metadata: count: Middle East and North Africa
docna: 0: docna: Food security and storage in the Middle East
            and North Africa
docty: Policy Research Working Paper
subtopic: Markets and Market Access,Economic Theory & Research,Food & Beverage Industry,Access to Markets,Emerging Markets
teratopic: Macroeconomics and Economic Growth,Private Sector Development,Industry,International Economics and Trade
abstracts: cdata!: In times of highly volatile commodity
            markets, governments often try to protect their populations
            from rapidly-rising food prices, which can be particularly
            harsh for the poor. A potential solution for food-deficit
            countries is to hold strategic reserves, which can be called
            on when international prices spike. But how large should
            strategic stockpiles be? This paper develops a dynamic
            storage model for wheat in the Middle East and North Africa
            (MENA) region, where imported wheat dominates the average
            diet. The paper uses the model to analyze a strategy that
            sets aside wheat stockpiles, which can be used when needed
            to keep domestic prices below a targeted price. This paper
            shows that if the target is set high and reserves are
            adequate, the strategy can be effective and robust. Contrary
            to most interventions, strategic storage policies are
            counter-cyclical and, when the importing region is
            sufficiently large, a regional policy can smooth global
            prices. This paper shows that this is the case for the MENA
            region. Nevertheless, the policy is more costly than the
            pro-cyclical policy of a targeted intervention that directly
            offsets high prices with a subsidy similar to food stamps.
repnme: repnme: Food security and storage in the Middle
            East and North Africa
display_title: Food security and storage in the
            Middle East and North Africa
listing_relative_url: /research///16251516/food-security-storage-middle-east-north-africa
publishtoextweb_dt: 2012-04-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Private Sector Development,Industry,International Economics and Trade
no_of_pages: 38
model_extractions: WPS6031 Policy Research Working Paper 6031 Food Security and Storage in the Middle East and North Africa _Donald F. Larson Julian Lampietti Christophe Gouel Carlo Cafiero John Roberts_ The World Bank Development Research Group Agriculture and Rural Development Team April 2012
Policy Research Working Paper 6031

# **Abstract**

In times of highly volatile commodity markets, governments often try to protect their populations from rapidly-rising food prices, which can be particularly harsh for the poor. A potential solution for food-deficit countries is to hold strategic reserves, which can be called on when international prices spike. But how large should strategic stockpiles be? This paper develops a dynamic storage model for wheat in the Middle East and North Africa (MENA) region, where imported wheat dominates the average diet. The paper uses the model to analyze a strategy that sets aside wheat stockpiles, which can be used when needed to keep domestic prices below a targeted price. This paper shows that if the target is set high and reserves are adequate, the strategy can be effective and robust. Contrary to most interventions, strategic storage policies are counter-cyclical and, when the importing region is sufficiently large, a regional policy can smooth global prices. This paper shows that this is the case for the MENA region. Nevertheless, the policy is more costly than the pro-cyclical policy of a targeted intervention that directly offsets high prices with a subsidy similar to food stamps.

This paper is a product of the Agriculture and Rural Development Team, Development Research Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at DLarson@worldbank.org@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Food security and storage in the Middle East and North Africa**<sup>*****</sup>

**Donald F. Larson, Julian Lampietti, Christophe Gouel, Carlo Cafiero and John Roberts**

_Keywords:_ food security, Middle East and North Africa, food security, price volatility, storage, strategic reserve, wheat.

_JEL classification:_ F1, O13, Q11, Q18.

_Sector Board:_ Agriculture and Rural Development

> * Donald F. Larson, Development Research Group, World Bank; Julian Lampietti, Middle East and North Africa Sustainable Development Department, World Bank; Christophe Gouel, Centre d'Etudes Prospectives et d'Informations Internationales and the World Bank, Carlo Cafiero, Statistics Division, FAO; and John Roberts, University of Maryland.
# **Food security and storage in the Middle East and North Africa**

## **Donald F. Larson, Julian Lampietti, Christophe Gouel, Carlo Cafiero and John Roberts**

High and volatile food prices, and their consequences for the poor, have revived concerns about food security and reinvigorated the debate about the role of strategic storage. For the second time in three years, food prices on international markets spiked in 2011, driven in part by rising wheat prices. For the first time in more than a decade, the real price of US wheat exports (adjusted to 2000 prices) breached the $200/ton threshold in July 2007 on its way to a high of $352/ton in March 2008 (Figure 1). International food prices fell sharply toward the close of 2008, wheat prices among them. By June 2010, wheat prices fell to $131 per ton, only to double within the year. Estimates suggest that the 2011 food price spike pushed 44 million people into poverty (World Bank, 2011a). Worst hit were countries that imported most of their food and the poor whose diets relied heavily on staple grains.

This is the case for many of the countries in the Middle East and North Africa (MENA) region. Diets there depend heavily on wheat that is largely imported (Table 1).<sup>1</sup> For example, between 2005 and 2007, Libya imported 98 percent of its wheat consumption and wheat generated 40 percent of the calories in the average Libyan diet. In Algeria, the comparable numbers were 69 and 46 percent. Consequently, spikes in international wheat prices can create hardship for the region’s poor and strain the resources of the public and private institutions that make up the region’s social safety net. To make matters worse, associated bouts of market volatility have made it difficult for households and governments to plan ahead.

