Development: Speculation played major role in food price crisis

The United Nations Special Rapporteur on the Right to Food, Mr Olivier de Schutter, has concluded that a significant portion of the increases in price and volatility of essential food commodities during the global food price crisis that occurred between 2007 and 2008 was due to the emergence of a speculative bubble. 

Please find below an article reporting on the Special Rapporteur's report on the issue, "Food Commodities Speculation and Food Price Crises". The article was published in the South-North Development Monitor (SUNS) #7006 on 28 September 2010, and is reproduced here with permission.

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Development: Speculation played major role in food price crisis

Geneva, 27 Sep (Kanaga Raja) -- A significant portion of the increases in price and volatility of essential food commodities during the global food price crisis that occurred between 2007 and 2008 was due to the emergence of a speculative bubble.

This is among the key conclusions of a briefing note titled "Food Commodities Speculation and Food Price Crises", and authored by Mr Olivier de Schutter, the United Nations Special Rapporteur on the Right to Food.

While the initial causes of the food price crisis related to market fundamentals, including the supply and demand for food commodities, transportation and storage costs, and an increase in the price of agricultural inputs, there is reason to believe that a significant role was played by the entry into markets for derivatives based on food commodities of large, powerful institutional investors such as hedge funds, pension funds and investment banks.

All of these institutional investors, he said, are generally unconcerned with agricultural market fundamentals.

According to the briefing note, such entry was made possible because of deregulation in important commodity derivatives markets beginning in 2000. "These factors have yet to be comprehensively addressed, and to that extent, are still capable of fuelling price rises beyond those levels which would be justified by movements in supply and demand fundamentals."

Therefore, said De Schutter, fundamental reform of the broader global financial sector is urgently required in order to avert another food price crisis.

"Previously unregulated Over the Counter (OTC) derivatives must be subject to rules requiring registration and clearing on public exchanges, and exemptions to these rules must be highly restricted," he recommended.

[Meanwhile, experts from more than 75 Member States of the UN Food and Agriculture Organization (FAO), who met in a day-long special meeting in Rome on 24 September, recognized that unexpected price hikes "are a major threat to food security" and recommended further work to address their root causes. The meeting came just as the FAO released a report showing that international wheat prices have soared 60-80% since July, and maize rose about 40%.

[According to an FAO news release, the meeting said that "Global cereal supply and demand still appears sufficiently in balance." It however added that "unexpected crop failure in some major exporting countries followed by national policy responses and speculative behaviour rather than global market fundamentals have been the main factors behind the recent escalation of world prices and the prevailing high price volatility."

[Among the root causes of volatility, the meeting pointed to the "growing linkage with outside markets, in particular, the impact of 'financialization' on futures' markets." Other causes were insufficient information on crop supply and demand, poor market transparency, unexpected changes triggered by national food security situations, panic buying and hoarding.]

The briefing note by the rights expert examines the impact of speculation on the volatility of the prices of basic food commodities, and identifies possible solutions going forward.

It cites estimates from the World Bank that as a result of the increases in prices of basic food commodities and oil in 2007-2008, the number of people in extreme poverty rose by 130 to 150 million. At least 40 million people around the world were driven into hunger and deprivation as a result of the 2008 food price crisis, raising the total number of people living in hunger to 963 million in 2008.

"As is nearly always the case, the brunt of the food price spike was borne by people in the Low Income Food Deficit Countries (LIFDCs), or the poorest developing countries. In these countries, of special concern are the urban and rural poor who even at the best of times must spend up to four-fifths of their income on food. The food price crisis undermined this already meagre ability to meet essential food needs."

Beginning around 2005, markets for numerous agricultural commodities started to witness price increases and higher levels of volatility. According to a document circulated under the auspices of the UN Conference on Trade and Development (UNCTAD), food prices rose by 83% between 2005 and 2008, with maize prices nearly tripling, wheat prices increasing by 127%, and rice prices by 170% between January 2005 and June 2008.

Moreover, the June 2010 issue of Food Outlook published by FAO finds that implied volatility in wheat and soy rose steadily from 2005 to 2008, and that the rise in implied volatility for maize continued, albeit at a much lower rate, until

At present, said De Schutter, there is a lively debate as to whether these developments were the result of factors adversely affecting food supply, or whether they were caused by excessive speculation in food commodities derivatives.

