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25 August 2022

Germany imposes new Covid restrictions

Germany has been one of the countries that initially reacted calmly to Covid 19. The country did well during the first wave of the pandemic. The situation changed dramatically a year later. The UK, by contrast, was hit early, and suffered much higher casualties, and initially imposed much more Draconian lockdown measures. But today, the likelihood of another lockdown is close to zero in almost any pandemic scenario in the UK. This is not so in Germany. The German government just passed a new pandemic law that allows the state premiers to impose whatever restrictions they see fit.

But the biggest restriction explicitly foreseen by the law is the legal requirement to wear FFP2 face masks in all public indoor spaces from October onwards. The concrete decisions will be taken by state premiers at their discretion, with exemptions foreseen for specific venues. The states also have the right to impose mandatory Covid tests as an exemption to entry to public events. Vaccinations that date back for more than three months no longer have to be accepted.

We see this arrangement as favouring a new wave of restrictions and lockdown in case of a new wave of Covid-19 were to hit Europe, as seems possible. Germany will this time be among the countries to impose severe restrictions early on. The way decision-making works in Germany, further restriction are more likely than fewer restrictions.

We wonder, also in light of our lead story, whether this could constitute yet another pro-cyclical shock. Restaurants have not fully recovered from the pandemic. Another winter of pandemic-related restrictions could force many over the edge. This come on top of the rise in heating and electricity bills. A recession is a moment where governments should try to help struggling households and businesses, rather than come up with ideas for new ones.

We also wonder whether it makes sense to leave such decisions to state premiers since they bear no responsibility for the national economy as a whole.

24 August 2022

What palm oil is in your Nutella?

We once heralded SAP as Germany’s last great contribution to the tech world. And it continues to come up with innovative ideas. The latest is a block chain-based tool called GreenToken. The aim of this tool is to get supply chain transparency and to discern sustainable sources from those raw materials that had been mixed up while moving through the supply chain. In a world where companies are faced with more conscious consumers, mandatory reporting requirements and demands from investors to demonstrate their sustainability credentials, these sort of tools will allow them to respond to those demands.

It is kind of a barcode that follows for example palm oil from the first mile. When the farmer brings his harvest to the mill for processing, a digital token is created at gram level. Each gram has a token then, so 1kg has 1000 tokens. It contains information about the farmer’s ID, the date the fruit arrived and a certificate for sustainable palm oil. The blockchain will follow the gram of palm oil on its way through a complex production process as it is mixed, refined and transformed. It can be used to make sure that when sustainable is on the label it really means that only sustainable palm oil has been used.

The tool can also be used by companies to measure against their sustainability targets and as a basis of their supply chain decision making. A ledger can be drawn on any of the raw materials to see how the company is doing in terms of sustainability. It works with various other types of industries, such as the plastic recycling, to determine the percentage of use of purely recycled materials. A clear benefit for those advocating a circular economy.  It could be used to trace green hydrogen too. All companies along the supply chain will need is a computer and access to the internet.

We are still puzzled by this idea to attach a token to a gram of oil and to follow that gram from somewhere in Malaysia to the Nutella pot that ends up on our kitchen table here in England. Maybe we have to upgrade our imagination too, so that we can follow this new marriage between digital and real product at microlevel.

23 August 2022

Inflation sleeps, then erupts, like a volcano

We would not normally cover this story about UK criminal barristers going on an indefinite strike over pay. But it tells something interesting about inflation - something that economic models do not take into account at all: that periods of long wage moderation are often followed by a short sharp shock of overshooting wage demands. We see this also with rail drivers in the UK, and engineering workers in Germany. Their real wages had been falling for a long time, and they are rediscovering their pricing power. Criminal barristers and train drivers are not easily replaceable. We recall Ronald Reagan's decision to dismiss the country's air traffic controllers when they asked for too much. Margaret Thatcher stood up to striking miners. Such radicalism would be needed for governments to stop overshooting wage demands in the public sector. But this is not going to happen in 21st century Europe. We are in the volcano age of wage inflation: nothing happens, and then one day it erupts.