The recent periods of high and volatile food prices have prompted proposals for policies that use commodity storage as an instrument. For example, French President Nicolas Sarkozy, when laying out an agenda for the French presidency of the G20, suggested that subsidized storage might be one way of mitigating volatile food prices (Hall, 2010). During his tenure as Director General of the International Food Policy Research Institute, Joachim von Braun promoted the use of real and virtual food inventories to dampen food price volatility (von Braun and Torero, 2009). And in a Financial Times Op-Ed piece, World Bank President Robert Zoellick urged the establishment of small strategic reserves of food in disaster-prone areas (Zoellick, 2011). The buildup of strategic reserves is also a key topic in the Middle East and North Africa (World Bank, 2009; Lampietti et al., 2001, Wright and Cafiero, 2011).

> 1 For the purposes of this paper, the MENA region includes Algeria, Bahrain, Egypt, Iran, Iraq, Jordan, Kuwait, Lebanon, Libya, Morocco, Oman, Saudi Arabia, Syria, Tunisia, United Arab Emirates, and Yemen.

2
Just as wheat is an important commodity for the region, MENA is an important region for the global wheat market. Between 2008 and 2010, an average of more than 29 percent of all exported wheat was destined for a country in the region. Over the last decades, countries in MENA have added to their capacity to store grains and wheat stocks have grown along with populations and demand. Precautionary policies led to an increase in the stock-to-use ratio as well, concentrating a greater share of global stocks in the region (Figure 2). From negligible levels in 1970, the region now holds more than 13 percent of global wheat stocks, an amount equivalent to 15 percent of global wheat trade and 52 percent of MENA imports (USDA, 2011, based on 2008-10 averages). Consequently, decisions taken by the region about strategic stores of wheat are of increasing importance for global markets. Moreover, with the expansion of domestic production constrained by available land and water resources, and with significant population growth projected in MENA, the region’s influence on global wheat markets is expected to grow.

In this paper, we examine whether stockpiles of wheat in the region could be used strategically to ameliorate the effects of sharp run-ups in international wheat prices. Using a numerical model of competitive storage under rational expectations, we examine a strategic storage rule designed to insulate the region from the most severe price spikes, those that fall in the top 10 percent of the range of simulated prices.<sup>2</sup> We find that the strategy can reduce the variability of domestic wheat prices and blunt the domestic impact of increases in global prices. In contrast to most policy approaches that countries use to insulate themselves from off-shore price disturbances, the strategy has positive spillover effects, reducing global price variability rather than increasing it. However, the strategy will sometimes fail, when consecutive negative supply shocks occur and MENA inventories are dissipated. The frequency of failure declines as larger inventories are held, but the costs of the strategy increase as well. By comparison, a pro-cyclical relief program that targets up to 40 percent of the population is a less expensive alternative.

# **Background**

Poverty is at the core of the region’s concerns about food security. About one-quarter of the population in MENA countries is poor and about three-quarters of these poor people live in rural areas (World Bank, 2009).<sup>3</sup> Poor households in the region spend anywhere between one-third and two-thirds of their income on food, so they are hardest hit by food-price shocks. In addition, since a relatively high concentration of the population lives on incomes near the poverty line in the region, small increases in the cost of living can have a very large impact on the incidence of poverty (World Bank, 2009).

> 2 The term competitive storage means that grain is held with the expectation of a profit and that competition among inventory holders limits profits to normal risk-adjusted rates of return. The condition is spelled out more rigorously in a later section describing the conceptual model.

> 3 Poverty calculations are based on national poverty criteria.

3
The combination of diets heavily reliant on wheat and wheat supplies dependent on imports means that events in global wheat markets play an outsized role for welfare outcomes in the region, and this link between international markets and domestic welfare will likely strengthen with time. Population growth in MENA is projected to be 1.7 percent per year, significantly higher than the world rate of 1.1 percent (World Bank, 2009). At the same time, the potential for expanding supplies on irrigated lands is severely constrained; per capita water availability is projected to fall by half by 2050, with serious consequences for the region’s already stressed aquifers and natural hydrological systems (World Bank, 2007). As a consequence, projections of the region’s food balance indicate that imports will increase by almost 64 percent over the next twenty years (World Bank, 2009).

When price shocks occur, governments often intervene. In MENA, the interventions come in many forms, but consumer subsidies are the most favored instruments (Lampietti et al., 2011). For example, in Tunisia, Jordan, Morocco, Egypt, Syria, and Iraq, where disaggregated data are available, food subsidies averaged 1.6 percent of GDP in 2009 and totaled $8.1 billion (World Bank, 2011c). More recently, and in response to high food commodity prices and popular uprisings, many governments have expanded consumer subsidies, likely contributing to significantly higher costs.

At the same time, the capacity of governments to shore up safety net programs against high food prices differs among countries in the region (World Bank, 2009, 2011c). All else equal, countries with large fiscal deficits and high cereal import dependency are least able to absorb a wheat price shock. These are mostly the oil importers (Jordan and Lebanon) and the region’s developing oil exporters (Yemen, Iraq and Syria). In contrast, the Gulf Cooperation Council (GCC) countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates) have ample budgetary resources to absorb higher costs, even though they are entirely dependent on the international markets for their wheat. Moreover, in these countries rising food import bills are frequently offset by rising export revenue, because of the positive correlation between energy and food prices. Egypt and Morocco do not have the luxury of ample fiscal space to absorb sustained higher prices, although their higher domestic production levels help cushion price shocks.

