1

London Metropolitan Business School

ECPP40C Economics Dissertation 2010-11

THE BRAZILIAN AND INTERNATIONAL WHEAT MARKET INTEGRATION BETWEEN 1973-2010 AND THE IMPACT ON THE GOVERNMENT POLICIES

Jose Garcia September/2011

This project is submitted in part of the requirement for the completion of a MSc Economics at the London Metropolitan University. The work is the sole responsibility of the candidate.

Introduction

The dissertation is about integration between the Brazilian and International market of wheat, where the United States (US) is taken as a proxy of the international market. The Argentinean market is the most important international supplier of wheat to Brazil, but the analysis of market integration is not in relation to Argentina, because US is the main exporter of the world and as mentioned by Arbitrigo (2011), Lopes (2008) and Coronel et al (2010), the Argentinean wheat market follows the US prices and the domestic prices are adjusted in front of US price variations. The main interpretation of market integration used here is the price adjustment between spatial markets. The general aim of the dissertation is to describe the understanding of market integration in the literature and its application to the wheat market in Brazil in relation to the world and analyse the impact of integration in the Government policies. To achieve such objective the dissertation was divided in four chapters, which will be briefly summarized here. The first is related to the structure of the wheat market in Brazil between 19752010, where will be seen that the market was closed and strongly protected until 1987 and only after a deregulation process the market become open, which impacted in the price formation and in the market integration level. Also is described the domestic production of wheat in relation to demand; how the production in Brazil is divided and its relations with milling industry to better understand the wheat market performance and finally some aspects of international market. Also is highlighted that an anti-inflationary policy related to wheats price increase is to be made in Brazil without taking into consideration the market integration. The second chapter is about the literature review in market integration, where the evolution and relation of prices between two or more markets will be the main source of information to determine the level of integration. The goal is to find out if at least one of the markets analysed has its prices adjusted in front of variations in the prices of the other market analysed. Apart from the price approach, other approaches of market integration will be examined.

3 During the second chapter will be mentioned some issues in the geographical market literature that can help to identify the market integration. The geographic market also studies the relation between markets in terms of price formation in one market influencing the price formation in another market. Because of this similarity, it is believed here that some of the issues applied in the geographic market can be reapplied in the market integration analyses. Having read the first and second chapter, this will be enough to conclude that the Brazilian wheats market is integrated with the international market, however, to give a formal support to the research, the third chapter will develop some econometrical analyses. Firstly the stationarity test will be done to determine the level of stationarity (on the level or 1st difference) as requested by the Pedroni`s cointegration test. The stationarity test will also be used to verify if prices in Brazil are adjusted in the short run or not, because the stationarity test is regarding the equilibrium of variables in the short run. It will be applied the LLC and IPS test. To support the existence of integration between the markets examined it is used the Pedroni`s Cointegration test. Finally, the Granger-Causality test will be done to determine the way of adjustments. It will be noted that the results from this chapter will be mentioned during the second chapter. With the econometric outcomes established, the fourth chapter is regarding Government policies that can affect the market integration and policies that are affected by the integration. The first part of the chapter shows how Government can influence the integration level through policies. The second part demonstrates how the authorities should be influenced when the market is integrated, for example, an antiinflationary policy towards a product with high variation in prices needs to take into consideration if the domestic market is integrated or not. Also are highlighted some policies that should be taken by Brazilian authorities to increase the domestic productivity and competitiveness in wheat production due to the Brazilian`s market being integrated with international market and it is performing a depended role. The final part of the dissertation will contain the main conclusions from the dissertation.

4 1. Regulatory changes and evolution of Brazilian wheat market

1.1 History and actuality of wheat production in Brazil The wheat culture in Brazil is an annual cycle plant, growing during the winter and spring. Currently, the wheat is the main winter crop in Brazil, especially being grown in rotation with soya and corn (Franceschi et al, 2009) and the production chain presents an important role in the Brazilian economy and society, as it represents an important part of food consumption (Caf, 2003). In short, the final products of this chain are bread, pasta, biscuits and flour, when marketed directly to consumers. The national production is mainly concentrated in the South Region of the country, being responsible for around 90% of the whole production (Embrapa, 2011) and the remaining part is mostly located in So Paulo (Southeast Region) and then Mato Grosso do Sul, Minas Gerais and Gois (Midwest Region) (Corte, 2008). According to the agricultural census of 2006, nearly 60% of the wheat production was originated from small and middle size farms, with less than 200 hectares (Mori et al, 2007). The size of farms and its influence power over politics will be better discussed in Chapter 4. The country is far from being self sufficient, producing enough to attend to only half of the national demand, therefore, the international market is a significant player in this market (Conab, 2011). Nowadays the market is open, where countries of Mercosul do not pay any import duties and countries that are non members of Mercosul need to pay up to 15% in duties (Ministerio, 2011). The markets were not always open, in 1962 and 1963 the Brazilian authorities initiated some programmes of agricultural policies to stimulate domestic production in order to further reduce the dependence on imported wheat, which regulated the market completely and even determining directly the levels of importation and raising import duties (Garcia & Neves, 2001). The control was also towards the mill industry, where there was a legal barrier to the entry of new mills in the industry and a close inspection of the mills performance and the overall result was a concentrated market (Colle, 1998). All the protectionism and control resulted in a constant increase of wheat production, but with distorted prices (Ministerio, 2011).

5 The protectionism extinguished in 1987, when the Government reduced the supply of resources for agriculture funding. It occurred when the country almost achieved the self sufficiency (importing less than 20%1 of the consumption needs of grains) (Corte, 2008). With the deregulation of the wheat culture, one effect was the reduction in the production and the increase of the importation, as it can be seen in the following diagram. Diagram 1: Production and Importation of wheat in Brazil between 1987 to 2010
8000 7000 6000 1000 tons 5000 4000 3000 2000 1000 0
19 87 19 93 19 95 19 97 20 05 20 07 20 09 19 89 19 91 19 99 20 01 20 03

production import

Source: Conab (2011)

After the record harvest of 1987, the period until 1995 was characterised by a strong and sudden fall of production due to the extinction of official grants and the over protected wheat market. From 1996 to 2004 the production started to increase again, due especially to the expansion of planted area and productivity. In 2003, the new record harvest yielded unprecedented productivity of culture (2,403 pounds per acre). From 2005 to 2010, there were some alternations related to climate conditions and prices, for example in 2008 was noted a good wheat production with the recovery of the area, stimulated by high prices and obtaining new record of productivity (2,480 kg/ha). However, the harvest of 2009 decreased due to climatic adversities (Embrapa, 2011), rising again in 2010 and reaching the biggest recent record in productivity of 2.578 kg/ha (FAESP, 2011), which is still half of the productivity reached in Europe (Coronel et al, 2010).
1

Considering the regulator stocks.

6 The next section shows certain factors related to world production.

1.2 International Market of Wheat According to the estimatives of the United States Department of Agriculture (USDA), the world production of wheat in the 2010/11 reached 645.4 million tonnes, lower than the consumption level (662.7 millions tonnes), consequently, reducing the wheat stockpiles (in general the production tracks consumption, with variations in the stocks and consequently in prices). The previous harvest (2009/10) was higher than consumption by 32 million tonnes, resulting in the highest final inventory ever (197.6 million tonnes), equivalent to 30% of the consumption needs (USDA, 2011), this exerted pressure in the international prices and kept the negative trend in 2009 (Ministerio, 2011). The next diagram shows the main producer and consumers of wheat in the world. Diagram 2: World wheat production and consumption between 2006-2010 in millions of tons.
250 200 Millions of tons 150 100 50 0 Cons Prod. Cons Prod. Cons Prod. Cons Prod. Cons Prod. 2006/07 EU
Source: USDA, 2011

2007/08 China India US

2008/09 Russia

2009/10 Australia Canada

2010/11 Other

It is clear that the European production and consumption dominate, followed by China, India and US. These four countries with the other mentioned in the above figure are sustaining their positions as leaders in production. The biggest evolutions

7 were made by Australia and US, with an increase of 131% and 22%, respectively. The US improvement is due mainly because of the expansion of pasta manufacturing and exportation policies. When the performance of the other countries is analysed, it can be seen that the consumption had progressively increased, whilst the average production basically remained constant, this means that the international market raised even more its importance as a source of wheat for such countries. Russia should be amongst the biggest levels of production expansion as well, but it decreased more than 30% because of climatic conditions (Chance, 2010), contributing expressively for the fall of 5.45% in the total world production. In front of production decrease and consumption increase, the wheat stockpiles in 2010/2011 shrank to 26.9% against 30.2% from previous crop, contributing for price increase in 2010 (USDA, 2011). The following section shows the main players in the international market and the Brazilian participation.