Macroeconomists are no strangers to the notion of overshooting. Rudiger Dornbush explained how exchange rates overshoot. But there is no theory of overshooting wages in current central bank macro models. In those models, wage increases are consistent with the central bank's declared inflation target. But this does not mirror the reality. What we are seeing in the labour market are long periods of wage moderation followed by sudden demands for very high wage rises. Unions cannot afford to go on strike every year over a few decimal points of pay. But they can afford a big strike every twenty years or so in defence of something they consider existential. It is unsurprising that they are choosing moments when governments are relatively weak - right after a crisis.

Central banks world-wide have been complacent about inflation. The primary cause behind this complacency is reliance on economic models that offer no insights into the main drivers of changes to economy activity. Forget the abysmal forecasting record. When you don't understand what is going on, you can't even predict the past.

Central bankers might want to recall that central bank independence rests on the assumption that inflation is a technical problem. If people no longer believe that, independence will be hard to maintain. We would put like this: if you don't understand inflation, a case for central bank independence can no longer be made.

22 August 2022

Greece no longer under surveillance

Greece exited the enhanced surveillance framework on Saturday. It brings to an end a 12-year period where its policies has been monitored and interfered with by the IMF and the EU in return of three bailout programmes worth €290bn in loans from European governments, EU institutions and the IMF.

We remember well the rollercoaster Greece went through, how often deficit and debt figures had to be corrected upwards, and how they had to commit to several rounds of cuts in public spending, pensions and salaries, implement long lists of reforms and privatisations in unfavourable market conditions and then found it difficult to implement them in time. Often there was high political drama ahead of a bailout tranche payout if one or several of the conditions were not met. Greece had to experience that European solidarity comes with a good dose of punishment.

The ESM was the EU’s institutional response to deal with this and future debt crisis inside the euro area. But for Greece, despite all the institutional money, a haircut on private hold bonds was still unavoidable. If only they had done a haircut in the beginning, the bill may not have been so high. But solidarity obliged, no one in the EU wanted to contemplate a default inside the euro area at that time. And neither creditors nor Greece did really understand what they got themselves involved in.

In the early years, the troika, the IMF, the Commission and the ECB, were in charge of the process. The ESM joined later. Germany and the northern countries were the most outspoken ones on austerity measures, which added up to €72bn, the Greek economy shrank by 25% and unemployment soared.

This interference process has now ended, but Greece is in for the long haul when it comes to debt repayment. The commitment to repay its debts to EU governments will continue until 2041 and the debt redemption schedule for the ESM and the EFSF is even increasing until 2070 as the following graphic shows:

Source: ESM

To say the pains are over, as Kyriakos Mitsotakis did on Saturday, is thus only looking at the past. What ends is that they are no longer told what to do, while the fiscal constraints remain in place until 2070. It would be naive to expect a smooth ride until then. Also, when it comes to the economy, some of the structural problems in its economy continue, such as cumbersome bureaucracy and tax evasion, all were on the to-do list from the IMF. Some of their reform pledges were watered down or are still pending such as on pensions and privatisations.

So it is far too early to say the pain is over. The episode certainly defined Europe’s understanding of solidarity when money is involved and tested its limits. In terms of relations amongst EU member states the narratives will not so easily be forgotten. One of the statistical jokes nails it to the point: when a teacher asked his students what the effects of the French Revolution are, the student’s answer was: too early to tell.

5 August 2022

When the fair weather is gone

This will be our last briefing before the summer break. We will return on Monday, August 22.

In this briefing we will only touch peripherally on yesterday’s events, but offer some thoughts on the policy errors in diplomacy and economic policy that are now interacting with each other and blowing up around us.

This is not so much a post-mortem than a pre-mortem. The really bad stuff is still ahead. China’s deployment of missiles in the Strait of Taiwan, and the Bank of England’s gloomy assessment of the economy, were two events from yesterday that in their own separate ways gave us as a flavour of what lies ahead. The political and economic instabilities of our time are deeply intertwined.

Microchips play an important role in Taiwan diplomacy. At its deep end, the fight is over the Taiwan Semiconductor Manufacturing Company, the world's largest producer of chips. Just as Germany has given itself an economic model that is reliant on Russian gas, the western world as a whole is reliant on cheap Taiwanese microchips. Electronics components are to our modern economies what cars and plastic used to be in the 20th century. What we term as the global supply chain crisis is really a semiconductor crisis. The west has the capacity to produce high-end versions of semiconductors, but they are not the ones that power the cheap electronic devices or the electronic durable goods we mostly buy in shops. And it takes a long time to get a chip factory up and running, as the Germans are just discovering. This is why our supply chain crisis comes with inflation and stagflation. We will produce at a higher cost, and lower volumes.