Despite the preponderance of consumer subsidies, evidence suggests that international food price shocks are nonetheless transmitted to various degrees to domestic food prices throughout the region (World Bank, 2011c). Over a five year period ending in February 2011, domestic food prices rose, on average, by more than 10 percent annually in Egypt, Iran, and Yemen, and by nearly 5 percent or more in Djibouti, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia and the United Arab Emirates.<sup>4</sup> Rising world food prices have been a major factor behind increases in domestic food prices, typically explaining some 20 to 30 percent of the

> 4 Average annual food price rates of increase are based on 60 months of data, with the following exceptions: 58 months of data was used for Lebanon, and the West Bank and Gaza; and 57 months were used for Yemen.

4
variation in domestic prices.<sup>5</sup> International price changes have been particularly strong drivers of food inflation in Iraq and West Bank and Gaza, accounting for over 50 percent of the food inflation, followed by Egypt, Djibouti and the United Arab Emirates (over 40 percent of the food inflation). Except for Tunisia and Algeria, exchange rate depreciation has been a minor factor in domestic food inflation. The pass-through is smaller but is still sizable, varying between 0.2 and 0.4 percent, for a large group of MENA countries, including Morocco, Jordan, Syria, Iran, Yemen, and all GCC countries other than United Arab Emirates. This indicates a high degree of vulnerability of households to international food price increases in virtually all MENA countries.

Over the past 50 years, most countries, even those that actively intervene in food markets, have come to depend on private markets for the physical distribution of food (Akiyama et al., 2001). This is less true in MENA, where governments often play a significant role in the procurement, storage, and distribution of wheat. And many countries have explicit policies determining the level of strategic reserves the government is required to have on hand at any given time. Overall, storage capacity in the region is on average six months of consumption and estimated ending stocks are five months (World Bank, 2012). Plans are already well underway to expand storage capacity in selected countries by an additional 5 months on average.

While there are different levels of private participation in wheat storage and distribution in the region, recent analysis suggests that the costs of port logistics, storage, inland transport (to the mills) and management are on average $42 per metric ton of wheat or 12.5 percent of the cost of a ton of wheat at current prices. The largest components of these costs are port logistics ($13 per metric ton) and management ($14 per ton), which includes such costs as product loss, cost of capital, and overhead. The average cost of storage for the region ranges between $1.5 and $3.5 per metric ton per month, which compares favorably with storage costs in the Netherlands and the United States, both large handlers of traded grain, where storage costs run about $2.00 per metric ton per month (World Bank, 2012).

Wheat consumption rates are high in MENA, and because of the large government presence in domestic markets, wheat price shocks have important budgetary consequences. The World Bank (2011c) estimates that the rise of food prices in MENA in 2010 increased the import bill by 0.6 percent of GDP with grains making the largest contribution, followed by edible oils, sugar and meat. Oil importers are expected to be hardest hit with an estimated increase in the import bill of 1.2 percent of GDP, and with half of the increase attributed to the impact of higher grain prices. The expected increase in the import bill of the developing oil exporters as a result of higher food product prices is estimated at 0.8 percent of GDP with grain accounting for slightly less than half the increase.

> 5 Based on calculated pass-through rates (World Bank, 2011c).

5
# **Commodity stabilization policy experience**

To a large degree, policy makers view strategic stores of commodities as a buffer against unusual and unanticipated disruptions to normally dependable commodity markets. However, there was a period, spanning several decades following the end of World War II when policy makers sought to manage commodity prices and the export earnings of commodity-producing countries, often through public management of stockpiles or through related financing instruments. The policies were much discussed and studied, so there is a large literature on the motivation and workings of public inventory schemes.<sup>6</sup> In this section we provide a brief review of past ideas and outcomes, which are worth keeping in mind as future roles for strategic inventories are considered.

A conceptual motivation for this class of price-management policies was formalized in Massell (1969; 1970), who compared a linear market model with and without additive mean-zero supply or demand disturbances and concluded that commodity price stabilization could generate welfare benefits that could be shared among producers and consumers. Wright (1979) confirmed, in a rational expectations model, that this positive result following an “ideal stabilization” is a possibility, depending on the type of disturbance, demand curvature and supply response. Use of stocks for stabilization had no similar analytical backing, but had gained favor internationally much earlier, from economists as diverse as Hayek (1943) and Keynes (1938). Low commodity prices were seen as an exacerbating factor in the Great Depression, and the feasibility of public management of commodity supply chains was demonstrated by country experience during World War II. Between 1954 and 1980, treaties between the major producing and consuming countries resulted in five international commodity agreements with price stabilization mechanism components. Three of the agreements, for tin, cocoa and rubber, relied on managed buffer stocks to smooth international prices. National governments launched domestic stabilization programs as well. The European Union, Japan, and the United States all employed government-controlled inventories to help manage commodity prices, and buffer stock schemes were launched in Bangladesh, India, Indonesia, the Republic of Korea, Mexico and the Philippines. In 1969, the IMF established a Buffer Stock Financing Facility to provide lending support to the stabilization efforts. The Common Fund for Commodities was established to provide liquidity to international stabilization programs under a UN initiated Integrated Program for Commodities established to stabilize the prices of ten core commodities in 1975 (Larson et al., 2004; Knudsen and Nash, 1990).