1.2.1 Wheat International Trade The main exporters were practically the same as the previous table, however there is a certain inversion in the order. The US despite being only fourth in world production is the largest exporter, as demonstrated by the following diagram.

Diagram 3: The main wheat export countries between 2005 to 2010 in 1000 tons.

38500 35000 31500 28000 24500 1000 tonns 21000 17500 14000 10500 7000 3500 0 2005 2006 2007 2008 2009 2010 US EU Canada A ustralia A rgentina B raz il Russia O thers

Source: USDA, 2011, b (world agricultural supply and demand estimates)

The 5 main wheat exporters are: US, EU, Canada, Russia and Australia, together they are responsible for an average of 69% of the exportation, where the leadership of world exports of wheat is the US. Russia was also an important exporter, which was amongst the 5 biggest ones, but its production decreased as mentioned before. The other countries also had an improvement in the exportation level, but still not enough to overcome the main players. It is important to mention that Argentina decreased its trade level and this occurred because the main importer of Argentineans wheat Brazil increased its production and started to trade more with other countries, as it will be seen in table 2. However, regarding importation, the next table shows the most dependent countries of imported wheat.

Table 1: The main wheat import countries between 2005 to 2010 in 1000 tons.

9
Country 2005 2006 2007 2008 2009 2010 2005/10 % 26.1 -3.2 -2.4 5.2 -22.6 -32.3 5.1 10 tons 2029 -197 -134 266 -1530 -2180 197 369

Egypt Brazil Algeria Indonesia Japan EU South Korea Nigeria

7771 6235 5483 5072 5469 6755 3884 3679

7300 7997 4874 5601 5747 5233 3439 3265

7700 6772 5904 5227 5701 6933 3092 2633

9900 6403 6350 5419 5156 7737 3317 3550

10300 7126 5167 5364 5502 5480 4470 4079

9800 6038 5349 5338 5225 4575 4081 4048

Others World

67229 111577

70552 114008

69843 113805

89047 136933

86196 133684

78763 122779

35.5 10

11534 11202

Source: USDA, 2011, b (world agricultural supply and demand estimates).

The world wheat imports level is not so concentrated, where the five main importers have an average of 31% of the total amount imported, therefore, there is a lower average than the one found in the exporters average. It can suggest that the exporters have more conditions to cause the price formation than the importers. However, in relation to Brazil, the country stands as the second largest importer of wheat and presents an average of 5.53% of the total traded (USDA,2011, b). Brazil is one of the main importers of wheat in the world and this trade only began to grow in Brazil after deregulation. In 1987 with less than 20% of the imported product, it reached 61.53% already in 1991 and reached a peak in 2000, with 83.11%. This shift can be explained mainly by the competitive differences between Brazil and the exporting countries (Maggian & Felipe, 2009), which will be further discussed in section 4.2. The countries members of Mercosul (Argentina, Uruguay and Paraguay) are the main supplier of wheat to Brazil, as the following table demonstrates.

Table 2: Participation of international suppliers of wheat to Brazil in %. Country

2002 2003 2004 2005 2006 2007 2008 2009 2010

10 Argentina Uruguay Paraguay Mercosul Canada US Others

82.87 0.22 0.87 83.95 0.82 10.37 4.86 84 0.08 1.05 85.13 2.59 7.59 4.69 96.19 0 2.29 98.47 0 1.53 0 90.86 0.46 8.08 99.4 0 0.60 0 91.51 2.01 5.13 98.65 1.1 0.25 0 84.99 2.21 2.32 89.51 4.53 15.06 0 70.31 1.46 8.63 80.41 4.53 15.06 0 59.19 15.89 14.94 90.01 5.57 3.94 0.48 57.52 18.06 10.09 85.99 5.90 7.82 0.62

Source: Conab, 2011

Historically, Argentina has been the largest supplier of wheat to Brazil. In the last 20 years Argentina supplied between 57% and 97% (Agencia, 2011). However, since 2005 there has been a loss of the country's participation, due to Argentinean policies of restricting the exportation of the grain to preserve the supply of its internal market and stimulate the export of higher value-added products (Ministerio, 2011). To replace this loss, the other Mercosul member countries Uruguay and Paraguay - that had increased their production in the last years are filling the gap, along Canada and US. Another reason for such reduction in Argentinean participation was highlighted by Arbitrigo2 in Miklasevicius (2011), where Argentinean dealers overcharged Brazilian importers, comparing with Argentinean domestic prices. The overcharge occurred due to a lack of supply with same conditions of free trade, because non Mercosul countries have to pay up to 15% in taxes. The statement given from Arbitrigo associates (windmills) were supported on the fact that they spent more money in the last two years, compared with previous years, and obtained less wheat than before, even with international prices decreasing. Second Arbitrigo, this was happening from a long time ago, especially between seasons in Brazil. Consequently, Brazilian mills started to buy more from other countries mentioned above. (Miklasevicius, 2011). Brazil also imports wheat flour, however the volume reached approximately only 2% of the total volume consumed in the last decade, though the last years the average increased. The increase is due especially to the Argentinean oriented policy to export higher value-added products in the detriment of the wheat grain. (Ministerio, 2011) The consequences of deregulation of the wheat industry in the late 80`s related so far was the reduction in the production of wheat and increase in its importation.
2

Wheat Brazilian non-Governmental Association.

11 However, the deregulation also brought the expansion of the number of mills, due to less bureaucracy. Some aspects of the milling industry can be seen in the next section.

1.3 The milling industry in Brazil In 1967, when the regulatory framework was established, there were 368 mills and in 1987 the number was reduced to 179 (Colle,1998), due to control imposed by Government. With the deregulation after 1987, the windmills industry began to follow a path of decentralization by: expanding the number of windmills; return of small units that were prevented from entering the market under the previous conditions and the end of import quotas resulting in expansion of milling capacity (Perosa & Perosa, 2007). Already in 2000 the crushing capacity was 65% higher than in 1987 (Garcia & Neves, 2001). The next diagram shows the numbers of windmills in Brazil, from 1967 until 2009. Diagram 4: Evolution of number of windmills of Brazil 1967 to 2009

400 350 300 250 Units of 200 windmills 150 100 50 0 1967

386

179

189

220

N. of Windmills

1987 Years

2000

2009

Source: Colle (1998) and Ministerio (2011)

It is clear that the protectionism of the market contributed to a market more concentrated and the opposite with the deregulation after 1987. As already mentioned, the South region and So Paulo are accounted for over 90% of the wheat production and are the most competitive region of mills, different from the North, Northeast and Midwest, where there are just few windmills (Garcia & Neves, 2001). Currently the milling industry is split within Brazil as follow.

12 Diagram 5: Estimation of wheats windmills in activity in Brazil 2010.

Other 17 States 15% Southeast- So Paulo 7% South - Santa Catarina 14% South-Parana 31%

South - Rio Grande do Sul 33%

Source: Arbitrigo, 2011

The distribution of the Brazilian Mills is closely tied to the production chain in the country. Traditionally, the southern region holds the largest number of mills due to the proximity of the main producing areas and Argentina. Already in the North and Northeast, where there is no domestic production, wheat Mills settled next to the ports of large cities, in order to facilitate the supply of imported wheat. (Ministerio, 2011) According to Ipea3 (Sena, 2007), the market structure of mills in Brazil in general is not concentrated, except in some areas of North and Northeast of the country where there are different models of production of windmills, also the industry is made of mills with small and large capacities. The different production models began to represent different strategic groups, where the smaller mills have a continuing relationship and mutual interest with cooperatives and farmers. The same does not occur in technologically up-to-date windmills, they need to appeal to the international market for wheat to better develop their market segmentation strategies (Corte, 2008) In front of the descriptions about the economic aspects of the wheat market in Brazil and abroad, the next section will consider the price evolution in Brazil.

1.4 The wheat prices evolution in Brazil and its relation to international price

Institute of Applied Economic Research (Ipea) It is a federal public foundation linked to the Strategic Affairs Secretariat of the Presidency. The institute provides technical and institutional support to government for the formulation of public policies and development programs.

13 There are many factors that involve the price formation of agricultural products, which can be from non controllable variables as climatic conditions and products perishability level, until controlled ones, like: infrastructure, cost production, etc. Also, the trade policies play an important role in the price formation, because the price evolution is different when the market is controlled or not by the Government (Brum et al, 2005). As seen previously, the wheats market in Brazil began to be regulated in 1967, where the local prices were much more susceptible to the decisions and political needs than anything else until the end of regulation in 1987 (Caf et al, 2003). After 1987 other factors rather than Government intervention became the key points of price formation. However the Brazilian Government kept some level of interventionism through the governmental agency Supply National Company4 (CONAB) operating a program of buying and selling simultaneously the wheat through the warranty policy that would pay to producers a minimum prices. Nevertheless, the program is little used and widely criticized for its ineffectiveness, currently the minimum price offered is approximately 15% below the stipulated by the So Paulo Stock Exchange (Paula, 2010). The variations related to domestic prices of wheat can be seen in the following diagram.

