculture and indirectly of agribusiness industries.
- By giving financial variables an increased role in investment decision-making regarding agricultural markets (both physical and futures markets),
- By attracting short-term investors in an environment of debt crisis and international trade liberalization,
2. An example: The I,mpact of the euro/dollar exchange rate and of the disparity in actual key rates charged by the American and European central banks on the relative competitiveness of the two agricultural sectors since 2004
This section examines the impact of exchange rates and monetary policies on he competitiveness of agriculture based on a bilateral comparison between the United States and the European Union for the years 2004 to 2009.
This represents a pertinent working hypothesis since the European Union and the United States are favored trading partners in agricultural products. In fact, out of the 20 key agricultural trading partners of the United States for the 2003-07 period, seven of them are European nations, which suffice to account for 13.2 percent12 of total U.S. trade13. As a result, Europe is the second largest agricultural trading partner of the United States, behind Canada (18.4 percent of trade for the 2003-07 period).
The above-mentioned results constitute a first estimate that will be refined and later expanded to other significant players of global agricultural markets––whether they involve developed countries or emerging nations––to take into account the multiple substitution and transfer effects.
The impact of exchange rates: The under-evaluation of the American dollar versus the euro presented American agriculture with a competitive advantage assessed at $17.8 billion in 2008 and $14.4 billion in 2009.
According to survey conducted by momagri on the United States and the European Union, exchange rates are playing a crucial role in the competitiveness of American agriculture14. In fact, the recorded under-valuation of the dollar versus the euro generates two key consequences:
- It restricts European agricultural importations and stimulates American agricultural exportations. At unchanged nominal prices, the under-valuation of the dollar versus the euro equally raises the price of any European import expressed in dollar15 and vice-versa. If the exporters' supply is not flexible in terms of volume, American producers are making a profit equal to their lowest production costs expressed in dollar. This translates into an export sales margin increased by an equal amount. If the exporters' supply is responsive to prices, they can increase sales by lowering prices, which may enable them to make a better profit.
- It drastically cuts the American consumer purchasing power for European agricultural imports. If the budget of American consumers for food imports is not very flexible, importation volumes decline by a percentage equivalent to the dollar under-valuation and most of the disparity is shifted to goods produced by American farmers, due to the limited flexibility of food expenditures in developed economies. If that were not the case, importation volumes would remain unchanged and their value increases by an equal amount.
Methodology to determine the impact of the euro/dollar real exchange rates on American agricultural competitiveness
In order to assess the impact of the euro/dollar exchange rates on the competitiveness of American agriculture versus European agriculture, the momagri analysis relies on exchange rate differentials in terms of purchasing power parity (PPP) as measured by the OECD. They measure the relation between the amounts of goods that can be purchased abroad with a national currency unit. So at the end of 2009, the exchange rate of the dollar versus the euro was 0.7198. However, the connection between the amounts of goods that could be purchased with a dollar in the U.S. and with a euro in the euro zone was 0.8547. The dollar/euro parity was thus under-evaluated by €0.135 (13.5 percent).
The 2003 referred to level of exportations and exportations is applied for the 2004-09e years. In fact, the 2003 effective dollar/euro parity was very close to the purchasing power, and we can thus consider that, for that year, exchange rates did not have a conclusive exogenous impact on foreign trade.
The methodology considered to evaluate the euro/dollar exchange rate impact on the agricultural competitiveness disparity between the United States and the European Union takes up that presented by Jungho Baek, Won W. Koo and Kranti Mulik in their econometric study "Exchange Rate Dynamics and the Bilateral Trade Balance: The case of U.S. Agriculture" published in the October 2009 issue of The Agricultural and Resource Economics Review.
That study analyzes American agricultural trade with various countries. It corroborates the relevance of their approach in the case of a bilateral evaluation. Indeed, the authors show that the weakening of the dollar exchange rate against a given country's currency generates a positive short-term consequence on American importations, but that such effect wears off in the long-term.
At first, American consumers preserve importation volumes, which leads to a higher dollar value of imports.
Afterwards, they lower the value of their imports. Considering the lack of elasticity in food expenditures, lowering the volume of their importations probably results in resorting to products from other exporting countries, or to domestic products.
In addition, US agricultural exportations to a given country react positively–both in the short term as well as in the long term––to lowering the dollar exchange rate versus that country's currency.