A series of conceptual and empirical studies emerged to suggest that average welfare gains from stabilization were small relative to changes in average price levels (Newbery and Stiglitz, 1981; Anderson e al., 1981; Myers and Oehmke, 1988). In a series of pioneering papers and a subsequent volume, Williams and Wright (1991) explored the interactions of public and private stocks. Their work and related studies showed that that,

> 6 See Larson, Anderson and Varangis (2004) for a more complete review.

6
because of resource limits, stabilization schemes are subject to eventual bankruptcy, even when they are rationally priced and hedged in financial markets when unlikely events eventually occur (Wright 1979; Wright and Williams 1982, 1984, 1988; <mark>Larson and Coleman, 1993). Choosing an appropriate price to defend is another difficulty faced by stabilization program managers and this technical</mark> hurdle was heightened by political economy problems that often converted stabilization programs into programs that defended unreasonably high price levels or taxed producers (Bauer and Paish, 1952; Bardsley, 1994).

More convincing for policy makers were the insurmountable practical difficulties of implementing the stabilization mandate once the policies were in place. Even well-run stabilization schemes faced large technical problems and many failed, sometimes in spectacular fashion, greatly depressing the markets they were designed to stabilize.<sup>7</sup> By the 1990s the stabilization component of the international commodity agreements were no longer in force and Gilbert (1996) provided an obituary notice.

As theoretical and practical objections grew for policies aimed at managing prices, a separate literature emerged on the consequences of commodity risks for vulnerable households and governments. This large literature centered on the role of risk-mitigation and adaptation strategies, rural livelihoods and forms of formal and informal insurance. Larson, Anderson and Varangis (2004) and Dercon (2005) provide reviews. Topics related to storage and trade are relevant here as well, since both informal mechanisms and formal market mechanisms, including storage markets, work to automatically smooth prices and incomes.

There is a widely held view that relying on trade and private storage is usually much more efficient than relying on government inventories to buffer normal demand and supply shocks, since world markets have the potential to diversify away volatility by pooling risks across many countries (see Dorosh, 2008, for a recent discussion). However, this can change when physical disruptions occur that isolate supplies from demand – for example disruptions from armed conflicts and lawlessness, sovereign risks, including trade disruptions, or logistical disruptions. It is perhaps most common to think of disruptions of this type as occurring at national borders; however, logistical constraints to providing food in response to harvest shortfalls in remote areas present a similar problem. For this reasons, countries and food relief agencies invest heavily in understanding the logistics of domestic food delivery systems (Thomas and Fritz, 2006; Van Wassenhove, 2006).

Though strategic and precautionary public stores are often a key component of food security programs, there are surprisingly few empirical studies that examine the cost tradeoffs between strategic storage and trade.<sup>8</sup> Instead, most strategic storage papers deal primarily with political and national security issues, often in the context of game theory and petroleum reserve. See, for example, Victor and Eskreis-Winkler (2011), Fan and

> 7 See, for example, Yamey’s (1992) description of the collapse of the tin stabilization fund and its consequences for the London Metals Exchange, or Bardsley’s (1994) description of Australia’s Wool Reserve Price Scheme.

> 8 Exceptions include Srinivasan and Jha (2001), Brennan (2003), and Gouel and Jean (2012).

7
Zhang (2010) and references therein. This creates a knowledge gap for policy makers, since other forms of investment, including investments that improve trade corridors or expand irrigation, can be viewed as partial substitutes to investments in public storage. A benefit of the model discussed here is that it can be used to evaluate the effects of more reliable production or lower transaction costs on price levels and price volatility.

# **The model**

In this section we describe the model that we use to assess the effects of strategic storage policy on domestic prices in the MENA region and the rest of the world (RoW).<sup>9</sup> The intuition behind the model is that physical storage and the equilibrium price of physical storage sits at the cusp of spatial and temporal arbitrage possibilities. Decisions about selling today for consumption or trade must be balanced against the known cost of storing and probable future prices. Expectations about the future value of stored goods are conditional, based on information available at present time, which in this particular model is summarized by inventory levels. In particular, all things equal, price outcomes are more likely higher and more volatile when initial inventories are low.<sup>10</sup> This is because, when stocks are low, outcomes in which production short-falls are rationed through high-prices rather than buffered through stock draw-downs are more probable.

A key feature of the class of models, including the one presented here, is the need to form a rational set of numerical price expectations, conditional on the parameters of the model and information available at that time, in order to value carry-over inventories and future production.<sup>11</sup> Specifically, the model uses a set of spatial and temporal price arbitrage conditions, together with assumptions about demand and supply, and about the distribution of supply shocks to model the distributions of price and consumption outcomes. With these as a baseline, policies are introduced that are meant to change price outcomes, and the consequences of the policy interventions on the distribution of prices and consumption are evaluated. It is worth emphasizing that the model is not a forecasting tool, but rather a way to evaluate strategic storage rules on price and consumption levels and volatility.

> 9 The trade-and-storage model was first developed in Williams and Wright (1991, Ch. 9), and was subsequently analyzed in Miranda and Glauber (1995), and Makki, Tweeten and Miranda (1996).

> 10 Wright and Williams (1982) show that the possibility of a stock-out is sufficient to generate this effect. Drawing on Working (1948), Makki, Tweeten and Miranda (1996) generate a similar outcome by introducing a convenience yield that increases with declining stocks. Considine and Larson (2001) show that this type of outcome is possible in the case of a commodity without seasonal production if short-run marginal costs have the expected curvature, increasing at increasing rates. Larson (2007) derives the temporal and spatial arbitrage conditions for the model analytically and shows that nonlinearities in the interaction of supply and demand are sufficient.