Diagram 6: Evolution of Brazilian price of wheat since 1975 in US$.

Conab - Companhia Nacional de Abastecimento It is a public company attached to the Brazilian Ministry of Agriculture, Livestock and Supply.

14

20 18 16 Prices in US$ 14 12 10 8 6 4 2 0
19 75 19 77 19 79 19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 20 05 20 07 20 09

Years Sack of 60Kg in Brazil

Source: Conab (2011)

It is clear that the end of the regulatory framework of wheat in 1987 had an impact in the price formation, where was seen a considerable fall. In 1986 the average price of a wheats sack was US$ 17.17 and dropped to an average of US$ 8.57 in 1987. The reason of such fall was the liberalisation of the market and the expressive cheaper prices in the international market, provided by the Chicago Stock Market. Therefore, in front of the international option, which was cheaper and with better quality, the Brazilian prices was forced downwards. Second Ignaczak et al (2006), due to the difficulties confronted by the Brazilian producer in relation to international competition, forced them to sell the crops only to CONAB through the national programme of minimum price, because the private windmills and cooperatives were importing. It was only after 1995 that the Brazilian producers started to sell their crops out of CONAB, when their prices started to match the international prices. It was not because there was an increase in the Brazilian competitiveness level, but mostly because there was a significant reduction in the international supply, which increased the prices (Ignaczak et al, 2006). After deregulation until 2005 the prices did not alternate much and after 2005 the prices of wheat had an upward trajectory, because it followed the world market variation due to international production not being able to match consumption. Encouraged by record prices, the world farmers broadened their

15 crops in 2008 and 2009 over consumption, even with a record production in 2008 (684.2 millions of tons), which reflected in a drastic reduction of the prices until the end of 2009 (USDA, 2011). From June 2010 the prices started to increase until nowadays, triggered by the confirmation of significant shortfall of Russia, Ukraine and Kazakhstan cultures. Currently the trend is positive in the short and long term due to consumption being not matched by production (Cogo, 2011). In general, the Brazilian prices followed international prices after deregulations, being slightly more expensive or cheaper in different moments, but in a similar fluctuation. This similarity will have a direct impact in the level of the market integration, as will be seen in the next two chapters. In 2011 the wheats price increased in the international market as in Brazil. Regarding the domestic increase in the last months, the Brazilian government is about to launch some manoeuvres to decrease the price, like getting closer supervision over cooperatives to avoid price increase during off season (time between cropping) and even suggesting to increase the governmental safety stock. All this to decrease the inflation pressure caused from the wheat (Ipea, 2011, a; Ipea, 2011, b). However, there was nothing related to importation and its prices, once it was seen that the domestic market was open and in front of the high level of national dependency in this cereal, the domestic prices might be under international influence. In the next sections there will be some discussion about theoretical issues of market integration and the econometric tools to analyse and identify the integration in the wheats market of Brazil.

2. The Literature Review in Market Integration 2.1 Introduction: Understanding the market Integration The concept of market is a topic that has fascinated social and economic researchers for a long time. However, the definition of the market is not unique and can have different applications, as mentioned by Scheffman & Spiller (1987, p.127) that while antitrust markets consist of the smallest relevant group of producers possessing potential market power, economic markets are based on arbitrage. The

16 arbitrage is simply the price difference of the same product traded in two different spatial markets. When spatial markets are analysed and compared, it can lead to the discussion of market integration, where markets located in different areas are linked by trading a same good and the geographic boundaries will not obstruct the existence of price dependence among such markets. That is a scenario which is more and more propelled with the globalization advent. (Baake & Wae, 2008). Through the market integration topic, the performance and the structure of a market can be better understood because this literature requests that to analyse the performance of one market, spatially located somewhere, it is necessary to identify if any other market has any influence in its performance, giving a more dynamic and deeper understanding of the market which is being studied. The existence of this influence is the raw idea behind the existence of the market integration5. The influence from one market into another is usually very evident in agricultural products and its prices, because every country trades some agricultural product and in absence of intervention the domestic price might vary with world prices, otherwise the demand will follow the cheaper option. It is important to mention that the agriculture is usually a subject that receives some intervention from governments and as a consequence the price adjustment does not fully happen. In front of such uncertainty, regarding the level of integration, Mundlak and Larson (1992) raised the follow questions: First, what proportion of the variations in world prices is transmitted to domestic prices? Second, what proportion of the variations in domestic prices can be attributed to variations in world price. These are the main questions that the market integration pursues and tries to answer through analytic approaches, usually cointegration and causality tests. As mentioned by Ravallion (1986) when answering the question about the necessity of studying the market integration, the answer was the necessity to fully understand the interactions between markets and consequently its performance, because when understood the interactions, it becomes easier to understand how each market performs, spotting the deficiencies and virtues of each market. Under this assumption, it is compulsory to understand the interaction to understand how prices are formed, as said by Stigler & Sherwin (1985, p. 555) the market is the area
5

Actually that is the usual supply side of the idea and the same can be reapplied for the demand side.

17 within which price is determined: the market is the set of suppliers and demander whose trading establishes the price of a good. This means that the market area is the area that incorporates the buyers and sellers that will form the primary tendencies of demand and supply of the product in question, where the price is the key factor to delineate the spatial area of the market. In general the market integration study is helpful to understand the formation of a products price. Being more specific, if we have a product x in two distinct areas, like A and B, the market integration analyses can assist to determine if both markets will determine the price of x together or separately. In the current case, we try to understand if the wheat (x) price in Brazilian market (market A) is formed only under domestic influence, or if the same price is also subject to the international price (given by market B Chicago Stock Exchange). In the latter scenario, the case would be of an integrated market, which can be determined by cointegration tests and then is possible to find out which market influences which, through causality tests. To draw a more improved depict of the price establishment, it is vital to analyse the right size of the market where the price is settled. The size is the sum of the spatial areas of all markets integrated. The performance of each market integrated will equilibrate the prices in both markets and this dynamic equilibrium process leads to another topic which is close related to market integration, the Law of One Price (LOP). The LOP concept is directly related to the arbitrage process, which guarantees that in the long run the prices equalises between two countries. Through the arbitrage the markets with cheaper prices will be induced to raise prices due to demand pressure and vice-versa. This process keeps happening until the prices in both spatial markets become equalized, where the price difference will be given by the transport costs. However, the existence of one price is not completely taken here, because it is not believed that markets perform perfectly; they are not in complete symmetry and are not fully open, mainly because there are political and governmental issues involved and the information is not perfectly shared. This divergence might be captured in the error term of the econometric model. To summarise, the market integration can be helpful not only to understand the market performance and the prices adjustment, but it can be very close to

18 governmental policy issues. In many cases the lack of integration can be a problem for Government, for example in the situation of one market with scarcity of something while the other has a surplus. Also a market too integrated, with prices being automatically adjusted can be a Governmental concern when prices in the central market are increased. The relation between Government policies and market integration will be more discussed in Chapter 4.

2.2 Definition of Market Integration based in price adjustment view. Second Faminow & Benson (1990) the attention for spatiality location of markets started indirectly from the studies of Alfred Weber6 and Walter Isard7 regarding the trade offs brought by spatial distances and costs, but as mentioned by McNew (1996) the definition of market integration still can have some different interpretation, which can be understood as locations that have high price correlations (Harris, 1979), or being spatial locations connected by trade (Ravallion, 1986). From this works other authors had started their studies in relation to market integration and here the Harris approach is more explored. However, the scholars that study market performances to identify the existence of market integration, usually have the general tendency to use econometric tools in their analyses. And one of the main tools used are the cointegration and causality concepts (like Ardeni, 1989, Bessler et al, 2003, Palaskas and Harris (1993), Alexander & Wyeth (1994), Mendonza & Rosegrant (1991), etc). As mentioned in Harris (1979) the concept of market integration will be formed through the comparison between prices of the same good in different places. As described by him: the degree to which price formation for agricultural in one market town is related to the process of price formation in other towns can be indicated by the zero order correlation (Harris, 1979, p.199). In other words, the author uses the variation of prices of one good to determine the market integration.

Weber, A. (1929), Theory of Location and Industries. Translated by Carl J. Friedrich. Chicago: University of Chicago Press. 7 Isard, W. (1951), Distance Inputs and the Space-Economy Part II: the locational equilibrium of the firm, Quarterly Journal of Economics, Vol. 65, Issue 3, pp.373-399.

