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Although we do believe China will see higher structural food inflation over the medium term, the current jump in the headline CPI index is clearly temporary.

Over the past six months, one of the biggest themes across global investment markets has been the threat of rising food inflation. Why? The first reason is the sharp increase in international grain prices; since the beginning of the year the price of exchange-traded corn, wheat and oats has jumped to near-record highs, more than double the level of the first half of 2005. And the second is the “China factor”, with key headline food items like pork and eggs now up 50% to 70% in the last four months alone. Could agriculture now be the “new oil”, with food prices pushing up global inflation and forcing a round of further central bank tightening?

In fact, we don’t see much to be concerned about. As it turns out, “food” is a very diverse category and grain prices are only one part of the picture. There is also relatively little pass-through from global food prices to domestic prices in the Asian region. And although we do believe China will see higher structural food inflation over the medium term, the current jump in the headline CPI index is clearly temporary.

The first point is that there’s a big difference between “grains” and “agriculture”. The latter includes a wide range of non-food products, and even when we restrict ourselves to food categories, grain and cereals are less than 15% of total food trade (the remainder is a diverse mix of meat, dairy and fish products, fruits, vegetables and soft commodities such as coffee, sugar, cocoa, etc.).

You can see this very clearly in Chart 1 below, which shows the behavior of the Reuters CRB commodity price index by selected sub-categories. As expected, the grain and oilseeds sub-index has been up nearly 50% y/y since the beginning of 2007, but the livestock sub-index is essentially flat and soft commodities are actually down over the past 12 months. What’s more, none of these components is very strongly correlated with the behavior of the overall CRB index, reflecting the high weight of other products such as fuels and metals in total commodity trade – and the overall index is now in negative growth territory.

In other words, rising grain prices alone are nowhere near sufficient to generate a “food price” scare, much less generate broad commodity price inflation.

The next point is that Asian countries don’t have a very large food import exposure. In fact, spending on grain barely makes a dent at all in the numbers. Last year nearly 20% of total Asian import spending went to oil, oil products and other fuels – while total imported food spending was only around 3% of the total. According to our estimates, the direct impact of rising global grain prices is nearly 40 times less than the impact of higher crude oil and other fuel prices.

You could of course argue that even if the import exposure is slight, global food prices have a large influence on domestic prices. But as it turns out that argument is wrong. When we look at the relationship between international food price indices and domestic prices in Asian countries, we don’t find a significant correlation at all. As it turns out, most food price swings are profoundly local in nature.

The final point concerns China. Many investors argue that as the mainland becomes more dependent on imported foodstuffs the world economy will enter an agricultural “super-cycle”, with large, sustained and across-the-board price increases just as we saw with oil and minerals over the past five years, and this would have a much bigger impact on CPI indices everywhere.

Could it happen? Over the longer term, it could. We have long argued that the combination of falling land supply, water shortages, rising migrant wages, tighter rural labor markets and booming food demand is already pushing up prices at home, and should also result in big increases in mainland agricultural imports over the coming years. Needless to say, this should be bullish for global grain and soft commodity prices.

But it’s not happening yet; so far there’s no sign whatsoever that China is even starting the process. Chart 2 below shows mainland agricultural import growth in real volume terms; as you can see, 2004 was a boom year for Chinese spending on food imports, but in 2005 and 2006 import volumes fell outright, with only a relative stabilization so far in 2007.

Now it’s true that food prices have been rising to an abnormal degree in the mainland over the past few months, but as we noted above much of the action here has been due to temporary spikes in specific product categories, and we actually expect a slowdown in overall CPI in the first half of next year as this effect is reversed. So while China should well have a more significant effect on global agricultural markets down the road, we don’t believe we’re at a major inflection point today.