> 11 Gustafson (1958) provided early insights about the link between rational expectations and the price of storage. He also pioneered an approach for solving a restricted version of the model using paper and pen. Gardner (1979) built on Gustafson’s analytic work and also adapted Gustafson’s algorithm for use in a computer program. This later served as the basis for an improved version of the algorithm by Wright and Williams (1982).

8
i i € {MENA, RoW} D'(Pi) =a! —b'P; P} t i Si t t+1 K(Si) = (1 +r)(kS} + PS}), k>0 r Si>0 1 Pi+k-E,PL, A+r)>0 t t+1 Hi Etat Phys Htetar t aft t (Pia. Hteta1) (1+1r)- yt (Ht), L =><sup>F(X)=0,X=b</sup> > F(X) <0asx<X<b LF(X) X=a > F(X) =0 X €Ja,bl
t(Pias€t41) (1+7r)= wi (Hi).

xi>0 1 Pi +02 P! forj i, Xi i 6

> PJ -0<Pi<P) +6 forj #i.

Sta Al, el At At = Sta + Hise Ai + XJ = Di(Pi) + Si+ X/ forj # i. {A, Ar } {pi,si,Hi,xi} i € (MENA, RoW}.
historical standards, since it is unlikely that the steady state is associated with extreme values. Therefore, we calibrate the rest of the world price at $176/ton, the average US export price in 2005—2007, a period before the very high prices of the food crisis but during a time when prices were higher than in the beginning of the decade.<sup>14</sup> The steady-state MENA price is defined by assuming that the price difference between the regions reflects transport costs, which is set at $35.55/ton based on a recent survey (World Bank, 2012).

Picking appropriate elasticities is a challenge given the large variation in elasticities reported in the literature. As a guide, we follow the literature on commodity price dynamics, which shows that observed price volatility is consistent with relatively low demand elasticities ( Roberts and Schlenker, 2009; Cafiero et al., 2011), thus, we assume the demand elasticity to be equal to –0.12, which is toward the lower end of commonly used elasticities. We consider a supply elasticity of 0.2, in line with commonly used supply elasticities for wheat.<sup>15</sup> The cost function is assumed to be quadratic, making the marginal cost function linear. We express the marginal cost function as The parameters �<sup>�</sup> and �<sup>�</sup> determine the supply elasticity (see Table 2) assuming that marginal cost equals the steady-state price.

� We specify two sets of uncorrelated supply shocks, �<sup>�</sup> ~��1, �� �. Based on historical production data, we derive an estimated distribution of supply shocks, where production in MENA is more volatile than in the rest of the world.

Interest rates and per unit storage charges are assumed to be the same for each region at 5 percent per annum and $22.40 per ton per annum. The storage costs are based on recent findings in a World Bank study on wheat markets in MENA (World Bank, 2012).

The rational expectations storage model is known to lack a closed-form solution and so has to be approximated numerically. The numerical algorithm that we use is based on a projection method inspired by Miranda and Glauber (1995) and is described in detail in Gouel and Jean (2012, Appendix D).<sup>16</sup>

> 14 Average annual prices are for wheat (US), no. 1, hard red winter, ordinary protein, export price delivered at the US Gulf port for prompt or 30 days shipment as reported by the World Bank (2011b).

> 15 See, for example, FAPRI’s elasticity database, available on the internet at <u>http://www.fapri.iastate.edu/tools/elasticity.aspx).</u>

> 16 A description of the solution algorithm and solver written for MATLAB is is freely available on <u>https://github.com/christophe-gouel/recs.</u>

11
# <u>Calibrated model behavior</u>

Recall that the model is calibrated around a set of prices and quantities, together with two distributions of supply shocks that the model randomly draws on in simulation. Because of this structure, the mean values of the simulated series will be near their calibrated values. However, the variations in the simulated variables are affected by the sets of randomly drawn supply shocks. Because these distributions are not specified directly, we use the ex post variability in the simulated distributions of price, demand, supply and trade as to provide a validation check on the aggregate consequences of our ex ante parameter selections. With this as background, the simulated and historical coefficients of variation are reported in Table 3. As the table makes clear, orders of magnitude are similar between the historical and simulated distributions.

As emphasized in our earlier discussion of the link between storage and price expectations, all other things equal, low inventories should be associated with both higher expected price and more volatile price outcomes. This relationship is evident in Figure 3, which maps next-period simulated prices and expected prices against carry-in stock levels. Expected prices rise as carry-in inventories fall and the model-generated prices become more dispersed.

Before moving to a discussion of alternative policies, a couple of points should be made about trade and storage outcomes in the baseline model. First, given the large gap between production and demand in MENA, the simulated model never generates an outcome in which wheat is exported from the region. This is consistent with expectations since MENA has not been a net exporter of wheat in the last fifty years.

The second point has to do with speculative storage—that is, storage that is held in order to profit from expected temporal price changes. Data series, including the data reported in Figure 2, contain all forms of storage: speculative storage, public storage, and pipeline storage that is needed to keep shipping and processing operations running smoothly. It is impossible to isolate speculative storage in the data; however, it is speculative storage that is key to the model’s pricing mechanics. Conceptually, when one country is a perpetual importer, speculative storage will always take place in the exporting country, absent physical impediments to trade, large differences in physical storage costs or changing transfer costs (Gouel and Jean, 2012). This is because an importing speculator pays interest on the costs of importing in addition to interest on the price of the commodity, a cost that a speculator in an exporting country does not have to pay. Unless there is an offsetting benefit to storing locally, competition will result in adjustments in trade rather than storage in response to changes in availability in the importing country.<sup>17</sup> This general finding applies to our model outcomes as well, and speculative private storage always takes place in RoW.