19 One of the authors that Harris (1979) used to build up his thought was Willard W. Cochrane, as can be seen when the latter scholar was referring to relationships between markets mentioned that the single market does not stand alone as a determiner of either price or quantity () the actions of buyers and sellers in a particular market are always influenced to some degree by the price signal and substitutional possibilities in other related markets (Cochrane, 19578 p. 34 cited by Harris, 1979, p. 199). The attention in the research about the delineation of the size of a market through prices comes in parts from the Cournot`s market understanding, in which he stated that a market is not a certain place where purchases and sales are carried on, but the entire territory of which the parts are so united by the relations of unrestricted commerce that prices there take the same level throughout, with ease and rapidity (Cournot, 18979, cited by Horowitz, 1981, p.3). Therefore, the analysis gives specific attention to the variation and approximation of the products prices for the specification of the market territory, which here is the sum of the integrated markets. There are several works in the economic literature, which some of them are highlighted throughout this section, that uses the price to determinate when markets are integrated. The focus in general is whether the area A and B are mutually responsible for the price of x, or just the area A influences the price in B or viceversa. In general it is analysed whether prices in one area are adjusted in front of variations in prices of another area, taking into consideration the level and speed of adjustment. One concept of geographic market that engages the existence of two separate geographical areas forming a single market and can be applied here for market integration, was found in Horowitz (1981, pp. 8): if two geographic areas do indeed encompass a single market for a particular product, then over time the price at which the product exchange in one area cannot remain continually out of line with the price at which it exchanges in the other. Under this concept, the price based analysis is a tool that can be used to delineate markets. Stigler & Sherwin (1985) shares the same principle when relating the product range to the dimension of a market: two
8

Cochrane, W. W. (1957), The market as a unit of enquiry in agricultural economic research, Journal of Farm Economics, vol. 39, pp.21-39. 9 Cournot, A. (1897), Researches into the mathematical principles of the Theory of Wealth, translated by N. T. Bacon, The Macmillan Company, New York, 213p.

20 products are in the same market (are close substitutes in production or consumption or both) when their relative prices maintain a stable ratio. We can apply here these thoughts to understand that when prices of the same product in different markets cannot remain continually out of line, the markets are in reality integrated. In Stigler & Sherwin (1985), the idea that a market is the area where the price is determined is broadened to a further idea in which the price is the key aspect that determines the area of a market. Under their assumption, if two goods present similar movements, they might belong to the same market, or in their words: if we find closely parallel price movements, the loci of the prices are in the same market. Consequently, if the price of a good in two spatially detached markets present a correlated relationship, without spourious causes, the price is in reality being determined in both markets, or in the integrated markets. This is exactly what can be seen in chapter 1 regarding the Brazilian prices decreasing after 1987 and starting to follow international variations. Under this reflection, the local wheat production is integrated with the international market and it was found true after statistic tests of cointegration in Chapter 3. It is important to mention that when it is said that prices with similar movements lead to integration, this means that prices are being adjusted to each other through market forces. Actually both markets have their prices mutually adjusted when either markets have influence in the price formation, or only one market has its prices adjusted in relation to the price variation in the main market. The way of the adjustment can be found by causality tests, as it was found in section 3.4, throughout Granger Causality test, where only Brazilian prices were adjusted in relation to US variation. As explained so far, the economics theory supports that markets spatially separated integrate with each other when there is a transmission of price between them in a level where prices in both markets do not variate away from each other in the long run. Moreover, in case of shocks the prices can show a significant variance in the short run10, but they will find equilibrium in the long run. The literature that uses a price based information to delineate the right size of a market taking in consideration the different spatial areas making part of it is far to be

10

The short run adjustment was inconclusive, because the stationary tests were ambiguous as demonstrated in chapter 3.

21 made of consensus or free of concerns. The main concerns tangents to this analysis are: a) The main concern is regarding spurious relations between the prices among the analysed variables, the non sense relation can suggest a false correlation and consequently the analysis can outline erroneously an integration. In front of this, a spourios relation could indicate that two spatial markets are integrated when it is not true. It can happen, per example, especially in the relation between different commodities, because they are susceptible for the same source of cost, like combustible or inflation in general. However, this dissertation deals with the evolution of wheat in two distinctly international markets, which had different inflation and cost history; b) Another concern is the presence of the same agent, with monopoly power, in both areas.The monopolist can control the price in the two areas and set the market as it better profits, which can set temporally an integration if set prices with similar evolutions or two distinct markets if the monopolist chooses different price evolutions between both areas. However, the wheat market as seen in the previous section is competitive, both demand side (flour mills) and especially the supply side (farmers of wheat); c) The time dimension also needs to be taken into consideration, because the price correlation can or can happen in a specific time frame. The time dimension in our case is taken into account and is very important, once the Brazilian wheat market until 1987 was formed only by Brazilian suppliers and only after deregulation the international suppliers became part of the Brazilian market. The time dynamics will be more discussed in the next section as a fact linked to market integration. This dissertation will use prices as the main source to establish the existence of market integration through price tests, however, there are other approaches that can be used to identify integration. Such approaches are briefly described in the next section.

2.3 Other sources and influences of Market Integration apart from price approach.

22 Probably the main source of information after price co-movement to define market integration is the level of trade between the spatial markets. In this path of investigation, Stigler & Sherwin (1985, p.580) stated that the physical movement of goods (or buyers) from one place to a second is a potential source of information on the geographic extent of a market. In this view, information about availability of transport, level of market openness and trade costs in general are crucial to define the level of integrability between different spatial markets. The movement of goods point of view gives support to our suggestion that the wheat market is integrated after deregulation. The physical movement of imported wheat started to increase consistently after deregulation until nowadays, as figure 1 shows and also by the fact that Brazilian dependency of Brazil in wheat increased significantly after 1987. Another work that can be added here is the seminal study of Hogarty & Elzinga (1973), which was actually done to define the size of a geographic market but can be applied here as the delineation of the spatial size of the market, where the idea that more than one area belongs to the same market is the same as the market integration idea. The authors consider an area X being the geographic market area for a product x and raised two requests to ensure that both markets do not integrate: First, the product x cannot be imported into X except under costly or prohibitive condition. Second, customers in X cannot readily go outside and consume or return with product x. If both of these conditions hold, then X becomes a unique geographical market area for product x (Hogarty & Elzinga, 1973, p.67). Under this consideration and using the example used in this dissertation, one can assume that the second request holds, once a customer cannot easily go to another country and consume or return with the wheat, because it would incur a complex and costly transport and management. However, the first request does not hold, because there are no legal barriers to import wheat and even there are no import duties from some suppliers, like Mercosul. In front of this situation, this conjecture suggests that the markets integrate, meaning, the international wheat is part of the Brazilian market. Another aspect that influences the market integration was highlighted by Golleti et al (1995), which is the situation of supply and demand surrounding each market analysed. The level of production versus local demand can become a crucial element

23 to determine the level of integration. When two markets of same good, per example, show a deficit, they will not integrate due to a lack of supply. In general, integrated markets have one market spatially located in an area where there is a deficit and another market in another spatial location that produce enough for itself and still has a surplus. Under this assumption, usually the prices from the scarcity area will be adjusted by the variations from the surplus area, because the demand needs to match the price supplied. In the case of the Brazilians wheat scenario, the local scarcity is the role, once the local production is barely enough for half of the domestic demand. Without price protectionism, such shortage in the Brazilian wheat is a great request for market integration. In Knutson & Ochoa (2004) they stressed the importance of the private agents to contribute to integration of markets. In a study requested by USDAs Economic Service the authors identified the articulations of the private sector activity as a factor that can have some influence in the integrability of markets. If there is no private interest to buy, sell and invest in commodities spatially distant from an original market, the trade and the integration would not happen. So it is necessary governments be aware of obstacles that can avoid the private sector to invest in such integration. Another fact related to market integration, which is not a source of integration, but is essentially linked with the adjustments of prices between spatial markets, is the time. Apparently the time effect is not an issue much discussed in the market integration analyses, what was also mentioned by Dercon (1995) when stated that the main approaches to the spatial integration of markets in the literature written by scholars like Ravaillon (1986), Harris (1979), Palaskas and Harris (1993), etc, are rather static than dynamic, exactly because they do not consider the time effect. In the usual analyses, the market is either integrated or not and do not take into consideration changes in the market structure. In the geographic market literature, the time effect is well recognized as an important matter that can bring important impacts in the integration between markets. As stated by Horowitz (1981, p.6) it is equally true that (the market) may have a significance of limitation in time, or what is widely recognized by the antitrust literature to be a time dimension. It means, in different words, that the integration can become straighter, broader or even disappear/start over the time.