The failure to take quantitative easing back in time was the big policy error of the last decade, next to austerity, the policy error that immediately preceded it. The $5tn US stimulus is the big policy error of this decade, the one the Biden administration will be mostly remembered for, though these are still early days.

The stupidity of various US politicians in trying to take on China and Russia at the same time has a distinct 19th and 20th century European quality. This is not about the ability to walk and chew gum at the same time, as one commentator put it. Germany’s strategic failure in the second world war was not the act of fighting on two fronts, but failing to comprehend that your enemies will unite in a strategic alliance. This is exactly what we expect to see now. A strategic alliance between China, Russia, parts of Africa, parts of the Middle East, and parts of Latin America is beginning to form. It will take a long time until this constellation wields real power. We don’t underestimate the massive shifts that would have to happen in those countries. China needs to change its economic model, and reduce its dependency on the US for its excess savings. This is a ten or twenty year project. But we think that China is far more likely to accomplish this shift than Germany and the UK, which also badly need new economic models. In our estimation, the German political establishment would rather let people freeze than switch off the likes of BASF, Bayer and other gas-guzzling chemical process plants.

Economic policy and diplomacy share the same ultimate goal: to stabilise. Both have failed spectacularly, for essentially the same reason: short-termism on an unprecedented scale. US foreign policy, love it or hate it, used to have strategic goals. Since the beginning of the Obama administration, it has embarked on a chaotic retreat.

The EU fares no better. As long-standing observers of European integration, we have come to the conclusion that the current model of European integration through enlargement, accompanied by only moderate deepening, is not suited to tasks ahead. It is based largely on the EU as an umbrella organisation, a piazza so to speak, to forge consensus among member states with usually diverging short-term interests. A lot of that stuff is fake, like the phantom investment programmes of the last decade. Most of it falls into the category of things that have minimum impact but maximum announcement effect. Ever wondered why EU programmes always have fancy names attached to them, like transmission protection instrument or next generation EU? We don’t use those terms ourselves, and prefer to call a spade a spade. The first is a permanent bailout-instrument. The second is an almost imperceptible investment programme, amounting to 0.3% of the EU’s GDP over a period of five years.

Brexit is of a similar category. What Remain and Leave had in common is a total lack of strategic purpose. Remain stood for a trickle-down economic system that no longer trickled. Concretely, it was based on the City of London as the financial centre of the euro area, and an entrepreneurial boom that was based largely on cheap immigrant labour from eastern Europe. The economic model of Leave was a return to the feudal past that bore no resemblance to reality. Brexit should have been discussed, and understood, as a shift in economic models. It is ludicrous to think that you can replace the physical trade in goods with your geographical neighbour with some far distant places. This should have been about how to exploit economic opportunities through a different regulatory regime.

We have been mostly focused on the EU in our work. But this lack of strategic thinking is not just an EU thing. It is a feature of liberal democracy itself. It is in the nature of liberal democracy that it is not centrally planned. Strategies are always a form of central planning. Free societies evolve. Its leaders take decisions, but they are not strategic. Strategies are taken at the micro level, by companies, groups and individuals. In the absence of large global shocks, this turned out to be a stable self-correcting system.

But it turns out a fair-weather system, such like the idealised world of macroeconomists with its rational agents, a world in which shocks are normally distributed. All the big issues we are facing today are not of that variety. Like climate change and global economic instability they need to be solved at a higher level.

We are sceptical that this will happen. The scariest thing about the Bank of England yesterday was not the decision, but the sheer look of panic on face of Andrew Bailey. The governor of the Bank of England had the look of somebody who has discovered rather late that he had inadvertently stumbled into a horror movie.

5 August 2022

Energy crisis: No easy way out

There aren’t any easy answers for how to fix Europe’s energy crisis. As the result of decades of failures and poor decision-making, it will take time to reverse. More pertinently, both national governments and the EU will face a difficult choice: how to bring down the cost of fossil fuels in the short term, while continuing to move away from them in the longer run.