He noted that advocates of the first position maintain that the price spikes were attributable to factors such as a decline in the rate of growth of food production, climate change and water depletion, and the growth of biofuels.

For instance, he pointed to a special feature in the FAO Food Outlook (Nos. 59 and 62) by B. D. Wright and E. Bobenrieth that argues that the roots of the food price crisis lie in the fact that between 2007 and 2008, stocks of world wheat, maize and rice were low. Wheat production, they note, was lower than expected because of a severe drought in Australia, and (according to the IMF) consumers in China and India developed a taste for meat which drove up grain prices.

Certainly, said De Schutter, supply and demand fundamentals played an important role in the creation of the food crisis. However, closer examination reveals that the above-mentioned arguments of supply and demand are insufficient to explain the full extent of the increases and volatility in food prices. For instance, the price of rice rose by 165% between April 2007 and April 2008 - a magnitude difficult to explain by reference to market fundamentals.

The briefing note stresses that it is also difficult to accept the IMF's thesis that the food price increases were the result of per capita income growth in China, India, and other emerging economies which fed demand for meat and related animal feeds such as grains, soybeans, and edible oils. That interpretation is not corroborated by data collected by the FAO for the period concerned: that data shows variously, that the supply and utilization of wheat and coarse grain increased at roughly uniform rates, that end-of-season stocks for grains had generally increased significantly, and that China and India exhibited falling aggregate and per capita food grain consumption.

Instead, argued De Schutter, a number of signs indicate that a significant portion of the price spike was due to the emergence of a speculative bubble. Prices for a number of commodities fluctuated too wildly within such limited time-frames for such price behaviour to have been a result of movements in supply and demand: wheat prices, for instance, rose by 46% between January 10 and February 26, 2008, fell back almost completely by May 19, increased again by 21% until early June, and began falling again from August.

"The 2008 food price crisis was unique in that it was possibly the first price crisis that occurred in an economic environment characterized by massive amounts of novel forms of speculation in commodity derivative markets," he said, adding that the particular area of concern is speculation in derivatives based on food commodities.

A study conducted by Lehman Brothers just before its bankruptcy revealed that the volume of index fund speculation increased by 1,900% between 2003 and March 2008. Morgan Stanley estimated that the number of outstanding contracts in maize futures increased from 500,000 in 2003 to almost 2.5 million in 2008. Holdings in commodity index funds ballooned from US$13 billion in 2003 to US$317 billion by 2008.

In light of such developments, the UNCTAD Trade and Development Report 2009 found that "the trend towards greater financialisation of commodity trading is likely to have increased the number and relative size of price changes that are unrelated to market fundamentals".

In other words, says the briefing note, the changes in food prices reflected not so much movements in the supply and/or demand of food, but were driven to a significant extent by speculation that greatly exceeded the liquidity needs of commodity markets to execute the trades of commodity users, such as food processors and agricultural commodity importers.

"In fact, while the food price crisis may have been sparked off by the above-mentioned developments affecting demand and supply, its effects were exacerbated by excessive and insufficiently regulated speculation in commodity derivatives."

Therefore, suggested De Schutter, the policy solutions that are needed to avert another crisis must address both the problems affecting underlying financial market fundamentals, and the conditions under which speculation is allowed to take place in essential food commodities, thereby exacerbating the effects of those movements in market fundamentals.

The sudden massive entry of index funds into commodities should be placed against the background of developments in the broader financial markets, says the briefing note, pointing out that following the passage of the US Commodity Futures Modernization Act in 2000, Over The Counter (OTC) derivatives were exempted from the oversight of the US Commodity Futures Trading Commission (CFTC).

As a result of the Commodity Futures Modernization Act and the decisions of the CFTC, such trading was allowed to take place without any position limits, disclosure requirements, or regulatory oversight. Moreover, the Act permitted for the first time OTC derivatives contracts where neither party was hedging against a pre-existing risk; i. e. where both parties were speculating.

De Schutter said that deregulation in the US allowed purely speculative OTC derivatives to be hedged on exchanges, and institutional investors participated in commodity index funds by arranging OTC swaps.

Understandably, the number of futures and options traded globally on commodity exchanges increased by more than five times between 2002 and 2008. The value of outstanding OTC commodity derivatives grew from US$0.44 trillion in 1998, to US$0.77 trillion in 2002, to more than US$7.5 trillion in June 2007.