24 The same concern about time implication was mentioned in Stigler & Sherwin (1985, p.558), the relation between two prices within a single market will not be strictly constant over time: their differences will not be constant or a constant of one price () the market definition tell us what it is supposed to tell: the identity of the sets of buyers and sellers who are establishing the common price in market A and B, and it also tell us when the market area has changed. This dynamic approach identifies over the time different players in the Brazilian wheat market, where while the market was controlled, the market was occupied only by Brazilian suppliers of wheat. This changed after deregulation and the imported goods integrated with Brazilian market. In this moment the domestic prices started to adjust in front of US prices, as co-integration and causality tests demonstrated. When time is included into the market integration analyses, the understanding of the performance of a market become even broader. Stigler & Sherwin (1985) gave some reasons of time effecting the level of integration, like quality and transactions alterations, but they did not mention the liberalization or government regulation as a possibility, which was the reason that broadened the integrability in Brazil in the late 80`s. The liberalization was also found in Dercon (1995, p. 112) as a reason of integrability when studying the food market in Ethiopia and concluded that liberalisation had important effects on the long-run and short-run integration of food markets. The same happened in Oxley et al (2009), in a research about integration in the energy market in China over the new regime, that means liberalization. To summarise, the liberalization of the wheat market in Brazil was an important and strong structural modification that was enough to change the market performance in a way to broaden the Brazilian wheat market and include the international market. After this the local prices started to adjust themselves in front of variations in the international price, as the causality test proved. Also the market integration requests the existence of a relationship between prices of a good in markets spatially located in different areas, but also it is necessary the existence of a direct or indirect trade relationship among such markets. When the trade exists, the prices show some similar movements because the prices are in reality being adjusted in front of both variation (bidirectional transmission) or prices from

25 one market is adjusting in relation to variations of one central market (unidirectional transmission). As mentioned previously, there were some literature reviews about price comovement and other factors that supported the idea that the international wheat integrates to the brazilian market, but in attempt to go further than purely checking the variations between prices or other economic signs, it is proposed here the econometrical tests to estimate the integration, as it was done by many other authors, which were already mentioned. The next chapter will estimate some econometric tests mainly to identify and give a formal support that the wheat markets between Brazil and US are integrated in the long run, among other tests to analyse the relationship between Brazilian and International wheats market.

3. Econometric tools to identify the geographic markets in the formation of wheat market in Brazil. This section will undergo some econometric tests to give a formal support to the assumption that Brazilian and International market of wheat are integrated. For such attempt will be used the Pedroni`s Cointegration Test. But before, the Stationarity test will be done to identify which is the level that the variables are stationarity, as requested by Pedroni`s Test. Also the stationarity test will be used to identify if the Brazilian prices are adjusted in the short run and it will happen if the variables are stationarity at the level. The testes will be based in the LLC and IPS approaches. The last test is the Granger-Causality in an attempt to identify which way prices are adjusted. All the tests were done using the Eviews program and applied for two time series: the first one it is the whole period between 1973-2010 and the second one is the period after deregulation (1988-2010). The two periods are tested, because, as mentioned in the previous chapter, the relation can be distinct over the time as a consequence of different conjectures through the time.

26 3.1 The model The theoretical model used in this work is the simple and known Purchasing Power Parity (PPP) where the domestic price of the agricultural commodity in in function of the international commodity price and the nominal exchange rate. The transformations of the theoretical model to a statistical model where based on QRM classes. Algebraically, this model can be represented by the strong form11 of PPP: Et = FPt FPt Pt = Pt Et

Where Pt = domestic price in the period t; FPt = Foreign Prices in the period t and Et = Exchange Rate in the period t. The period t is between 1973-2010. The domestic price is given in Brazilian currencies and the data was obtained by email from Conab (2011). The Foreign price is given in US dollars and the data is regarding the price from the Chicago Stock Market, which was obtained from USDA (2011) website. All the prices reflect the sack of 60kg of wheat. The exchange rate is the amount of Brazilian currency per dollar and was obtained also by email from Brazilian Central Bank. However, the participation of exchange rate to the wheat market it is not analysed, so the model uses Pt * = Pt , where P* is the price of wheat in the brazilian market in US dollars. Following the same procedures used in Mundlack e Larson (1992), to capture possible deviations, in function of variables not introduced in the model, it is added an error term (u) in the equation, also a constant (the intercept) to capture countryspecific fixed effects and the coefficient or multiplier , which is the elasticity of the domestic price in relation to the international price. So we have: Pt * = + FPt + u t The same approach used in Ravallion (1986) is reapplied here, where Pt is taken as the price of a central market which is assumed to establish the variations of the
11

It is the strong form because the model does not take into account the qualitative differences between the products, transportation costs, storage and the prices of domestic inputs.

27 prices in a peripheral market Pt *, which is Brazil here. The will have a variation from 0 to 1, when 0 the Pt has no influence in Pt * and when 1 the market is completely integrated and any variation in Pt is adjusted by Pt *. It is assumed that the u t is not correlated with any of the variables of the model, moreover, as assumed in Ravallion (1986), the different inflation level in each country will be captured by the error term. Now it is necessary to take the log of the model to make it linear in parameters: Ln Pt * = ln + ln FPt + u t From this single equation model will be done all the tests. 3.2 Stationarity (unit Root) test While keeping the simplicity of the correlation prices, where requires only the price series, the stationarity has the advantage of considering the lagged relations, it means, it consider the possible relation between contemporaneous variation of one variable with previous variations of the another variable. Also is well known that the original unit root tests often suffer from low power when applied to series of only moderate length and pooling the data across individual members of a panel helps increase power (Oxley, 2009) The basic concept of stationarity is related to the relationship amongst the variation of two variables in the short run. If the variables do not variate away from each other in the short run, it can be understood that the variables are in equilibrium or simply that they are stationary. It follows the economic perception that if the products are substitutes their prices can not drift away from each other, otherwise the demand or supply will change towards some direction to eliminate the arbitrage. In here, if the tests indicate that the variables are stationarity at the level [I(0)] it will mean that the price variations in Brazil and international market are in equilibrium, thus, the price adjustment occur in the short run. Also is necessary to identify when the variables are in the same level to do the cointegration test. However, if the tests infer that the variables are non stationary it will be necessary identify the cointegration results to find out if there is an equilibrium amongst

28 variables in the LR. As mentioned by Haldrup et al (2008), the results from stationarity test can be used to identify the order of integration and apply the cointegration test to deal with the analysis of co-variation of prices instead of the mean and verify if the prices present a stable relation in the long run. In general, the stationary test take into account the mean of the variation of the variables and the most used stationarity tests in the literature is the augmented Dickey-Fuller (ADF) test. To test the stationarity will be used LLC and IPS tests, where both are based in the ADF test. The estimations were done in the level form, either with or without trend and using 5% of significance level to draw the inferences. The model specification used in LLC is as follow: y i ,t = ai + y i ,t 1 + k y i ,t k + i t + t + u it
k =1 n

(Asteriou, 2007)

The t is a constant (FEM or REM) and if kept in the model it allows for heterogeneity, once (the coefficient of the lagged variable) is homogenous across all i(units) of the panel. The i t represents the time trend, which can be included or excluded from the model. The model uses a t-statistic under the normal t-bar statistic. The null and alternative hypothesis are: H0: =0 for all units, it means, each individual time series contains a unit root (nonstationarity) H1: < 0 for all units, the all time series is stationary. The main limitations of LLC are: a) the supposition of the autonomy across units of the panel data where a cross-sectional correlation may be present; b) the autoregressive parameters () is homogeneous across the series (all units) (Asteriou, 2007). The estimation of LLC was done with eviews and the decision was done by using the t-statistic (when p>0,05 the H0 will not be rejected). The result from eviews that gives a stationary model regarding the two time frames: 1973-2010 and 19882010, can be seen in the follow table. Table 3: The LLC test of unit root to define the size of the market.