The crisis itself is perhaps best thought of as two interlocking crises, which have somewhat independent causes but mutually reinforce each other. We can call them, for simplicity’s sake, the Germany-centred gas crisis, and the French-centred nuclear one. The first is the most well-discussed and publicised. It’s also generated more attention because of how it functions as a reversal of the German morality tale of European political economy. There can be no more credible lectures about responsible policymaking after most of Germany’s political parties have been willing participants in one of the most irresponsible policies in Europe’s post-war history.

But the French crisis has also had a marked impact. France’s nuclear fleet has normally functioned as the backbone of northwestern Europe’s energy system, and it enabled the country to become the EU’s largest energy exporter. But maintenance issues with Electricité de France’s ageing reactor fleet and summer heat waves have conspired to hit output. France’s nuclear output dropped by 15% in the first half of this year, pushing EDF into a historic H1 loss of €5.3bn. The need to import power has meant even more gas burning in Germany and the UK, further contributing to the gas crisis.

In the shorter term, neither of these issues will be easy to mitigate. German firms can, and are, trying to convert gas boilers and generators to run on oil distillates instead. But this simply replaces one problem with another. Limited refinery capacity, partly linked to pandemic shutdowns, has driven up refining margins, and large-scale switching could make the situation worse. Fixing the corrosion issues could take years, and summer heatwaves will be an ever-present risk as climate change takes its toll.

But longer-term, solving the energy crisis is complicated because it coincides, awkwardly, with an energy transition away from fossil fuels. Europe will continue to need gas in the short term, but over the coming decades it will have to shift away from it in order to meet its climate targets. The timing is dicey because this transition can’t happen overnight, but potentially needs to happen more quickly than the kind of use that’s necessary to guarantee viability for new gas infrastructure.

As was the case with Germany’s Energiewende, the European orderly transition model was built on the assumption that there would be cheap and plentiful natural gas. In a world where that is no longer the case, new thinking will be necessary in order to guarantee energy security without also wrecking climate targets.

It will be especially tricky to do so without a revision of Europe, and especially Germany’s, economic model. If cheap energy and feedstock inputs for industry are scarce, that will require adjustments. It will also mean heightened geopolitical sensitivity. In an interview with Les Echoes, Martin Wansleben, the head of Germany’s chamber of commerce and industry, hit the nail on the head when he said that

“The principle that a company can choose its suppliers based on the best price, and sell to its customers the best bidders, no longer works”

One of the more profound impacts of the energy crisis could be how investors and creditors appraise political risk, after Russia reneging on its gas contracts threatened to financially destroy Germany’s energy sector. That may also have implications for the energy transition, and how Europe charts its course out of the current crisis, given China’s firm grip on battery and solar supply chains.

5 August 2022

Heat waves and their knock-on effects

The third heat wave for this summer is upon us. For the next ten days temperatures will be rising to record levels under a heat wave that is moving from Spain to the northwest of Europe.

Social media is still debating whether is this a unique event, like the heat wave we had in 1976, or a new trend due to climate change. We may not know the answer to this question for another couple of years. In the meantime, adapting to heat will be a new concrete challenge. We look at a few below.

Heat is not for the lighthearted. It kills up to half a million people worldwide each year, more than any other natural disaster. Cities are more badly affected, heating up twice as fast as the average global rate due to the fact that they can trap heat more than non-urban areas. Health policies will need to offer a mix of preventive and emergency measures at local and departmental level. Some countries like France have heat plans already. In other countries like Germany, plans exist but they are either not serious or have not been tested. A lot more effort will have to go into planning to make sure vulnerable people are looked after in these times. Some cities have already created a new job profile, the heat official, to find ways to help cities cope better. This will include new ways of thinking about how to offer cooling areas for citizens, with new requirements for infrastructure and buildings codes.

Heat waves make the current energy crisis worse. High temperatures push up demand for more energy. At the same time, nuclear power stations will have to power down as rivers, usually used to cool reactors, are heating up. This means more dependence on gas and coal. This is bad news for those countries preparing for a winter without Russian gas and count on their storage facilities. Instead they have been forced to draw from them already during the summer. Some countries, like Spain, have ordered to limit air conditioning to 27 degrees, in order to save energy. In the medium term, the new energy mix will have to take heat waves and the increased energy demand during the summer into account. Northern European predictions may have to be updated, if this heat wave is not going to be a single year event but a trend.