Thus as a rule, three scenarios to assess the impact of the euro/dollar exchange rates were retained, on the basis on the pragmatic results presented in the Jungho Baek, Won W. Koo and Kranti Mulik's study:
- Scenario #1 (low estimate): The dollar under-evaluation results in a proportional increase of exportations, and higher prices on imports result, for 50 percent, in transfers to the domestic production;
- Scenario #2 (high estimate): The dollar under-evaluation results in proportional transfers of importations to purchases of the domestic production, and even higher proportional transfers for exporters, who can increase their market share by 50 percent;
- Scenario #3 (median estimate): the dollar under-evaluation results in a proportional increase of exportations and in proportional transfers of importations to purchases of the domestic production.
Depending on the various estimates, the dollar under-evaluation versus the euro resulted in a competitive advantage for the American agriculture. That advantage was assessed at between $11.2 and $18.4 billion for 2009, and $14.4 billion regarding a median scenario.
The impact of key rates: The monetary policy implemented by the American central bank (Fed)––more accommodating than that of the European Central Bank (ECB) since 2007––favors the competitiveness of American agriculture in the amount of $2.9 billion in 20008 and $106 million in 20-09.
The monetary policy implemented by the Fed since 2007 represents a significant factor for the American agricultural competitiveness, through the indirect support it generates for farmers by making their indebtedness less expensive than that existing for their European counterparts.
That monetary policy is beneficial to American industry as a whole. As far as agriculture is concerned, it has, since 2004, translated into a recurring competitive advantage for American farmers compared to European farmers. The year 2006 was the only exception: The European monetary policy was then more profitable than the American policy, thus representing an indirect support assessed at $1.42 billion in favor of European farmers.
Evaluation methodology to assess the impact of the disparity in key rates implemented by the Fed and the ECB on the American and European agricultural competitiveness.
In order to assess the disparity of agricultural competitiveness induced by a beneficial monetary policy, the momagri study16 relies on the disparity in real key rates charged by the ECB (b) and by the Fed (a), which is applied to the total American agricultural debt borne by banks (c).
The chart below presents the results obtained.
The beneficial monetary policy implemented by the United States compared to that of the European Union resulted in a competitive advantage for American agriculture in the amount of $106 million for 2009 and $2.9 billion for 2008.
The technical conditions of the Farm Bill support, which are more responsive to international price variations than the European agricultural policy, allow maximizing profits for American farmers and consumers, profits linked to a beneficial monetary policy and favorable exchange rates.
The leveraging effect of exchange rates and of an accommodating monetary policy on the competitiveness of agriculture is all the more significant that:
- Agricultural subsidies are correlated to price fluctuations on international markets;
That is precisely the case of the United States, where subsidies granted to agriculture are concerning both production––through direct support coupled to production––and consumption by stimulating domestic and foreign demand17. The rationale that inspires the Farm Bill thus aims to provide security and to revitalize the American agricultural market, from upstream (producers) to downstream (consumers) and in a countercyclical manner. In this respect, it is rapidly responsive to market signals and tends to increase the positive results induced by a beneficial monetary policy and favorable exchange rates for American producers and consumers.
- Agricultural subsidies stimulate both production and demand;
- The market share in international agricultural trade is substantial;
- The local currency serves as reference in most trade transactions.
In Europe, agricultural subsidies are mostly direct support to farmer's standard of living, particularly with the CAP Single Payment Scheme (SPS), and represent 40 percent of all agricultural aid granted in 200818. The prevailing underlying principle is therefore resolutely directed to producers, but decoupled from produced volumes––which makes the European policy more inflexible to modifications generated by market conditions, and thus less reactive to international price fluctuations and levels than the American policy. As a consequence, the positive effects induced by a beneficial monetary policy and favorable exchange rates are relatively less valuable for European producers than for American producers.
This study shows that:
1. The exchange rates and the monetary policy conducted in the United States since 2007 are generating a major competitive advantage for American agriculture versus European agriculture, an advantage that has been assessed at $20.7 billion in 2008 and $14.5 billion in 2009. American agriculture is therefore benefitting from the current currency disparities and the under-evaluation of the dollar versus the euro.
2. The financialization of agriculture currently has a strong impact on the fundamentals of physical agricultural markets. Hence, it plays an increasing and unprecedented role on global agricultural balance, whether we consider meeting food needs, international food assistance, agricultural development in the poorer nations, environmental preservation or the contribution of agriculture to energy challenges (biofuels and plant chemicals in general). The financialization of agriculture may bring about unprecedented economic opportunities––if adequately controlled––it can, at the same time, also constitute a genuine threat by altering the fundamentals of physical markets.