> 17 The result also depends on the assumption that trade is instantaneous in our model. If trade takes time, it is rational to store while importing in order to be able to wait for the next shipment (Coleman, 2009). In a related way, variations in production generate greater price variability in landlocked and isolated countries (Byerlee, Jayne and Myers, 2006).

12
# **Strategic storage**

In this section, we describe a regional cooperative strategy, where strategic inventories of wheat are held in MENA as a hedge against high global prices. In keeping with our earlier discussion, the objective of the cooperative strategy is to mitigate the consequences of price spikes, that is, brief periods of exceptionally high prices like those experienced in 2008 and 2010. Government interventions are designed to be rare in order to manage the costs of the program, which include the costs associated with displacement of private storage by costly government storage.

As discussed, there is no speculative storage in the MENA region in the benchmark model. However, we assume that MENA governments hold strategic reserves, which are not directly available for consumption unless released by managers of the strategic reserves, who follow strict rules. Furthermore, we assume that the goal of the strategy is to stabilize domestic prices rather than to directly influence global prices; a practical implication is that exports are prohibited when stocks are released.

Three inter-related components are needed to fully define the public intervention. The first has to do with the maximum domestic price the strategy hopes to defend. As discussed in an earlier section, most programs designed to stabilize domestic or international prices through the build-up and release of strategic stockstabilization are prone to failure because they set out to defend unrealistic price goals. What’s more, even when goals are set reasonably, inventories are depleted when rare but eventual combinations of events occur, for example, consecutive bad harvests. With this in mind, we have chosen a conservative strategic reserve objective for our simulation. Based on the benchmark model, we simulated the range of MENA price outcomes and from the resulting set of prices, picked the last decile—that is, the minimum price that is above 90 percent of the simulated price outcomes; this works out to be $263 per ton. Importantly, by choosing to intervene at the 90<sup>th</sup> percentile, the policy insures that interventions will be rare. It is also the case that, because the policy targets a thinning portion of the probability density function, most price outcomes abovethe-trigger are expected to cluster near the target price. To summarize, choosing the 90<sup>th</sup> percentile means that most strategic interventions will occur when prices are slightly above the target price, and conversely, large gaps between world prices and the target price will be rare.

A second decision sets the desired size of the strategic reserve, the target storage goal. This decision affects the robustness of the strategic policy because, when high prices do occur, domestic prices can only be lowered if there are sufficient supplies of wheat to be released from storage. When stocks are exhausted, domestic prices can rise above the target level. Said differently, the program fails less frequently as the size of the government’s strategic reserve increases.

The third decision relates to how aggressively MENA wants to build toward its target storage goal. When the domestic price is below the price threshold and strategic inventories are below the target storage goal, MENA 13
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accumulation and avoids, in this way, over-accumulation. Our policy differs from a price peg only in equation (13) which sets the rate of stock accumulation.

# **Simulation outcomes**

# <u>Parameter interactions</u>

As discussed, the intervention price is set high and is designed to protect against the highest ten-percent tail of the expected price distribution. Choices about the targeted size of the reserve and the rate at which it is replenished determine the robustness of the policy. For the analysis reported in this section, the model is simulated 100,000 times for each of three buying strategies (10, 50 and 100 percent replenishment rates) and a range of target inventory levels from no strategic reserves (the benchmark model) to a target reserve equivalent to 120 percent of steady-state consumption, which is equivalent to more than 2.5 years of steadystate imports. For a given starting point, outcomes depend on the realized supply shocks, and it is only by simulating over several possible sequences of shocks that probable outcomes merge to an expected trajectory. However, before delving into the aggregate results, we use an example from a single price path to illustrate how the parameters interact to affect prices.

Figure 4 shows the dynamic path of prices under three scenarios: the benchmark model where prices are determined competitively and two strategic storage regimes, one where the target reserve level is set at 20 percent of steady-state consumption and another where the reserve is set at 100 percent. In both strategic reserve scenarios the target price is set at the start of the 90<sup>th</sup> percentile and the restocking rate is set at 10 percent. The time horizon of the path covers 80 periods.

It should be emphasized that the particular path reported in the figure is illustrative and a different sequence of random shocks would evoke a different path; but the figure does provide insight into how the strategic rules interact. In the first years, stocks build. When prices are high enough to trigger a release of inventories, the gap between domestic prices and the target prices is frequently small and a partial release of stocks is sufficient to drive down domestic and international prices.<sup>19</sup> Toward the end of the path, a large shock occurs which depletes reserve stocks, completely in the case of the smaller reserve, allowing prices to exceed the target price. An unfortunately timed second negative shock occurs before stocks can be rebuilt and the smaller-reserve policy fails again. The example yields two seemingly contradictory results that are nonetheless intrinsic characteristics of strategic reserves: the policy is capable of successfully defending a target price for many years but can fail even when reserves are large and the target price is high.

> 19 When stocks in MENA are released, imports into MENA are displaced. When prices are only slightly above the trigger prices, a small displacement is sufficient to bring international prices to a point where domestic prices are at the trigger price.

