consultation on financial crisis and trade: towards an integrated response in the latin...

Consultation on Financial Crisis and Trade: Towards an Integrated Response in the Latin

America-Caribbean RegionDates: September 1-2, 2009, Venue: SELA (Caracas)

Draft of Remarks Prepared by Dr. Jan Kregel, Professor, Levy Economic Institute, Bard College

For SESSION II (1:30 – 3:20): FINANCIAL MARKETS AND SPECIALIZATION

IN INTERNATIONAL TRADE: THE CASE OF COMMODITIES

Introduction: Trade and Finance are Inseparable in Theory and Practice

• Adam Smith, increasing returns• Dynamic comparative advantage• Getting prices wrong• Supporting investment and large size

Developed Countries’ policies• Thus the proscriptions on the production of manufactures that

could be produced in the colonies that were proposed by Adam Smith not only provided protection and foreign demand for English manufacturers, this dynamic commercial policy also created the specialization of developing countries in raw materials noted by Prebisch and other theorists as providing the basic constraint on their development.

• It is thus somewhat paradoxical that it was foreign financial flows financing investments that created the monocommodity specialization in developing countries and created the constraints on development in the form of financing the external deficit.

• It had virtually nothing to do with static comparative advantage. It might better be called imposed comparative advantage.

Reacting to Monocommodity comparative advantage

• Financing development by increasing exports was thus a "Sisyphean task". The solution could only be found in stabilizing commodity prices – – thus the proposals for commodity stabilisation funds, moving

into the production of goods with higher rates of technical progress –

– thus the proposals to support industrialisation where economies of scale were higher – and the need to borrow external funds to finance the import of capital goods to build up manufacturing.

– While these positions eventually came to be known as structuralist or supporting import substitution they were far from either position. Indeed, as Alice Amsden has recently noted, they look much like a blueprint for the Asian development model as practiced in countries like Korea.

The Impact of Globalisation on the Relation Between Trade and Finance

• Since the 1950s when this discussion about market structure was going on there have been substantial changes.

• Most importantly, international commodity markets are no long as purely competitive as they once were, and are now dominated by a small number of large monopsonistic oligopolists.

• This has tended to increase the final prices of commodities to consumers, but has had little impact in increasing prices for producers.

• Rather, the increase in real incomes that was transferred from the developing country producer to the developed country consumer by the competitive mechanism has now been captured by the intermediaries, to the benefit of either party.

• This tendency has been noted in the Report of the UN Expert Commission on Commodities in its Report presented to the General Assembly in 2003

Other Non-competitive impacts• Other non-competitive measures have also had a negative impact

on prices paid to producers. • Price supports practiced by many developed countries for their own

producers who sell to protected domestic markets have increased outputs above domestic absorption levels.

• This not only decreases global demand, but also increases supply as the excess is sold or better dumped on world markets, causing further price declines.

• The case of cotton is exemplary – the global price of cotton is below the cost of production of the cheapest developing country producers, who are driven to poverty, while their developed country counterparts receive hefty subsidies that allow them to increase capital investments and productivity.

• Thus, while market structure is clearly a problem, changing it does not seem to provide a solution

Globalisation and Commodity Price Movements

• The outbreak of the oil crisis in the early 1970s, along with the warnings of the Club of Rome, created the last reversal of the trend decline in commodity prices. It created the basis for the aspirations for a New Economic Order in which developing countries would play a more important role in global trade, finance and most importantly is global politics. However this dream was short-lived and evaporated with the eventual collapse of petroleum prices in the 1980s. This ushered in another sustained trend decline in commodity prices.

• The New Millennium has seen a similar reversal of the downward trend in commodity prices, although they never reached the levels of the 1970s in real terms. While most of the attention was again on petroleum prices, it was widespread across energy substitutes, metals and foods.

Commodity Index Funds and Commodity Prices

• There has been a good deal of discussion concerning the impact of investments in commodity index funds on commodity prices. No one would deny that the size of these funds has grown dramatically, as shown the chart.

• Nor would anyone deny that this growth has been accompanied by the rise in prices and by an associated increase in volatility as shown below.

• Some of the arguments in this section were presented to the Tercer panel: Temas sistémicos, Consulta Regional Preparatoria de la Conferencia Internacional de Seguimiento Sobre la Financiación para el Desarrollo Encargada de Examinar la Aplicación del Consenso de Monterrey, Santo Domingo, Republica Dominicana,12 de junio de 2008.

How Commodity Funds Affect Both Future and Spot Commodity Prices

• However, a commodity index fund has no interest in ever taking physical delivery of the commodity, indeed has no interest in the behaviour of the physical market conditions that determine the price of commodities at all. This is because one of the basic justifications for the sale of commodities as an asset class is that they are uncorrelated with other asset classes used as investments. The absolute direction of the change in price is not important, as long as it does not change in the same direction as equities, or bond or real estate or foreign exchange. Thus a commodity index fund, investing in futures has a permanent unquenchable demand for futures, irrespective of the price of the cash or the futures contract.


