It appears that the market is pricing in a benign outlook for food prices in the coming six to 12 months after global food prices retreated recently. However, we think recent extreme weather incidents have created upside risks to food inflation in the second half of 2011.

Recent incidences of extreme weather events could result in raw food prices rising in the latter half of the year. Indeed, drought-like conditions in areas of China and Europe are likely to hit food production. Higher raw food prices in an environment of elevated energy costs may also put further pressure on the prices of prepared foods, which have been climbing in the past three months. While we expect headline inflation numbers to roll back, the moderation may be limited given the emerging tail risks.

Raw food prices have stabilized since February. The price of Thai fragrant rice, the variety widely consumed in emerging Asia including Hong Kong, dropped to $682 per metric ton on May 18, down 26 percent since it peaked at $931 in November 2010.

Although food prices have fallen significantly in the past two months, growing conditions are turning less favorable.

We are seeing initial signs of a turnaround in the recent good planting conditions, with the Southern Oscillation index falling sharply from +30 (big wet) on April 25, to 3 (neutral) on May 18. In China, for instance, the Yangtze River basin is in the grip of its worst drought in four decades while eastern Shandong province is experiencing one of its worst droughts in recorded history and faces an acute shortage of water.

Shandong has received just 12 millimeter of rain since September 2010, with some reports indicating that around 40 percent of the province's wheat crop has been lost. For now, we believe any food shortages in China can be offset by abundant harvests in Indochina.

Drought in southern China poses downside risks to food production. In an attempt to relieve the impact of the drought, officials opened the sluices on the Three Gorges Dam on May 16, discharging 9,500 cubic meters of water per second for 12 hours.

Furthermore, there are fresh signs that raw food prices may pick up in the second half in Europe as well. Amid the worst rainfall conditions in the past 50 years, the French government has convened a drought committee because groundwater levels have fallen at an alarming rate, after the country received less than half the usual amount of rainfall from September to April. In the wheat fields around Beauce, south of Paris, government officials are comparing conditions with the severe droughts of 1948, 1976 and 2003. This trend portends drier conditions for the northern hemisphere summer. We will also be watching for signs of any abnormal weather patterns in the Ukraine, which could raise the risks of a repeat of the spike in wheat, corn and barley prices seen in August 2010.

For now, we think the key implication is that the risks to food inflation are set to rise, contrary to the more benign outlook that is currently priced in. One risk is another sharp swing from the extreme La Nina pattern (big wet) to El Nino (big dry) later this year. If this happens, raw food prices could jump again. The pass-through impact of higher energy costs is already being seen in the cost of prepared foods.

On average, we estimate that prepared food accounts for more than 40 percent of food inflation in emerging Asia.

The share of prepared food is especially higher in economies such as Singapore, South Korea and Hong Kong, reflecting their "eating out" cultures. This means that the pass-through from higher raw food prices into prepared food in these economies is usually rapid, especially in an environment of elevated energy costs. Indeed, we are already seeing this pass-through impact starting to accelerate in emerging Asia.

We still expect headline inflation to moderate, but this change is likely to be limited given the emerging tail risks. While the risks of a large spike appear contained, elevated food prices are likely to entrench rising price pressures. Currently, we forecast that 2011 regional inflation will be close to 5 percent. If we were to see a large price shock (eg, a 10 percent rise in raw food inflation), we would expect an upside of close to 50 basis points to our average inflation projections.

The authors are analysts at Barclays Capital. The views expressed here are entirely their own.

(HK Edition 05/26/2011 page2)