29
Time series from 1973 to 2010 1 difference without trend 1st difference with trend
st

pi ,t = ai + pi ,t 1 + k pi ,t k + t + u it
k =1 n

(t-statistic: -7.89802) (p=0.000) (lags:0 to 8)

pi ,t = ai + pi ,t 1 + k pi ,t k + i t + t + u it
k =1

(t-statistic: -6.93575) (p=0.000) (lags:0 to 8) Time series from 1988 to 2010 Population Level without trend

pi ,t = ai + pi ,t 1 + k pi ,t k + t + u it
k =1

(t-Statistic:-1.92899)
n

(p=0.041) (lags:0 to 4)

Level with trend

pi ,t = ai + pi ,t 1 + k pi ,t k + i t + t + u it
k =1

(t-Statistic: -2.36031) (p =0.009) (lags: 0 to 4)

As can be observed, the whole time frame is stationary only on the first difference, either with or without trend. In this case the LLC gave the integrated model I(1). Under this test, the prices were not adjusted at least in the short run. A different result was obtained for the time after deregulation. The section 1.4 indicates the existence of a trend between prices after 1988, when prices between Brazil and US follow the same path, but even although, the test was done considering with and without time trend and both results gave a stationarity result at the level [I(0)], however, it will be considered the test with trend. In this shorter time frame the market is integrated and prices are adjusted in the short run. Now, reapplying the data to do the IPS test, the outcome is different. The IPS test broadened the LLC test allowing the autoregressive parameters to differ among units under the alternative hypothesis, it means, permitting a heterogeneous coefficient of Yit-1. The IPS test uses the same model specification but with different alternative hypothesis and t-statistic: y i ,t = ai + y i ,t 1 + k y i ,t k + i t + u it
k =1 n

The model is similar of LLC, it just does not contain t because IPS already allows the heterogeneity, the main difference is the test hypothesis. The null hypothesis has H0: i=0, where each individual time series contains a unit root, as the LLC test. Nevertheless, the alternative hypothesis is different: H1: i < 0 for at least one i, meaning that part of the panel can have unit roots. While LLC all the units

30 needs to be stationary, the IPS only some units needs to be stationary (Asterious, 2007) The t-statistic is based on averaging individual unit root test of the series or simply the average of the individual ADF statistics for testing i = 0 for all units as: = 1/N

t
i =1

The main limitation of IPS test is regarding the H0, if only one of the i differ from 0 the H0 can still be rejected and there are no procedures to know which of the i are statistically different from 0. The result from eviews that gives a stationary model is in the table 9: Table 4: The IPS test of unit root to define the size of the market.
Time series from 1973 to 2010
1st difference without trend 1st difference with trend

pi ,t = ai + pi ,t 1 + k pi ,t k + u it
k =1

(t-statistic: -8.13226) (p=0.000) (lags:0 to 8)

y i ,t = a i + y i ,t 1 + k y i ,t k + i t + u it
k =1

(t-statistic: -7.51295) (p=0.000) (lags:0 to 8) Time series from 1988 to 2010 1st difference without trend 1st difference with trend

pi ,t = ai + pi ,t 1 + k pi ,t k + u it
k =1
n

(t-Statistic:-6.51403)

(p=0.000) (lags:0 to 4)
k =1

pi ,t = ai + pi ,t 1 + k pi ,t k + u it
(t-Statistic: -9.5075) (p =0.000) (lags: 0 to 4)

The IPS test for 1988-2010 almost gave a stationarity result at the level [I(0)], with p-values of 0,058 with trend, but with 5% of critical value the H0 could not be rejected. So, the model under IPS test gave integrated models [I(1)] for both series, meaning that the prices were not adjusted in the short run at all. This different results might to be due to IPS be more strictly than LLC, where only one of the i differs from 0 the H1 is rejected. In front of this dual results, to finally define the existence of an integrated market between the two spatial markets analysed, will be done the Pedroni`s Cointegration Test.

31 3.3 Cointegration Test The cointegration can show that two series although deviation from the short run equilibrium (nonstationarity), they still can be in equilibrium in the long run. In simple terms, the cointegration verifies the existence of a long run equilibrium relation amongst nonstationary variables. As mentioned by Mendonza & Rosegrant (1991) cointegration tests permit the empirical testing of the persistence of deviations of price across differentiated markets. And the presence of cointegration between two series indicates interdependence between them in the long run, it means in our case that the markets are integrated. The main two procedures to identify cointegration are: Engle-Granger and Johansen test. The Engle and Granger Based is based in the VECM (vector error correction model), which has a two-step estimation procedure to test the presence of a long-run relationship between two non-stationary processes. Assuming that yt ~I(1), the first step starts with the estimation of the static regression: Yt= + Xt + t Them, regressing changes on Y with estimated residual (t) as a regressor we have: Yt= 0 + 0Xt + t + wt The vector () shows the adjustments of short run to correct any disequilibrium and becomes cointegrated. If is not significant them there are no adjustments towards a long run equilibrium. The 0 captures the short term effects of X in the prior period on Y. The main critiques regarding EG: a) only one endogenous can lead to endogeneity bias; b) Assumes only a single cointegration vector, being not open for multiples equilibrium. In our case, the problem of endonegeity bias it is not a real concern because the model has only one exogenous variable and only the Brazilian price can be considered as a endogenous, because as seen in the first chapter the wheats production in Brazil is not even big enough to afford the internal demand, so its price variations could not be strong enough to have an impact into the international prices. Also the GrangerCausality will demonstrate that Brazilian prices do not predict International prices.

32 Regarding the second critique to EG, the Pedroni-s test overcome it to allow for multiple regressors, which will be used here. The use of Pedroni`s test to identify market integration was also used in Oxley (2009) and Abumustafa (2008). The first one analysed the energy market in China and the second one the stock market in some countries of Middle East. The model proposed by Pedroni is: Yit = i + 1t + mi X mi ,t + u it
m =1 M

(Asteriou,2007)

Regarding the inclusion of time trend ( 1t ), it will be included for the time between 1988-2010 and for the whole period the test will be done with and without time trend, because the in time before deregulation there was not a common time trend between Brazilian and US prices. The model proposes seven cointegration statistics to capture the within and between effects. Pedroni builds up the seven test statistics with distinct power and size for different N and T using normal distribution. The between-dimension is based in the average of the individual values of i estimated for each i. The within-dimension pools the i across different i. So There is one null hypotheses of no cointegration (H0: i = 1 for all i) and 2 alternative hypotheses: a) within supposes a homogenous i - H 1 : i = < 1 for all i; b) between supposes a heterogeneous i - H 1 : i < 1 for all i. (Pedroni, 1999) In Pedroni the critical value used is 1,64 (Asteriou, 2007) and apart from vStatistic all the results should be negative. So any statistic in absolute values bigger then 1.64 will indicate that the variables analyzed cointegrate. The following table gives the 7 statistic with and without trend for the two time frames.

33 Table 5 Pedroni Tests for the US and Brazilian prices for the periods: 1973-2010 and 1988-2010. common AR coefs. (within-dimension) H1: homogenous Statistics 1973-2010 Intercept Int. & trend 1988-2010 Int. & trend Panel v- Panel Statistic rhoStatistic
0.576159 -0.49023 0.847929 -1.59536 -1.42083 -2.97543

Panel PPStatistic
-1.37005 -1.83227 -4.73211

Panel ADFStatistic
-1.41947 -1.53189 -4.3482

individual AR coefs. (bet.dimension) H1: Heterogeneous Group Group Group ADFrhoPPStatistic Statistic Statistic
-0.7729 -0.63543 -2.16521 -1.10409 -1.53559 -4.6652 -1.16275 -1.20949 -4.0109

It can be seen for the period 1973-2010 that without time trend, none of the statistics are over 1.64, meaning they do not cointegrate. When it is added the trend, only the within PP-statistic shows cointegration, but it is not when compared the same statistic in the between dimension (H1-heterogeneous), so it is not cointegrated when the test is tougher, as it happened in relation to LLC and IPS tests for the 1988-2010 period. Also, this period present a trend only after deregulation, so the trend is not completely in the whole period. So, in front of this, it can be concluded that the markets analyzed do not integrate in the whole period, because the variables drifts away from each. The opposite happen for the period 1988-2010, where only the v-statistic, despite being positive, is under the critical value, but all the other tests show cointegration. In front of this one can conclude that the markets integrate in the long run. So, the overall results of cointegration are consistent with expectations and support the suggestions that the markets were integrated. As stated by Granger (1988), when a model with two variables that presents a cointegration relation between them, it is expected that will exist causality at least in on direction. So the next section will do the Granger-Causality test.

34 3.4 The Granger Causality test The Granger Causality (GC) does not mean causality as usually understood, but means precedence instead. In case of two goods X and Y it can be said that when X granger causes Y, changes in X might to temporarily precede any changes in Y, which open space for forecasting (Madalla,1999). A modern way to test the GC is allowing the test for the long run through the use of Error Correction Model (ECM), which is the essence of cointegration analyses. The ECM examines whether the lags of X can explain changes in Y even if the past values of Y are not relevant, as long as both variables are cointegrated. With both variables being integrated, part of the current change in Y can bring corrective movements in X to make Y be in the long run equilibrium. So this precedent movement in X before Y, through an ECM, can be said that the variables drift in the same direction in the long run and the granger causality will exist as well. In this case the X granger cause Y, but in general, when variables are cointegrated can be supposed that there is GC, but can not define the way. If only one variable precedes the variations in the other variable the transmission is unidirectional, otherwise, if both precede each other, there is a bidirectional transmission. To test for GC in the long-run relationship it is used the ECM for Y and X with 2 lags:
Yit = i + i ECTit 1 + y1i X it 1 + y 2i X it 2 + y1i Yit 1 + y 2i X it 2 + yit

X it = ei + ei ECTit 1 + e1i X it 1 + e 2i X it 2 + e1i Yit 1 + e 2i X it 2 + eit et al, 2010)

(Nondo

Where denotes the difference operator; ECT is the lagged error correction term; y e are the adjustment coefficients that allows the cointegration and the is the disturbance terms. The outcomes of Granger Causality test can be seen in the following table.

