Can China tackle the great grain challenge?

By Wei Gu

HONG KONG (Reuters) - China has shown that it can act by raising domestic fuel prices, but will Beijing be able to tackle an even thornier issue: cheap subsidized grain?

After oil, grain could be the next big price risk for China. The government shifted the focus of its agricultural subsidies from protecting farmers' incomes to shielding its 1.3 billion consumers from inflation when food prices surged last year.

In response, Beijing tried to restrict exports and promote imports. Good harvests and restrictions in the last four years had prevented Chinese grains prices from rising as fast as international prices.

But as so often with subsidies, where one worry subsides, another one rises in its place. Chinese farmers are facing the same inflation in farm input costs as their global counterparts. International fertilizer prices are surging along with oil, and although the government shields the farmers to some extent, it cannot keep up, especially on labor costs.

The result is lower farm profits and the risk that farmers stop producing. About 250 million Chinese farmers, more than the entire population of Indonesia, have left farming in recent years for higher-paying jobs in cities.

"The big grain challenge is still to come," said Paul Cavey, head of China economics at Macquarie Capital Securities. "Next year and beyond is trickier."

Worried by both high inflation and the global food crisis, Chinese officials are more attached than ever to the goal of self-sufficiency which they have been hoping to achieve through continued subsidies along with new technologies or farm modernization. But they may be missing the point.

Maybe China will be best served by doing the thing it least wants to do for fear of its inflationary impact, which is easing off on subsidies, and allowing farmers to export. That would bring prices more in line with global markets, thereby enriching farmers though market means.

"China's domestic grain prices have to be raised," said Shikha Jha, a senior economist at Asian Development Bank. "China is now subsidizing the entire population, but there are people who can afford higher prices."

China's agriculture subsidies, expected to reach 134 billion yuan ($19.5 billion) this year, are just enough to preserve farm profits, not enough to keep people in the fields.

Even China cannot afford to increase the subsidies by a big margin, partly because it is increasingly subsidizing the world when grains are smuggled out of the country.

In the past 10 years, the government's average purchase price of grain edged up merely 5.3 percent, according to official figures. Outspoken government officials and experts said some increase in grain prices will give Chinese farmers an incentive to stay back to till the fields, which will prevent a further run-up in prices.

However, Beijing has been hesitant to use price mechanisms and always hopes improved technology -- high-yield seeds, better use of water -- could solve the problem by allowing fewer farmers to produce even more.

That is almost like rolling a big rock uphill. China will be hard put to modernize one of the world's least-developed agricultural systems in time to prevent imports. Large U.S.-style farms might work in northern China, but not in southern China where plots are much smaller.

But just consider how reluctant the government had been to bring domestic fuel prices closer to global levels. Higher grain prices, which hit everyone rather than just some affluent car drivers, will surely be more controversial.