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# <u>Stabilization results</u>

The tradeoffs among the strategic storage rules are illustrated in Figure 5. A range of targeted reserve levels are reported along the horizontal axes of the figure’s panels while variables of interest are reported on the vertical axes. The data behind the graphs is reported in Annex Table 1 and Annex Table 2.

Turning first to the two upper left-hand-side panels, simulation results suggest that the strategic reserve can be effective in lowering the overall variation in domestic prices and consumption, and that the efficacy of the policy increases as the level of strategic stores is set higher. For example, at a restocking rate of 10 percent, a targeted reserve rate of 20 percent of consumption and a target price at the 90<sup>th</sup> quantile, the strategy reduces the coefficient of variation (CV) for MENA wheat prices from 16.4 to 15.2, and reduces the CV of domestic consumption from 1.98 to 1.83. Increasing the restocking rate from 10 percent to 50 percent increases the robustness of the policy as the probability of a stockout falls from 4.4 to 2.4 percent. This, in turn, boosts the performance of the strategic reserve policy, further reducing domestic price and consumption volatility to 14.8 and 1.79 percent.

An important outcome from the model is that the strategic reserve policy, designed to protect domestic consumers, lowers the volatility of prices in the rest-of-the world as well. Indeed, a comparison of the upper and lower portions of the first panel of Figure 5 shows that, because of trade, the coefficient of variation of price in RoW evolves similarly to the CV in MENA. By design, there are periods when the stocks released under the strategy are large enough to completely displace imports into MENA. However, this occurs infrequently, partly because the targeted price is set high and is rarely breached. In fact, the full displacement of MENA imports occurs less than 0.1 percent of the time and only occurs at target storage levels of at least 30 percent of normal consumption. In very rare instances, the correlation between local and RoW prices is also re-established when the trigger is breached, but stocks are insufficient to insulate domestic consumers.

As discussed, an aggressive strategy of restocking reserves lowers the chance that sequential periods of high prices will deplete the reserves. However, while supply shocks may be uncorrelated, high prices are not since low inventory levels can persist, setting the stage for sequential periods of high prices. An aggressive restocking rate means that the reserve manager is more likely to add more reserves when international availability is tight and prices are high. Consequently, the relationship between the coefficient of variation of price and the build-up rate is not monotonic. For low reserve targets, prices are less volatile with a higher build-up rate, but the opposite is true for high target reserves. As the size of the reserve builds, the probability of a stockout falls significantly even at low restocking rates. Consequently, a more aggressive restocking policy becomes destabilizing since larger interventions reduces the quantities available for consumption and private storage, but yield only small increases in the capacity of the policy to withstand sequential periods of high prices, and therefore generate small marginal reductions in price volatility.

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The effect of the policy on trade is unambiguous and generates increased rates of volatility, with the CV of trade increasing from 8.6 to 11.5 percent for a 20 percent target reserve with a 10 percent build-up rate (Figure 5, last panel). Periods of stock accumulation imply trade levels higher than the normal. And releases of stock displace imports.

Public storage also has an effect on private storage, through two channels. First, by decreasing price volatility, public storage decreases the profit opportunities from speculation and the incentive to store privately. Second, public reserves follow a predictable storage rule that can be exploited by speculators, either by running on the public stocks or by strategically dumping private reserves into the program. In the policy we examine, a run on public reserves (as in Salant, 1983) is unlikely since the intervention price is quite high. On Figure 6, the behavior of the various storage rules is illustrated. In order to draw the storage rules in a 2- dimensionsal figure, we are obliged to choose a situation in which the model depends only on the level of global availabilities; this is true when the build-up rate is equal to 100 percent and when MENA is always importing. We observe that private storage is significantly reduced by the policy and that private storage starts to accumulate stocks for much higher availability level under a strategic reserve program. Overall, the level of global stock increases because of the policy, but this is accomplished partly at the expense of speculative storage.

# <u>Program costs</u>

The direct costs of the strategies are provided in the fifth panel of Figure 5, based on the following:<sup>20</sup> where the discount rate used to calculate costs is the same rate used to discount storage costs. It should be kept in mind that the calculation is strictly one of costs and not net benefits which ultimately depend on assumptions about risk aversion in MENA and the RoW.<sup>21</sup> The annual average cost of the strategic reserve program evolves almost linearly with the targeted size of the strategic reserve. For a 10 percent build-up rate and a target at 20 percent of normal consumption, the annual cost of the policy is $303 million. Program costs increase rapidly as the target storage goal increases, climbing to $1,593 million for a target equivalent to one year of consumption. As discussed, the marginal stabilization benefit of increasing reserves falls quickly once the reserve target moves beyond 40 percent of consumption

> 20 Since the program is on-going, the annualized cost is the average of an infinite sum. To calculate it, we follow the dynamic programming trick of transforming the infinite sum into a recursive problem that can be solved by value function iteration.

> 21 In general, the benefits of changes in price volatility are small relative to changes in price levels (see Newbery and Stiglitz, 1981, Ch. 14).

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(87 percent of trade). A more aggressive restocking rule raises the average purchase price for the strategic reserves and this drives up program costs as well. Among the policy options presented in the Figure 5, the calculations suggest a reasonable approach would be a strategy that sets the reserve target at 50 percent of annual consumption with a restocking rate of 10 percent. This strategy is expected to reduce domestic price volatility from 16.4 to 14.5 percent, reduces international price volatility from 19.6 to 17.4, and reduces demand volatility from 1.98 to 1.74. The program is expected to fail 0.55 percent of the time and cost $827 million per year to maintain. While the failure rate is low overall, keep in mind that because the trigger price is set at the high end of the price distribution, no intervention is required 90 percent of the time on average. Consequently, a less sanguine interpretation of this result is that the policy will fail, completely or partially, about 5.5 percent of the time interventions are required.