35 Table 6 Granger-Causality Tests for the Us and Brazilian Prices for the periods: 1973-2010 and 1988-2010.
Time series from 1973 to 2010

Null Hypothesis
P_BR does Granger Cause P_US P_US does Granger Cause P_BR P_BR does Granger Cause P_US P_US does Granger Cause P_BR not not

F-Statistic
0.11781 0.53463

Prob.
0.8893 0.5912

Time series from 1988 to 2010

not 0.65149 not 4.9968 0.0286 0.5403

The Granger Test done here shows that in the whole period (1973-2010), neither of the markets could precede each other, once either of the probabilities are above the p-value of 0,05 and, thus, can not reject the null hypothesis. This result was expected due to markets not being integrated. The opposite outcome were obtained from the period 1988-2010, where Brazilian prices did not precede the variations in the US prices (0.5403>0.05), but the US prices precede the Brazilian price, once the null hypothesis is rejected (0.028<0.05). The GC testes of the causal dependence between spatial markets done here follow the assumption used to develop the model where the US has a central role whilst Brazil is a peripheral market. The test also contributes to verify that only Brazil adjust its prices and the anti-inflationary policy should take it into consideration.

4. Market Integration and Government Policies: An approach to the Brazilians wheat market 4.1 Government policies and impacts in the market integration and vice-versa. As mentioned in section 2.1, the discussion around market integration is not only about price adjustments and market performance, but also is relevant to policy issues. In this moment the analysis is not regarding definitions and delineations of market integration and whether the wheat market is integrated or not. Now, will be

36 giving some comments indicating how governmental policies can influence the integration and how an integrated market can influence the policy makers. Once the spatial market is identified being integrated or not with another spatial market, the political causes and consequences can be indicated in an attempt to improve the market performance and even more important, the life quality of the population living in the market. Regarding the life quality, our case can be straight related to inflation as mentioned by Golleti (1995), which stated that the Government needs to elaborate more improved price policies, or in different view, needs to be careful to relate the good to inflation, once prices in one spatial market will be related to the price of the another spatiality. As he said knowledge of market integration is relevant to the success of policies such as market liberalization or price stabilization (Goletti, 1995, p.185). Apparently that is exactly what is not happening in Brazil, once the wheat price rose considerably in 2011, as the international price also increased. Such variation was the main impact in the Brazilians consumer basket, consequently, decreasing the Brazilians life quality. The Government is trying to tackle this source of inflation only through Brazilian supply side, it means, the Federal authorities are mentioning to decrease the governmental safety stock and getting closer supervision to cooperatives to avoid manoeuvres to increase price during off season (time between cropping). The first suggestion made here is that this Governmental approach is wrong, once the markets are integrated and the national prices are in reality adjusting themselves to international price variations, as the causality test demonstrated. Therefore, the policy should take into consideration the international supply as well and find out ways to avoid increase adjustments happening so fast. Unfortunately the stationarity tests were ambiguous regarding prices being adjusted in the short-run. The food market in developing countries is one of the main topics studied under the market integration as mentioned by Alexander & Wyeth (1994), exactly because of the social implications of this matter. Under this assumption, a clear social implication touched by market integration as a Governmental issue is the case where a food market in two regions is not integrated and in one region there is scarcity and in another there is surplus. In this situation the ideal scenario would be the Government spotting the existence of some structural factor, as transport deficiency, that could be obstructing the integration and then orientating an improved policy towards such

37 market development and integration. Apart from the population lacking of such foods, the prices should be higher in the non sufficient region, as it was in Brazil before deregulation. In the example studied in this dissertation, the closed market in the Brazilian wheats market was the reason of lack of integration along international market and higher prices as consequences. However, there are many other reasons that can be affected by Governments that are straight related to the level of integration between markets. The infrastructure is one of the main items after the level of market openness, which Government can influence. The influence can grant or spoil the evolution of integration, so infra-structure policies, like transportation syste ms, R&D national programs, storage facilities and public stock policies, might have impacts in the level of integration. Nevertheless, once the markets are integrated and the matter is regarding international trade between developed and developing countries it seems crucial for producers spatially located in the developing markets that they have equal conditions to compete against producers from the developed side. Items like credit availability, advanced technology accessibility and frontier knowledge being reachable, could be added to the previous infra-structure examples to keep the local market competitive in front of the outsiders. A non integrated market is not desirable in the food market, but even less attractive is a scenario of integration when the local producers do not have the same conditions of competition. The competition scenario drawn above is also a concern in Brum & Muller (2008), which in a deep and actual study about the wheat culture in Brazil they mentioned that the national wheat culture is threatened and will hardly reach selfsufficiency, since Brazilian producers cannot become competitive enough, neither sustain comparative advantages particularly in relation to competitors from Argentina (Brum & Muller, 2008, p.146). They mention Argentina because this is the main supplier of wheat to Brazil, but it would change if Brazil enters in NAFTA, as the US Government wants, where the trade barriers between Brazil and US would decrease and the level of integration would respectively increase and the price adjustment in Brazil should be even faster and definitely bigger. Such scenario would

38 complicate even more the anti-inflationary policy if the focus remained exclusively in the Brazilian supply. Brum & Muller (2008) indirectly supposed that it was necessary decrease the level of integration between national and international wheat markets, but differently from the past, it should be done not using policies to close the market, but through policies in favour of Brazilian producer to expand their competitiveness in front of international players, as US and Argentina, and consequently reach an increase in production and decrease the international dependency. Such competitivity dynamics would have implications in the level of price adjustment and decrease the inflation pressures when international prices increase. Regarding the integration between Brazil and Argentina, a study about it was carried out by Lopes (2008), which did cointegration test between Brazilian, Argentinian and US wheat markets for the period between 1995-2005, using the Johansen test. The conclusion was that the Brazilian and US markets are integrated, but the Brazilian and Argentinean are not. It might be the consequence of wheat being over charged by Argentinean dealers, which besides following US prices, they are not fully adjusted in relation to the Brazilian market, because they try to maximize profits charging the maximum they can in front of Brazilian scarcity and their better trade conditions in relation to US and other Mercosul non member countries. If the Argentinean market is not really integrated with the Brazilian market, even being the main supplier of wheat, while US has its prices integrated with Brazil and Argentina, apparently that is the case approached by Fackler & Goodwin (2001, cited by Fackler & Tastan, 2008) of indirect price transmission. The lack of integration between the South American markets might in reality be hiding some deal manoeuvre, as mentioned earlier. The above conclusion is not part of the study done by Lopes (2008), once the author said that one of the plausible explication of why the model did not detected any statistic significance from Argentinean wheat prices upon Brazilian prices might to be due to the fact the US is the country that builds up the price while the other countries are only price followers (Lopes, 2008, pp.41, my own translation from Portuguese). Once more, the assumption here is that the lack of integration is due to Argentinean producers manoeuvre and it is a clear sign for the Brazilian Government

39 to review agreements or create pressure for changes towards his neighbour and main partner of Mercosul. Nevertheless, any review in international agreements is far to be easy, but it is clear that Brazilian producers need to improve their competitiveness capacity and/or receive more fair trade from Argentina. The trade review would remain the market integrated, but in better conditions. It also should have an impact in the evolution of domestic price evolution in Brazil and, consequently, less inflationary pressure. Apart from the improvement in the bilateral agreements between Brazil and Argentina, the next section will demonstrate other ways of Government Policies and behaviour that could improve the Brazilian competitiveness over international wheats market.

4.2 Policies towards the fall of international dependence The dependence is directly related to a lack in production and it happens, in general, due to poor productivity and profitability. This section will highlight some policies that could decrease the Brazilian dependence on international wheat. A lack of competitiveness noted by Brum & Muller (2008) was the reduction of nearly 2 millions of hectares in the harvest area since 1987, which migrated to other cultures mainly because of the low productivity. The productivity in Brazil is in average 2070 Kg/ha, less than half (or even less than half) of that achieved in the most competitive countries (Coronel, 2010). One of the main sources of competitiveness is the grain`s quality, which is based mainly by the qualitative and quantitative level of protein inside of each grain (Peterson, 1998, cited by Potril, 2010). To achieve a higher quality, the Embrapa, which is the main agricultural researcher institution in Brazil, has been developing R&D in this area and have good results, especially in Midwest region, which obtained a higher level of productivity under irrigated conditions, but the region is a small producer of wheat and the productivity achieved would not have any bigger impact in the total production level (Potril, 2010). However, even with the above achievement, the Embrapa outcome is not enough to boost the productivity and production and more resources should be directed to wheat culture researches to increase the seed quality and, therefore, higher productivity.