Climate change politics will get a boost with this free advertisement, and climate change deniers will seem more radical. There will be new pressures building up in societies on both sides. Heat is not as directly linked with life threatening disasters, such as sudden floods or hurricanes. Heat is more of a silent killer. But the message will get through eventually. Heat also affects biodiversity. Heated up rivers and savanna-like grass land will change the mix of animals able to cope with the heat. How and to what extent we will only find out when it is already happening.

Heat will affect agriculture. Farmers have already lost parts of their crop due to the two previous heat waves. Water use has been restricted and the new crop got hit with too much heat too early. Some livestock farmers won’t be able to let their cows or sheep graze on the meadows. This means farmers will have to use their reserves to feed the animals, drawing down on what was usually reserved for the winter. In the heat there is also a heightened risk that cows may lose their foetuses. Fields as well as stored haystacks may catch fire. Fires on fields are more frequent, and fire procedures in several northern countries will have to be updated to allow for a quick deployment of fire helicopters to these emergencies. New farming methods have to be found, with more heat-resistant crops and new machinery, as some of them increase the risk of fires.

Heat affects trade. It requires new routes of transport for those relying on rivers that now become too shallow to pass through like the Rhine. Cooling will become more of a necessary requirement, as well as checking on the fire safety of merchandise. This may add additional costs, and will boost demand for some new storing methods as well as more cooling, drawing down further on energy resources.

It may affect tourism. Heat in cities is not something tourism is prepared for. The hospitality sector might be pressured to do more to look after the wellbeing of their tourists. If these heat summers reoccur, expect holiday makers to switch destinations to cooler places, or chose different months for their holidays.

At this point we stop our list, ready for our holidays. No, we have not changed our plans due to the heat and we will not avoid cities nor the south of Europe. But maybe next year, we may choose Scotland or Sweden instead.

4 August 2022

The Germans and their stupid turbine

We have been scratching our head over the Russian turbine, previously under repair in Canada, now sitting on display in a factory in western Germany, waiting to be dispatched to Russia. German government ministers, from the chancellor down, are repeating the implausible statement that Vladimir Putin no longer has an excuse to reduce gas flows. The notion of an excuse is a very western concept. Olaf Scholz posed yesterday for an absurd photo shoot in front of turbine, an impressive-looking piece of mechanical engineering, very much in contrast to the diminutive and oddly twisted frame of the German chancellor. He says there is no reason, absolutely none whatsoever, for this turbine not to be send to Russia straight away. We suppose he is right, but so what? There are a lot of jokes in Germany about what to do with the turbine. Our favourite, from the cartoonist of FAZ, is to put it on a pedestal next to the Brandenburg gate, as a memorial to Germany’s failed Russia policy. There is not really much else that it can be usefully deployed for.

So why are the Germans going to these ridiculous lengths about this turbine? In doing so, they are violating the west’s sanctions regime. Ukraine condemned the decision, as did several central and eastern European countries. The damage that the silly turbine has done to European unity is significant because it demonstrates once again that Germany acts unilaterally with no regard to its neighbours. We are also not surprised to hear Annalena Baerbock make the exact opposite claim. She praised Canada’s decision to send the turbine to Germany as a contribution to European solidarity. The Germans have an interesting definition of solidarity.

The reason why everybody is acting so strangely is, of course, domestic politics. There are already voices in the SPD calling on the government to give in to Putin’s demand to open Nord Stream 2. This is something the German government cannot do even if it wanted to because the pipeline is not certified. So instead, they play this game of charades to demonstrate that they have done everything in their power to maintain a minimally sufficient level of gas flows. In an extreme scenario, where people die during a cold winter, they don’t want a discussion that they could have done more. This is not about depriving Putin of an excuse, but to avoid a domestic discussion.

We keep an open mind on whether current gas flows stay the same, go up or down. The one thing we know for sure is that the levels of gas flows are a political, not a technical decision. And that Putin, unlike Scholz, doesn’t need or care about excuses.

3 August 2022

Nordic Nato accession not a done deal

Nato membership for Sweden and Finland is not a done deal yet. This will depend on whether they can deliver on their anti-terrorism commitments to Turkey. It will also be intertwined with what happens to Kurdish opposition at home, according to Burcu Ozcelik, a Cambridge lecturer, in Arab Weekly.