• Since there is no such thing as a perpetual future, this means that a commodity fund must buy contracts with an expiration date. Since they are trying to track the physical price, this usually means the shortest, or near contract. It also means that it has to sell the contract before expiration, to avoid taking delivery of the physical commodity. Thus, before expiration commodity funds will be selling the current holdings of futures and buying new ones. If the funds to be invested are increasing, the funds will always be buying more contracts than they are selling. This has meant in general that not only has there been no convergence of the future with the spot contract, but that for most commodity markets since the turn of the century they have been characterized by a condition called “contango”. That is, the future price is above the spot price.


• This is a market condition that Keynes characterized as representing conditions in which speculators dominated commercial hedgers, or in the present case in which commodity fund speculators dominate commercial traders.

• The opposite, condition, called “backwardation” Keynes considered to be normal. Normal because there are usually more producers seeking to hedge their selling prices, than speculators will to risk a decline in price, so to give the speculator a remuneration for his risk the future price has to be below the spot, so that after convergence of the future rising to meet the spot price at the future date the speculator has a profit equal to the difference for his trouble. As noted above, this difference has a limit in the costs that would be incurred to buy and store the commodity until the future date since this is the only way that the speculator could absolutely cover his risk. The point about the spread determining who holds the stocks of commodities thus returns.


• But the important point here is that the emergence of the commodity funds had converted the market into a virtually permanent contango market, in which convergence became uncertain. As noted above, convergence is necessary to provide the incentive to use the futures market. In a contango market, the producer is selling at a price that is above the current spot price and will converge to the future spot price. To extinguish the contract he thus relies on the price convergence, that is to be able to buy the contract back at spot, for a profit. If the futures price does not converge, then he has to buy back at a higher price than the market cash price, reducing his hedge coverage. Further, as prices rise during the contract period, sellers of futures will be facing higher margins that must be paid to the clearing house or the contracts will be closed out. This raises the costs of using futures for producers.


• Finally, in many markets, not only has convergence failed at expiry, the size of the contango in the market has exceeded the fair price of the future contract as given by the spot price plus carrying costs. As noted above, the cost of the future determines how much and who stores commodity stocks over the contract period. When the contango exceeds this fair price (called the full carry) then it pays for producers to keep commodities in storage. That is, instead of selling a future at the beginning of the period and covering it through sale or delivery just before expiry, it is more profitable to keep the commodity in storage and roll over the future contract, waiting for a higher price.


• All of these factors will lead producers and other holders of physical commodities to favour a holding strategy of paying the carrying costs. This will induce storage and reduce supply, and exert an upward push to spot prices. Thus, there is a very clear reason why the emergence of commodity funds has led to a breakdown in the efficiency of futures markets and a sustained rise in prices at the same time as recorded stocks (not to mention those not recorded) have been observed. What seems illogical in a normal physical market, higher production relative to demand with rising prices, becomes normal when the market becomes dominated by speculative futures traders.

• Again, it is not clear whether producers actually benefit from this positive impact of commodity index funds on market prices. The large wholesalers have increasingly become full service financial centers in which they engage in the storage of the physical commodities, so that much of the increase accrues to these large multinationals rather than to the producers. There is clearly little benefit to the final consumer. Indeed, the world has been faced with the paradox of higher primary product prices which should be good for developing countries, and a food emergency in developing countries, as the retail prices full reflect the rising futures prices.

•


• Although the US Commodities Futures Exchange Commission originally argued that there was no evidence of any impact of Commodity Fund trading on the efficiency of futures markets prices, it has now changed its position and a recent Staff report of the Majority and Minority Staff of the Permanent Subcommittee on Investigations Committee on Homeland Security and Governmental Affairs, entitled “Excessive Speculation In The Wheat Market” June 24, 2009 finds “substantial and persuasive evidence that the large presence of commodity index traders in the Chicago wheat futures market is a major reason for the breakdown in the relationship between the Chicago futures market and the cashprices for wheat.” P. 113.

•

How Commodity Price Boom has impacted Developing Countries

• Lifted External Constraints• Increased Reserves• Changed relative prices – Internal and external– Soya

• Impact of biofuels

The Danger of “Financial” Commodity Prices on Development Plans

• However, the recent improvements in commodity prices appear to have an impact that is very similar to the commodity lottery that dominated Latin American exports in the 19th century. The price improvements in a range of primary commodities brought an increase in the terms of trade, but which was just a quickly reversed when the financial bubble in developed country markets imploded.

• . Irrespective of the reasons for these changes in relative prices, the impact that they have had on export performance is clear. And the reversal in this position for many countries has been equally rapid and extreme.

• The improvement in trade and current account balances has been accompanied by increased capital inflows from international investors seeking to participate in the improved conditions. But, also it has brought a return of capital reversals seen in the 1990s.

consultation on financial crisis and trade: towards an integrated response in the latin...

Documents