# <u>Targeted transfers</u>

Often governments find it more cost effective to target the most vulnerable for assistance. The basic notion is that some portion of society can rely on its own resources even in times of high food prices, and excluding them from safety-net programs lowers program costs. With this in mind, we consider an alternative food security policy in which only a targeted group is protected during high-price periods. The alternative policy allows domestic prices to fluctuate as markets dictate, but provides direct assistance in the form of food coupons to a targeted group, permitting them to purchase wheat at the targeted price.<sup>22</sup> Contrary to a storage policy, there are no physical inventories and the targeted program does not fail as long as the government is willing and able to fund it. Because public inventories are not stored in support of the program, costs are only occurred when prices breach the targeted price.

Before continuing, it should be pointed out that there are alternative ways of structuring targeted food safety nets.<sup>23</sup> There are also alternatives ways to manage the financing of safety net programs, drawing on financial risk-management instruments, including options, weather insurance or catastrophe bonds (Alderman and Haque, 2006; Mahul and Ghesquiere, 2007; Skees et al., 2005). However for our purposes, cash-equivalent transfers where the program’s cost falls to the government serve as a realistic, useful and simple benchmark with which to compare program costs.

> 22 The program is somewhat akin to the US food stamp program. Though effective, such programs require careful implementation. See Mykerezi and Mills (2010) and references therein for more on the impact of the US food stamp program on food insecurity.

> 23 Because technological advances have lowered implementation costs, they are increasingly used in developing countries (Ahmed, 2005). But targeted food transfers are still much used, including self-targeting approaches, such as belowmarket-wage food for work program (del Ninno, Dorosh, Subbarao, 2007). Moreover, there are potential reasons for doing so, separate from logistical considerations. Food transfers may provide a more consistent delivery of benefits compared to cash transfers when local prices vary significantly from national averages (Sabates-Wheeler and Devereux, 2010); there is also evidence that cash transfers can raise local food prices, thereby diminishing their efficacy (Cunha, De Giorgi, Jayachandran, 2011).

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In the context of the model, the market equilibrium equation for MENA under the new policy is: where � represents the share of households covered by the policy. The costs associated with implementing the identification and targeting of qualifying households is excluded, even though the costs may be very consequential.<sup>24</sup> The cost of this policy is given by: Simulation results from the alternative policy are shown in Figure 7. Because the trigger price sits at the 90<sup>th</sup> quantile, payouts occur infrequently. Moreover, because the program covers the thin tail of the price probability distribution, prices that would warrant payouts are clustered near the trigger and this keeps typical payouts low. In turn, these features keep average program costs down to $53 million per year, when 40 percent of the population is covered, well under the cost of a strategic storage program. Even when the program is extended to the entire population, average program costs are low at $142 million per year.

Even so, the average cost of the program masks rare events that may strain budgets and threaten the sustainability of the program. In our simulation, the maximum payouts, for a program-coverage of 40 percent of the population, was $3,784 million—nearly 70 times average costs. At the same time, the value was an extreme one and 99 percent of the payouts were under $1,338 million (about 25 times average cost).

The policy is designed to allow vulnerable households to consume at levels consistent with lower prices when wheat prices are high. For some households, the benefits are large and lasting, since the capacity to purchase more food precludes the long term consequences of even temporary periods of poverty and malnutrition. But it also means that, for the portion of the population covered, price does not ration demand. Specifically, when the market price reaches the ceiling price, protected consumers face a constant price and their demand becomes perfectly inelastic to prices. As a consequence, the program creates an added cost for most consumers, since less adjustment in demand leads to greater price volatility, both in MENA and in the rest of the world.

Quantitatively, simulations suggest that the average effect of the policy on volatility is small; extending the policy to all households in MENA would increase price volatility by about 1.2 percentage points.

# **Conclusions**

In this paper, we describe a rational expectations model of competitive storage and trade, based on wheat markets for the Middle East and North Africa and the rest of the world. We use the model to quantify the

> 24 In addition, local storage also protects domestic consumers from physical disruptions in trade. This is a real and practical source of risk for some countries, although it is not directly accounted for in our analysis.

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effects of a strategic inventory policy designed to protect consumers in the region from very high prices. We find that, with a modest protection goal, the program can effectively protect consumers in MENA against steep price spikes, and by doing so lowers price volatility in the region. Moreover, because MENA is a large importer, releasing stocks when international prices are high lowers international prices since the released stocks displace MENA imports.

Theory and practical experience suggest that strategic reserve programs fail when a series of rare but eventual adverse events occur. The model suggests the probability of the program’s failure can be reduced by holding greater reserves. A more aggressive restocking of spent reserves reduces failure risk as well, but the strategy can be destabilizing since larger purchases are made when international supplies are tight.

Making the strategic reserve program robust to failure drives up the program’s costs. Simulations show that a targeted consumer subsidy program that insulates the most vulnerable from the upper range of price increases is a much less expensive alternative on average. Even so, the targeted program remains reliant on trade and adds slightly to global price volatility. In addition, the program is subject to rare peak expenditures that could undermine the policy when alternative risk-sharing financial instruments are unavailable.

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