To overcome the veto against their Nato membership, Sweden and Finland bent over backwards to give Turkey its anti-terrorism assurances last month. One of the pledges is the extradition of 76 Kurds, deemed as terrorists by Turkey. But this is not so easy. The question is whether the courts in Finland and Sweden have the same definition of a terrorist as Ankara does. There is also resistance from politicians, especially on the left. Theoretically, their Nato membership could still be stopped or delayed if the Turkish parliament votes against it. So indeed, their membership is not a done deal from a Turkish perspective.

The international deal with Sweden and Finland strengthened Erdogan’s cards at home. He is facing his own challenges with a tanking economy and sliding popularity ahead of next year’s presidential and parliamentary elections, coinciding with the centennial anniversary of the founding of the Turkish Republic in 1923.

Kurdish voters have been a significant bloc in previous polls and their votes have swayed tight elections, according to Ozcelik. Selahattin Demirtas, the jailed former leader of pro-Kurdish Peoples’ Democracy Party (HDP), wrote a passionate letter from his prison cell, saying that politics and violence does not go together and called on Kurdish groups to find new ways for a joint effort against Erdogan’s AKP party. He also called on his own party to seek an honourable peace within the unity of the country. The question is whether the Kurds will follow his advice. The HDP is a significant party with a mandate of 12% of voters. But the Damocles' sword is coming from Turkey’s Constitutional Court, which will review a case seeking to ban the HDP on grounds of its links to terrorism. Depending on the timing relative to the elections this could trigger an avalanche of more violence. The road towards peace with non-militant Kurds has many stumbling blocks, at Nato level and domestically.

2 August 2022

Ukraine grain shipping started

The first Ukraine grain ship left Odessa a cargo with 26,500 tons of corn under a Sierra Leone flag, bound for Tripoli, Lebanon, with a stop-over in Istanbul for checks. It is the first Ukrainian shipment via the Black Sea since Russia invaded Ukraine in February, made possible under a deal brokered by the UN and Turkey. It is a first sign of hope for Ukrainian farmers and those threatened by food insecurity due to the war. But it is far from a normalisation of the situation.

The two big questions are whether grain shipment can be sustained throughout the year even if the war going on, and whether it can be scaled up to reach pre-war levels of grain exports.

As a starter Ukraine loaded sixteen ships with 580,000 tons of grains ready for departure. This first batch is still far from the 4-5m tons Ukraine used to export last year. Turkey’s government is optimistic that they could get 25m tons exported this way over the year. But that will depend on security and prices.

Ukrainian grain exports may take pressure off of grain prices around the world, but prices for Ukrainian grains could rock up any moment. The missile Russia sent to Odessa just a day after the grain deal was signed with the UN and Turkey was a warning, it immediately increased the insurance premium for grain shipping. Then there are storage issues. The summer harvest is in, and silos are full. If they are not discharged in time, other temporary storage places need to be found, with a potential loss in grain quality resulting. And finally, the agreement only lasts for 120 days, but could be extended if agreed to by Russia and Ukraine. Another moment when things could go wrong.

Turkey plays a key role in the enforcement of the deal. It is checking the Ukrainian ships that there is nothing but grains on their passage from and back to the Ukrainian ports. A special agency under the auspice of the UN and Turkey was put into place to coordinate the various shippings.

It is worth noting that Turkey concluded de facto two agreements, one with Ukraine on grain exports from Ukraine, and one with Russia covering food and fertiliser exports from Russia. Under the Ukraine agreement, safe passage of export ships would be allowed from the ports of Odessa, Chornomorsk, and Pivdennyi. Significantly, the agreement does not extend to the port of Mykolaiv, which accounts for about one fifth of annual Black Sea exports, but is closer to combat zones within Ukraine, according to the International Food Policy Research Institute.

In the second agreement Russia gets assurances from Turkey that its exports of food and fertiliser will not be affected by export sanctions. Russia is after all still a major exporter of agricultural products and fertilisers. Russia also has also geopolitical interests in Africa. On his recent tour in Egypt and Central Africa Russia’s foreign minister promised to fulfil their export contracts and heralded their balanced views on the war.

So the road to ensure Ukrainian exports making it through the year is hazardous and could be jeopardised easily. As long as both Ukraine and Russia have an interest in the agreement, there is at least a chance that both countries can contribute to alleviating the looming food crisis in the world.