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Consultation on Financial Crisis and Trade: Towards an Integrated Response in the Latin America-Caribbean Region

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Title: Consultation on Financial Crisis and Trade: Towards an Integrated Response in the Latin America-Caribbean Region


1
  • Consultation on Financial Crisis and Trade
    Towards an Integrated Response in the Latin
    America-Caribbean Region
  • Dates September 1-2, 2009, Venue SELA
    (Caracas)
  • Draft of Remarks Prepared by Dr. Jan Kregel,
  • Professor, Levy Economic Institute, Bard College
  •  
  • For SESSION II (130 320) FINANCIAL MARKETS
    AND SPECIALIZATION IN INTERNATIONAL TRADE THE
    CASE OF COMMODITIES

2
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

3
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.

4
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.

5
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

6
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

7
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.

8
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.

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13
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.

14
How Commodity Funds Affect Both Future and Spot
Commodity Prices
  • 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.

15
How Commodity Funds Affect Both Future and Spot
Commodity Prices
  • 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.

16
How Commodity Funds Affect Both Future and Spot
Commodity Prices
  • 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.

17
How Commodity Funds Affect Both Future and Spot
Commodity Prices
  • 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.

18
How Commodity Funds Affect Both Future and Spot
Commodity Prices
  • 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.

19
How Commodity Funds Affect Both Future and Spot
Commodity 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.

20
How Commodity Price Boom has impacted Developing
Countries
  • Lifted External Constraints
  • Increased Reserves
  • Changed relative prices
  • Internal and external
  • Soya
  • Impact of biofuels

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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.
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