Regulators and experts recently met in Brussels to analyse market volatility in food and agricultural commodities, fossil fuels and energy, and industrial raw materials, and to debate what regulators can and should do, and how multilateral institutions might respond coherently.
French President Nicolas Sarkozy delivered an impassioned speech on why markets should be regulated. A handful of players are controlling large chunks of most markets, driving and determining prices. Further, huge gains are being made from orchestrated price movements rather than availability based on production and weather conditions, or changes in demand for products owing to economic growth or natural disasters. He implied that an intolerable situation was developing and that regulation had become imperative. He indicated that he was giving the speech in anticipation of the following week’s Paris meeting.
That G20 agriculture ministers’ meeting took place in Paris to discuss measures against volatility in global agricultural markets. The members could not conclude concretely. They, however, agreed to collect comparable information with the Food and Agriculture Organisation’s involvement, committing to an Agricultural Market Information System. It is an onerous task since the US, which is the only member that publishes reliable data, remains unwilling to regulate the markets effectively. But data are not enough. It is important to ask how the data would be used for indicators, and if the indicators are meaningful.
Only after the first stage is completed could agreements be meaningfully drawn up on regulation to contain prices and volatility. But volatility is not the only concern. The world is also worried about extreme price rises and, based on evidence, the increased volatility as prices rise. Two explanations follow. First, the rapid change in the nature of market operations, with price determination in commodity markets moving closely with financial markets. And second, the real demand-supply gap in global markets.
On the first, price rise and volatility have been closely linked to the increasing financialisation of commodity markets that Mr Sarkozy denounced, unless regulated. Commodities have become an asset class. They now comprise investor havens for hedging against higher-risk sources, low interest rates and a depreciating dollar. Hedgers take speculative positions on commodities, and exploit arbitrage opportunities in markets through index funds, pension funds, mutual funds and the like. These activities would not have been questioned but for the emergence of instruments that do not necessarily reflect market fundamentals such as hedge funds, swap deals, exchange-traded funds and exchange-traded notes, where passive traders track commodity values and act on them. Thus, commodity index futures are operating much like financial market indexes, creating bubbles intermittently. Their regulation must, therefore, be along the same lines.
The regulatory indicators should, therefore, target such trend spotters who have little or no intent of taking futures to delivery. They ride the wave, accelerating and enlarging both price upswings and downswings. Speculative position limits have to be stipulated to prevent excessive speculation and assist in monitoring potential violations in the market. It can be implemented through surveillance of individual and institutional traders’ activities to contain, if not obviate, an oligopoly in market power.
In the absence of full agreement on the course of action, monitoring based on traditional macroeconomic indicators remains in vogue. It cannot be sufficient since links between an economy’s macro performance and financial/commodity market-driven global doldrums are tenuous. Unfortunately, there is a stubborn continuation in, and overemphasis on, using macroeconomic indicators such as savings rate, fiscal deficit/GDP, or current account balance as indicators linked to all ills. But fiscal deficits have different impacts – multipliers – reflecting country characteristics. Similarly, the current account indicates net financial flows, while we need gross flows from trade in goods and services to obtain trade in financial assets that comprise the bulk of cross-border financial activity. In fact, gross financial flows make current account positions look small. Claudio Borio of BIS, Piti Disyatat of the Bank of Thailand, this author and others are pointing to the need for indicators that are more directly linked to global market movements.
The problem is that many of them are financial indicators that the US seems reluctant to touch despite the experience of the 2008-09 financial crisis and its continuing fallout. Fortunately, the large trader reporting system has been endorsed by the Dodd-Frank Act, which has accepted the importance of collecting data to implement aggregate position limits for certain physical commodity derivatives. The G20 process must push forward on this issue. While the French chairmanship appears to be a silver lining, the outcome of the Paris meeting is not sufficiently reassuring.
What are the better indicators? These have to be found from observed associations between volume and value in the line-up of global commodity markets measured by indices such as S&P GSCI Commodity Spot, CRB Spot Index Fats & Oils, and others that can be related to prices of corn, wheat, crude and minerals on the one hand, and movements in major asset classes such as the Dow Jones Industrial Share Price Index and FTSE Global Bond Index, and global liquidity such as global money stock (M1) as a percentage of real GDP, on the other. Further, the correlation between the financial asset classes and off-index commodities (commodities not included in commodity indices) will shed more light on the impact of portfolio rebalancing on indexed commodities.
Price stability can be achieved by putting together a framework of triggers based on observed strong associations. Otherwise we are heading for another vortex of price escalation and volatility that would fuel the next global recession. Further, there is a continuing lack of resolve to tighten belts or control runaway financial innovation.
Now to the demand-supply gap — the second explanation on global price movements. Take China. At an overarching level, China is criticised for excessive savings and current account surplus. Yet at the Brussels conference, China was singled out for over-consumption of global resources. China consumes over 50 per cent of the global supply of cement and iron ore, and just under 50 per cent of steel, copper, nickel and zinc. Its per capita consumption of these metals is higher than developed countries’. Hence China is over-consuming. Finally, this author found himself in the awkward position of having to speak on the argument’s internal inconsistency. At the macro level, China has too much current account surplus and excessive savings; at the micro commodity market level, it is over-consuming. So, should China stop producing and only import finished products when global demand reflects otherwise? Additionally, that China consumes only 10 per cent of global oil supply was ignored until pointed out. And since oil prices and their volatility are central to the prevailing inflation, price volatility and potential resurgence of global recession, should the solution not lie in rapid fiscal and monetary tightening elsewhere?
I felt a strong desire to escape from the real world and found refuge in Brussel’s museums showcasing Bruegel’s unreal miniatures and Magritte’s surreal vision of the world.
The author is director and chief executive, Icrier, New Delhi. Opinions are exclusively of the author