40 As mentioned by Maggian & Felipe (2009), the Embrapa should focus the investment in R&D of more productivity varieties to be introduced in the south region. It was advocated by Potril (2010) that once the resources for R&D are limited, the idea should be decreasing the higher sums designated to cereals, like soya and coffee that are self sufficient markets, and enhance the resources to the wheat research. As already mentioned, the Midwest Region is becoming a potential important producer of wheat in Brazil, due to a much higher productivity and quality grain conditions, which could lead to a great enhancement in the national production. As mentioned by AgroValor (2011), the problem in this region is not about improvements in the culture, but progress in efforts to spread knowledge about the culture within the local farmers and decrease the resistance of the producer with little experience in the production of wheat. There is a lack of knowledge which could be fulfilled with governmental support. Such support could be given by governmental institutions like Embrapa and other institutions that support (agro) business in a way to increase the professionalization level in the crop management, like: helping to identify which is the best choice of seeds in terms of cost and benefit; the best time to harvest in relation to the density of the grain; how to manage water and soil, etc (AgroValor, 2011). Another problem regarding Midwest region is the low regional demand for wheat due to few mills operating in this region, as demonstrated in the first chapter. Second Albrecht (AgroValor, 2011), an Embrapa researcher, this poor infra-structure situation is the main factor that contributes to repress the farmers interest in wheat and only a clear governmental policy to heighten the production would raise the private interest towards the milling industry. The same idea is shared by Oliveira et al (2005) regarding the expansion of wheat frontier towards north and northeast regions, where the milling industry only would invest in front of a clear sign from Government that farmers would be more supported. Still regarding the increase of wheat production throughout the expansion of its frontiers was pinpointed by Crespi & Konzen (2009), where it could happen if the Government speed up the land reform in the country, especially in the north and

41 northeast regions of the country where exist huge latifundium12, which could be used for harvest, but it is used for valorisation (speculation) and illegal deforestation instead. Another factor very criticised is the lack of special credit source for a cereal production that present a good potential to expand and the demand is still so dependent of the international supply. Those who defend more credit to the sector, like Potril (2010); Oliveira et al (2005), Maggian & Felipe (2009), etc, usually support the idea in front of those arguments: a) due to actual international exchange policies, the importer can pay the goods up to a year later of the trade, which is a great incentive to the milling industry in importing rather than buying from domestic market (Oliveira et al, 2005); the imported wheat always follows international standard classification, what makes the trade easier (Potril, 2010); the international producer have better resources of financing with lower interest rate (Magian & Felipe, 2009); the milling industry has less concerns about stock, because the international producer can supply wheat throughout the whole year (Potril, 2010). Regarding the international standard classification, that is an option to increase the profitability of producers, it consist in separating the grains harvested in accordance of its quality. Second Protil (2010) the technique consists in: a) establishment of the level of water inside the grain; b) separating foreign objects, like stones, soil, grass, etc; c) splitting the wheat from impurities, like wheat leaves, straw, peel, etc; d) separating the grain damaged from weather, bugs, environment or are simply broken; e) detecting the bruised grain, which has less quality due to impact of fermentation usually during stockage; f) separating the infirm and too small grains. These and other procedures of standardization will establish the right value for each bunch of wheat and the final value of the whole lot will be much more than when the wheat is sold as a mix. However, the practice of classification is still not a tendency amongst Brazilian producers due to scarcity of suppliers. Incentives from Government could increase such service, even under importation without duties if proved the lack of national offer and its importance to regional economy (Brum et al 2005; Brum & Muller, 2008). Still about financing policies, the State of Parana has a regional policy that covers 15% of any rural insurance. The policy aims to increase the agricultural
12

Latifundium is a Latin word that defines large landed property.

42 stability, reduce production costs and enhance the income of the producer, so they can apply more resources in technology and consequently achieve a higher quality/productivity. The same principle could grow to a broader Brazilian Program (Ortigara, 2011). Apart from the principle that the wheat should receive more attention from the Government due to the Brazilian dependence and great potential to increase the production (especially expanding its frontiers to other regions than south region), the wheat deserves more consideration because of three other reasons. Firstly, because the wheat is mainly grown in rotation with soya and corn (Franceschi, 2009) and second Ronaldo Triaca, a wheat producer, the wheat is a soil improver for other cereals, especially the straw that is left on the soil (AgroValor, 2011), demonstrating a positive externality of this cereal. Secondly, because in Brazil the wheat is still mainly produced by small and middle sized farms, consequently, policies towards the improvement of the wheat crops are in reality programs of distribution of wealth. Moreover, the wheat expansion would directly reflect in the development of the milling industry, reflecting in a bigger income creation and job formation, resulting again in a better distribution of wealth (Oliveira, 2005 and Brum & Muller, 2008). Thirdly, the consumption of wheat in Brazil is still low 52kg per capita per year, against the world average of 85kg and under the Brazilians economic growth in the last years it is highly possible that the consumptions in the years to come will overcome the world average and even get closer to developed countries average, like the 100kg in France (Protil, 2010). Such increase in demand, in front of the production/consumption evolution demonstrated in figure 2, might lead to higher inflationary pressures and faster price adjustments (higher inflationary pressure) if Brazil does not expand its domestic supply. However, stronger policies in favour of Brazilian wheat producers require initiative and concerns from the interested parts and policy makers. Nonetheless, differently from other cultures, like soya, corn and coffee, the wheat producers have low power to enforce lobby pressure towards the policy makers once the producers are in their majority made of small and middle size crops. It is supported by Potril et al (2010), which highlighted that there is a lack of organization and representativeness

43 of the wheat producers inside the political ground, shrinking the political influence and consequently obtaining less attention to the sector. To conclude the chapter, it is clear that the Government policies affect the market integration in a variety of ways and can have either a positive or negative impact into the market integration and identify what Government can do is already an improvement in the market performance/competitiveness. Also, the market being integrated will affect the way the Government develop the policies, like a different anti-infationary policy is demanded due to the market be integrated. In Brazil there are many opportunities to decrease the Brazilian dependence through expansion of production frontier, higher productivity and improvement in infra-structure. It is just need more attention from the Government.

Conclusion
To attend the general aim of the dissertation the general conclusion is that the Brazilian and international markets of wheat are integrated and this recognition was obtained from many economic signs mentioned in chapter 2, especially the price evolution, and from cointegration inference obtained from six of the seven test statistic indicating that the markets are integrated. However, the Brazilian Government apparently is not taken such integration into consideration when establishing some policies in relation to domestic price increase. The Government is concerned with the price increase in wheat market, but instead putting extra efforts to decrease the speed of adjustment, the authorities only focus in the domestic supply. The effort probably would be more beneficial in the short term if authorities were more concerned with the over price charged from Argentinean market. The over charge was mentioned by Abitrigo and also was detected here that the non integration between Brazilian and Argentinean markets, even when both are integrated with US market, was a sign of a malfunction in the markets. The other econometrical tests done in chapter 3 were the stationarity and causality tests. The stationarity tests were ambiguous, the LLC indicated that the prices in Brazil are adjusted in the short run, whilst the IPC indicated that prices are not adjusted in the short run. In relation to the Granger Causality test, it was specified

44 that only the Brazilian market adjust the prices in front of variations in the US market, meaning that US has a central role in the relation while Brazil has only a peripheral. This inference matches with the assumption made in chapter 1 that wheat exporters have more conditions to influence the price variation than the importers, because the importers are much less concentrated than the exporters. From the first chapter, the issues that must to be considered here, apart from price evolution and Brazilian wheat dependence, is that the wheat market in Brazil is not concentrated neither in the supply and demand sides, with many small and middle farmers regarding the supply side and many mill companies, specially in South and Southeast regions, regarding the demand side. Another important issue is the wheat production frontier, where most of production is limited to South region. Most of the topics signalled above from the first chapter have a fundamental relation with the development of Governmental policies. It was found that the international market is integrated with the Brazilian market and the last one has a role of dependent player, due to its low production. The production is low because of low productivity; lack of scientific and management knowledge and weak credit support and all these can be affected by Government policies. It was demonstrated that if Brazilian authorities want to be less affected by international market it is necessary the Government foment the frontier expansion, especially to Midwest region; support the diffusion of knowledge that is only dominated in south region; improve the infrastructure to increase the profitability; give better credit conditions to domestic producers, even because of national laws the importers have up to a year to pay the good imported and speed up the land reform. It was clear that without Governmental support the wheat sector can not raise in the country. The market is too weak to find itself the resources to become a more competitive player and less dependent of international supply. The sector also has no politic power to incentive the necessary attention and it complicates the situation. However, the potential of expansion that the country has; the problems regarding the high dependence with low consumption per capita and the positive externalities should be taken into consideration of policy makers and start to change the participation that Brazil develops in this integrated market. With a less dependent country, the inflationary pressure from increases in the international prices should fall.

45

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50