Latest victims of financialisation - food and commodities

Food- and commodity-producing countries in the Third World have long faced the problem of price volatility arising from many sources. Speculators operating from financial and commodity markets are now adding to their woes. Michael Lim Mah-Hui explains.

IT is apropos to recall the words of the great economic historian Karl Polanyi. In his book The Great Transformation, he wrote that in the transformation from feudalism to capitalism, everything becomes commoditised for the sake of profit - trees become timber, men/women become labour, and land becomes real estate.  Today we can add to this list - food becomes a financial commodity.

The term 'financialisation' has gained increasing prominence and usage over the last few years. Basically it refers to the process and result of the domination of finance over the real economy. The financial industry includes banks and non-banking financial institutions such as insurance and mortgage companies, pension funds, investment banks, hedge funds, private equity funds, stock and bond markets, commodity and other types of exchanges etc. In the United States, the financial industry has grown to become the largest sector in the economy, accounting for slightly over 20% of its GDP in 2007, twice as large as the next sector, trade at 12%, followed by manufacturing at 11%. The financial industry accounted for 30% of total corporate profit in the same year. Wall Street employees earn on the average $435,000 per year - 10 times the salary of an average worker in the private sector.

The financial industry itself has undergone significant transformation. It used to be that banking was the major portion of the financial industry. But this is no longer the case in the advanced economies of the United States and the United Kingdom. The non-banking financial institutions that are not regulated, or what is sometimes termed the shadow banking system, have come to overshadow the banking institutions, though the links between the two are very tight. In fact, it is the activities in the shadow banking system and its links to the banking system that brought about the Great Financial Crisis of 2007.

The primary functions of banking and finance should be to serve the activities of production, trade and investment. However, today, instead of finance being the servant of the real economy, it has become its master. The tail is wagging the dog. Financial transactions are undertaken largely for speculative purposes and bear little relationship to real economic activities. And the volume and speed of financial transactions are so overwhelming they have come to destabilise the real economy. Take, for example, the foreign exchange markets, whose daily volume of transactions (spot, forwards and derivatives) totals $5 trillion, or $1,250 trillion per year (based on 250 working days). Compare this amount to the volume of world trade that totalled only $13 trillion for the year 2007. Even if we add other real economic activities like direct investment flows and tourism, we will not reach a fraction of the $1,250 trillion. Foreign exchange rates are determined more by financial flows such as carry trades rather than trade flows. These free capital flows have undermined the effectiveness of national monetary policies.

The financialisation of commodity markets and the effects of speculation in these markets are the subject of two important reports published earlier this year: Price Formation in Financialised Commodity Markets: The Role of Information by the United Nations Conference on Trade and Development (UNCTAD), and Broken Markets: How Financial Market Regulation Can Help Prevent Another Global Food Crisis by the World Development Movement (WDM) (see following article). Much of what follows is based on these reports.

Financialisation of the commodity markets

Agricultural commodities are naturally exposed to the vagaries of weather and natural calamities. Hence since time immemorial, farmers have sought to shield themselves from price fluctuations by entering into forward contracts with investors, hedgers and speculators who are willing to take contrary positions.  These futures markets allowed producers to transfer their risks to market participants who are willing to take on price risks. 

However, over the past 10 years, a great transformation has occurred in the commodity markets; finance has now come to dominate operations in these markets. One example is the wheat market. In the mid-1990s financial speculators accounted for 12% of the market, with the rest held by commercial hedgers; in 2011, financial speculators held 61% of the wheat market and commercial hedgers 39%.

After the equities bubble collapsed in 2000, financial investors intensified the diversification of their investment portfolio. Studies were done to show that commodity markets were less volatile than the stock and bond markets and were a good hedge against inflation. Around the same time in 2001, the Commodity Futures Modernisation Act in the US exempted derivatives from oversight under state gaming laws, and also excluded certain swaps from being considered as 'security' under the Securities and Exchange Commission rules.  By ruling that credit derivatives were neither a security nor a gaming activity, the Act opened the floodgate to derivatives business that rose five times - from $100 trillion to $516 trillion between 2002 and 2007.

Deregulation of commodity markets has allowed an explosive growth of financial speculation in these markets.  This can been seen in Figures 1 and 2 that show the outstanding futures and options contracts on commodity exchanges, and over-the-counter (OTC) commodity derivatives respectively. There was a dramatic increase in these financial transactions in both markets between 2001 and 2008. However with the great financial crisis, there was a sharp drop in the OTC derivatives transactions, while there was a slight decline in the futures and options contracts on commodity exchanges in 2007/08 followed by a dramatic increase in 2009 and 2010.

The decline in the relative importance of OTC commodity derivatives probably reflects a change in the relative position of financial players in these markets. There are two major types of financial players in these markets - commodity index funds and active commodity fund traders. 

Commodity index funds are attractive to investors like pension funds because they allow investors to gain exposure to a wide range of commodities without direct trading in the market. These funds normally take a 'long only' position, i.e., they buy to hold, and roll over their positions upon maturity, taking the view that prices will rise over the long term. They are normally passive investors. The index investors will usually enter into a swap transaction with a bank or financial institution that will in turn hedge its position through futures contracts on a commodity exchange or in the OTC market.

The other category of financial players is the traders who actively buy and sell futures contracts in commodity markets. These are banks, hedge funds and private investors who choose active trading in commodity markets and significantly contribute to increasing price volatility. At the extreme are the big financial institutions that use computerised high-frequency trading to take advantage of price changes. They are criticised for creating extreme volatility in the markets. The chairman of the World Sugar Committee wrote that: 'Computer-based traders do not even contribute to the traditional function of the speculator in allowing producers and consumers to transfer price risk, since they do not take price risk home. Instead, it would appear that the computer-based traders are parasitic.'