3. The currently implemented agricultural policies play––or must play––an important role on the equilibrium of agricultural sectors, as well as on the way producers and consumers benefit from economic competitiveness discrepancies induced by exchange rate variations and real key rates. In order to efficiently meet their objectives, agricultural policies must maximize the interface between national agricultural issues and national and international economic and financial issues. This requires to have:
a. Identified the manner in which agricultural activities can be affected by a variation of exchange rates and key rates;
4. As consequence of the above-mentioned point, it is crucial to conduct a thorough analysis of the various agricultural support policies in effect in the major agricultural powers, using a common evaluation grid that would include, in a transversal manner, the reality of direct and indirect subsidies, whether they are budgeted or not. It is the reason why, in light of these facts, the momagri think tank initiated the design of a new indicator in the framework of its project to develop a rating agency for agriculture––the momagri Agency. It will be officially presented in early 2011 and the first two evaluated regions would be the United States and the European Union in the years 2004-2009. Other countries will be analyzed in the course of 2011, such as Brazil, Russia, India, Canada, China and New Zealand, among others.
b. Assessed the effectiveness of the national agricultural policy to provide all agricultural players and consumers with the most favorable environment allowing them to best benefit from these added competitiveness factors.
1 The figures indicated for the year 2009 are estimated figures (2009E) since figures for the corresponding executed expenditures were not available when this paper was being prepared.
2 This is all the more true since we are considering countries for which agriculture represents a significant share of national production and trade balance. Exchange rates and interest rates charged by central banks can also have a direct impact on global food security––especially in the poorest countries––through a double Price and substitution effect that was not measured in this paper.
3 The GATT Marrakesh Agreement
4 The quality of the product itself, as well as in relation to countless international norms regarding sanitary or phytosanitary issues.
5 This is demonstrated by the critical price elasticity theorem, also called the Marshall Lerner Condition. Over time, a given trade balance at a break-even point deteriorates following an exchange rate depreciation, then adjusting volumes allows to improve balance and exceed the initial equilibrium (the J curve effect). As shown by Baek, Koo and Mulik in their recent study "Exchange Rate Dynamics and the Bilateral Trade Balance: The case of the US Agriculture", Agricultural and Resource Economics Review, October 2009), the J curve does not apply to American agriculture in the sense that the dollar depreciation did not translate in a deterioration of the American balance of trade.
6 The case of China's manufacturing industry, as well as its agricultural sector, is indeed enlightening because the under-evaluation of the RMB (Yuan) versus international reserve currencies (US dollar and euro).
7 Agricultural products account for about a third, the balance is essentially concerning energy commodities such as oil and gas.
8 On negotiated contract markets, the interaction is a bilateral one. The protagonists offer quotes and transactions are achieved if a seller finds a buyer at the quoted price, thus orders follow prices. Negotiated contract markets significantly prospered with the increased development of electronic trading systems.
9 Tang and Xiong, Princeton University, 2009
10 Goldman Sachs Commodity Index (GSCI) and Dow Jones AIG (DJ AIG)
11 This issue is covered by Harvard University Professor Jeremy Stein in "Informational Externalities and Welfare-reducing Speculation", The Journal of Political Economy, 1995, vol.95, No.6)
12 Source: Foreign Agricultural Trade of the United States (FATUS), US Department of Agriculture (http://www.ers.usda.gov/Data/FATUS).
13 Importations and exportations.
14 The impact of exchange Policy on agricultural competitiveness is assessed in relation to a reference region, which is tacitly recognized as the European Union. Therefore, amounts assessed for the United States can be positive (An advantageous situation for American farmers compared to that of European farmers) or negative.
15 In the assessments to be made next, global prices are considered to be exogenous. This constitutes a simplifying hypothesis compared to reality, which underestimates the actual impact of an advantageous exchange policy implemented by some exporting nations, such as the United States, all the more so since the US currency is the international reference currency.
16 The impact of monetary policy over agricultural competitiveness is assessed in relation to a region of reference, which is to be the European Union. Therefore, the amounts assessed for the United States can be positive (advantageous situation for American farmers compared that that of European farmers) or negative.
17 Domestic food assistance programs represent 50 percent of total US agricultural subsidies granted in 2009.
18 Based the EU budget and the budgets of Member States.