Excessive financialization of primary commodity markets

The UNCTAD yearly publication – Trade and Investment report -2009 was released recently (heavy pdf file here). The theme of the  report is – Responding to the global crisis Climate change mitigation and development. Climate change is becoming a hot topic as World Development Report 2010 is also based on the same theme (for an economic perspective see this Spence paper).

Anyways, the UNCTAD report has a interesting chapter on the topic of the post. It says:

The impact of the financial crisis on developing and transition economies through the slowdown of trade was amplified by the sharp fall in international prices for primary commodities in the second half of 2008. To a large extent this is a symptom of the financial crisis itself. Commodity prices, stock prices and the exchange rates of currencies affected by carry trade speculation moved in parallel during much of the period of the commodity price hike in 2005–2008, during the subsequent sharp correction in the second half of 2008 and again during the rebound phase in the second quarter of 2009.

It is true that deteriorating global economic prospects after September 2008 dampened demand for commodities; but the downturn in international commodity prices was first triggered by financial investors who started to unwind their relatively liquid positions in commodities when the value of other assets began to fall or became uncertain. And the herd behaviour of many market participants reinforced such impulses. Financial investors in commodity futures exchanges have been treating commodities increasingly as an alternative asset class to optimize the risk-return profile of their portfolios. In doing so, they have paid little attention to fundamental supply and demand relationships in the markets for specific commodities. A particular concern with respect to this financialization of commodity trading is the growing  influence of socalled index traders, who tend to take only long positions that exert upward pressure on prices. The average size of their positions has become so large that they can significantly influence prices and create speculative bubbles, with extremely detrimental effects on normal trading activities and market efficiency.

Under these conditions, hedging against commodity price risk becomes more complex, more expensive, and perhaps unaffordable for developing-country users. Moreover, the signals emanating from commodity exchanges are getting to be less reliable as a basis for investment decisions and for supply and demand management by producers and consumers.

Hmmm… so finally there is some reckoning of the problem by an international institution. When prices were rising last year, all was  considered well and demand -supply reasons were given.  As usual, a crisis tells you the nature of the probelm.

The chapter does some fresh analysis on whatever little data is available and sees financial speculation as a cause of concern. What is the way out:

In order to improve the functioning of commodity futures exchanges in the interests of producers and consumers, and to keep pace with the participation of new trader categories such as index funds, closer and stronger supervision and regulation of these markets is indispensable. The financialization of commodity futures trading also confronts the international community with the issue of how supply-side measures can address excessive commodity price volatility. This issue is of particular importance for food commodities, because, despite some recent improvements, current grain and oilseed inventories remain very low. This means that any sudden increase in demand or major shortfall in production, or both, will rapidly trigger significant price increases. Hence, physical stocks of food commodities need to be rebuilt urgently to a level adequate enough to be able to moderate temporary shortages and buffer sharp price movements.

I couldn’t understand much of the analysis as I don’t understand commodities markets. But these policy lessons are interesting. Policymakers please take note….

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One Response to “Excessive financialization of primary commodity markets”

  1. High costs of non-participation in economics of global warming « Mostly Economics Says:

    […] on climate change and its impact is capturing the minds everywhere. Quite a few reports are being written with this theme. This year’s Nobel Prize predictions are heavily tilted towards Environmental Economics and […]

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