Passive index investments that accounted for 65-85% of total commodity investments prior to the financial crisis have fallen to about 45% since 2008. A recent survey by Barclays Capital conducted in December 2010 revealed that only 7% of commodity investors plan to use index funds compared with 43% that preferred active management that includes the use of exchange traded products and exchange traded funds backed by futures contracts.

Impact of financialisation of commodity markets

Distortion of market prices

The recent volatility in prices of many agricultural and other commodities cannot be explained by the fundamental forces of demand and supply alone. Speculation plays a crucial role in this extreme volatility. For example, according to data from the US Department of Agriculture, there is no shortage of wheat and maize, yet the prices of these commodities have spiked in recent years. In the oil market, it was estimated that around 20% of the movement in price is due to positions taken by financial speculators. In the cocoa market, the attempt last year by a major player to corner the market by taking a huge position sent the price of cocoa skyrocketing, only to be followed by an equally major correction.

Studies have also demonstrated a close correlation between commodity prices and the positions taken by financial investors who pursue an active trading strategy. While over the long term, prices reflect fundamental forces of demand and supply, over the short term, price movements have more to do with the momentum of speculation than with fundamentals.

Market efficiency theory assumes investors make rational decisions based on full information and act independently of each other. However, the lack of transparency and reliable data, and the inherent uncertainty in commodity markets tend to push investors to follow the herd rather than to make independent decisions on the basis of information. This is especially true when commodity goods markets have become commodity financial markets. In the goods market, demand is driven primarily by consumption and prices are determined by forces of demand and supply; when price rises, demand falls and supply increases, and vice versa. In financial markets, demand is undertaken for investment rather than for consumption purposes. In other words, when price rises, demand also rises in anticipation of further rise and investors profit the most by following the crowd for some time and then divesting and taking profit just before the rest of the crowd does.  Investors have to be nimble, to be able to dip in and out of markets quickly. Hence, in the short term, prices are determined by speculation rather than the fundamental forces of demand and supply.

This tendency for prices to deviate from fundamentals generates wrong market signals and gives rise to price distortions. Consequently genuine market players such as producers, consumers and genuine hedgers are faced with a greater degree of uncertainty and this makes hedging more expensive and crowds out the genuine market hedgers. Hence it makes the transfer of price risks from producers and consumers to others who are willing to assume the price risks more difficult.

Aggravating price inflation

Commodity index funds have been criticised for exerting structural upward pressures in commodity futures markets due to the large and long positions they take. The volume of index funds in agricultural commodities increased 26 times from $3 billion in 2003 to $80 billion in 2011, accounting for 60% of overall financial holdings in agricultural futures markets (WDM, 2011). The total value of assets under management by financial investors in commodities rose from about $80 billion to $410 billion between 2005 and 2011 (UNCTAD, 2011: Figure 6).

Futures markets affect spot prices in the physical commodity markets through various ways.  On the one hand, traders in physical markets use futures prices as benchmarks for bidding in the spot physical markets. On the other hand, food producers are also influenced by futures prices. If they expect prices to rise as indicated in the futures markets, they may adjust supply accordingly and further push up prices.  Futures prices are also used as a basis for pricing in the spot market by adding or subtracting an agreed margin or 'basis' to the spot prices. In short, financial speculation in the futures markets exerts a strong influence on the price of commodities in the spot markets.

Commodity speculation complicates monetary policies

Just as free capital flows and carry trades undermine national monetary policies, commodity speculation likewise complicates monetary policies. After the dramatic fall in 2008 and 2009, commodity prices rebounded with equal vigour in 2010, way ahead of any recovery in the real economy. The rise in commodity prices generates inflationary pressure on the real economy and could force monetary authorities to tighten monetary policy prematurely, as in the hiking of interest rates in China and India in early 2010. This will in turn abort a recovery in the real economy.  As the UNCTAD report concluded:

'The fact that monetary policy reacts to price pressure stemming from rising commodity prices, rather than to bottlenecks in industrial production, points to a worrisome aspect of the impact of financialisation that has so far been underestimated, namely its capacity to inflict damage on the real economy as a result of sending the wrong signals for macroeconomic management.'

Conclusion

Prices of agricultural and other physical commodities have not only risen steadily but, more importantly, have been highly volatile in recent decades. Forces of the underlying physical demand and supply of commodities alone are not able to explain this worrisome trend. Increasingly, financial transactions and speculation that have little to do with the physical demand and supply of commodities are determining the price movements in these markets. Studies have shown that prices are correlated with positions taken by financial speculators. The financialisation of commodity markets distorts market prices, makes genuine hedging more expensive and difficult, crowds out genuine commercial market participants, complicates monetary policies, and contributes to rising food prices that can either push more people into poverty and/or slow down the rate of poverty reduction in the poorer countries.

Given the negative impact financial speculation in commodity markets has on the real economy, it is necessary to step up the regulation of commodity markets. Proposals for enhanced regulation include: better information on various aspects of commodity markets particularly with respect to inventory positions; increased transparency of positions taken by market players; establishment of individual position limits for any individual player, and aggregate position limits for any category of market players; tighter regulation of over-the-counter transactions and pushing more of such OTC transactions into publicly regulated exchanges; increasing margin requirements for financial speculators; and introduction of a financial transaction tax on all commodity derivative transactions.                                                   

Michael Lim Mah-Hui is a senior fellow at the Penang Institute based in Penang, Malaysia. He was previously a post-doctoral fellow at Duke University and Assistant Professor at Temple University in the US, and an international and investment banker.

*Third World Resurgence No. 254, October 2011, pp 9-11