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How International Commodity Price Shocks Impact Indonesian Food Prices

March 8, 2011

Sjamsu Rahardja

By: Sjamsu Rahardja, economist at the World Bank office Jakarta

This is the second in a series of articles by Indonesia-based World Bank economists drawing on analytic work done by the World Bank in collaboration with local partners, on the impact of commodity prices on the Indonesian economy. Having discussed the drivers of the 2008 world rice price crisis in the first article, this second article looks at commodity price shocks more generally and their impact on Indonesia given the characteristics of its market integration.

As discussed in our previous article that focused on rice, the past several years have seen the prices of commodities fluctuating dramatically, with a tendency towards increased prices. Indonesia is certainly not immune to these price fluctuations. Regardless of import restrictions or subsidized pricing, global price increases are inevitably transmitted to domestic markets. Given the impact that such price rises can have on the poor and the degree to which they can undermine the government’s efforts to reduce poverty, it has become vital for policymakers to understand the extent to which international price shocks are transmitted to domestic markets and the speed, geographical patterns, and drivers of the transmission of these price shocks. With such an understanding, policymakers are in a better position to formulate policies that benefit consumers, while at the same time protecting producers. And it is important not to forget Indonesian producers in the equation. Weak integration between domestic and global markets implies a weak domestic supply response. This in turn represents a huge lost opportunity for the Indonesian economy, with agricultural producers generating suboptimal levels of revenue from their products.
In a report recently published by the World Bank in Jakarta, the extent to which commodities in Indonesian markets such as sugar, cooking oil, soybean and maize were integrated into world markets was analyzed. The analysis shows that all four commodities are well integrated with world markets. Over a period of about one year, a one-percent increase in world prices leads, on average, to a one-percent increase in domestic prices. The different commodities are found to respond to world price shocks at varying speeds. In general, the speed of adjustment of domestic prices to shocks in the world market is fastest in the sugar and cooking oil markets and slowest for soybean and maize markets. The speed of transmission of a shock in the international price to the domestic market also varies between the different provinces.

Within Indonesia, the report finds the main factors determining the extent of market integration between the various provinces are remoteness andthe quality of transport infrastructure in that province. The analysis also shows that those commodity markets with the highest degree of integration across provinces have smaller price differences: in the sugar market the average price differences across regions is 5%, while in the soybean, cooking oil and maize markets they are 16%, 19% and 22%, respectively. Similarly, the differences between the maximum and minimum price in the country are lower for commodities that are deeply integrated across provinces. Buying maize in the most expensive province can cost up to 117% more than buying it in the cheapest province.
Up to 70% of price differences across provinces can be explained by differences in the degree of remoteness, transport infrastructure, amount of locally-produced output, land productivity andincome per capita. Remote provinces pay more unless they have a good transport infrastructure.
The report also finds that after taking into account for variations in exchange rates and world prices, remote provinces appear to have a higher level of price volatility than central provinces.

The results of the study suggest that international commodity price shocks are fully transmitted to domestic prices. Thus, their impact on the economy is not just through changes in the prices and volumes of exports and imports, but also through changes in domestic production caused by changes in domestic prices. The results also imply that the economic impact is not homogenous across the country because of the differing degree of integration between provinces. The speed and magnitude of the price change in remote provinces will be generally slower and less significant than in other regions.

The analysis has some important policy implications. The study indicates that government intervention is rarely the most effective means of reducing price volatility because shocks in international commodity markets will be fully transmitted to domestic market. It also shows that improving the quality of infrastructure can alleviate constraints to the transmission of price signals created by geography and remoteness. This has important implications for food security. Targeted policies that aim to protect the poor and vulnerable from volatility in food prices are considered a priority. Policies that aim at decreasing transportation costs by improving infrastructure or by eliminating bureaucratic impediments to transport will enhance integration of commodity markets within Indonesia and contribute to a reduction in price differentials between provinces. The study also highlights the importance of improving agricultural productivity as a way to reduce prices for consumers, while at the same time increasing incomes for farmers.