Beginning end 2001, food commodities derivatives markets, and commodities indexes in particular, began to see an influx of non-traditional investors, such as pension funds, hedge funds, sovereign wealth funds, and large banks that packaged and dealt the commodity index instruments mentioned above. The reason for this was simply because other markets dried up one by one: the dotcoms vanished at the end of 2001, the stock market soon after, and the US housing market in August 2007. As each bubble burst, these large institutional investors moved into other markets, each traditionally considered more stable than the last.

According to the briefing note, the 2008 food price crisis arose because a deeply flawed global financial system exacerbated the impacts of supply and demand movements in food commodities. Reforming the global financial system should therefore be seen as part of the agenda to achieve food security, particularly within poor net food-importing countries.

The note points to both the US and EU initiatives in this area.

It says that the recent Dodd-Frank Act on financial reform passed by the US Congress is encouraging in this regard. With specific relation to agricultural commodities, the Dodd-Frank Act sets out a new Section 4a( c) of the Commodity Exchange Act (CEA), which requires the CFTC to establish, within 270 days of the passage of the Act, limits on the number of agricultural commodities that can be held by any one trader, as well as on energy related commodities and futures. It also requires the CFTC to establish limits on the aggregate number or amount of positions in certain contracts based upon the same underlying commodity that may be held by any one person, including any group or class of traders, for each month.

On the other hand, said De Schutter, the Dodd-Frank Act has not brought about the structural changes in the financial markets many had hoped for. In particular, the "Volcker rule" announced by President Barack Obama in January 2010, which was intended to prevent banks from using taxpayer-backed funds to speculate on financial markets and give up their stakes in hedge funds and private equity funds, has been severely watered down in the Act.

As for the EU initiative, De Schutter noted that Michel Barnier, the EU Commissioner for the Internal Market and Services, announced on 15 September 2010 a Proposed Regulation on OTC derivatives, central counter-parties and trade repositories. This proposed regulation imposes mandatory reporting and clearing (where possible) of OTC derivatives, and stipulates that "non-financial actors" will be subject to the same rules as "financial actors" if they meet certain thresholds.

More specifically, an information threshold is proposed, which will allow financial authorities to identify non-financial actors that have accumulated significant positions in OTC derivatives, and a clearing threshold, which, if exceeded, will render a non-financial actor subject to the clearing obligations. Moreover, the proposal draws a distinction between commercial and financial actors by stipulating that "in calculating the positions for the clearing threshold, derivatives contracts should not be taken into account if they have been entered into to cover the risks from an objectively measurable commercial activity."

The proposed regulation will place obstacles in the path of index speculators' participation in commodity index funds. However, these obstacles do not appear to be insurmountable: the CME group, for instance, has already successfully developed cleared commodity index swaps.

Moreover, said De Schutter, there may be a difference between the "position limits" imposed by the Section 737 of the Dodd-Frank Act, and the "concentration limits" imposed by Article 44 of the proposed regulation. The former provision sets out clear restrictions, while the latter appears to set out more variable, individualized limits that could be subject to dispute.

"The goal of commodity derivatives reform is not to inconvenience financial speculation in commodities, but to limit, control, or even prohibit it outright. As such, it cannot be said that the proposed regulation tackles the subject of speculation in commodities directly," said De Schutter.

In general, says the briefing note, the EU has yet to act as boldly as the US with specific regard to speculation in food commodities, although the consequences of inaction are equally considerable: London is the world's largest agricultural commodities market outside the US. Despite various calls denouncing the impact of speculation in foodstuffs, such as the demarche by the French government to the European Commission, European regulation of commodities trading remains insufficient.

In July 2010, Andrew Ward, the manager of Armajaro, a London-based hedge fund, purchased US$1 billion (770 million euro) worth of futures contracts for 241,000 tons of cocoa. This represented about 7% of the world's annual output of cocoa, and is enough to supply Germany for an entire year. Even more amazingly, the contracts were for delivery, which means that Armajaro owned almost all the cocoa beans sitting in warehouses all over Europe. Although the announcement of good harvests ensured that the spot prices did not rise as Armajaro had hoped, that such hoarding is permitted in this day and age stretches belief, said De Schutter.

The rights expert suggests certain steps that could be taken to prevent improper speculation in the commodities derivatives markets.

These include amongst others, that all regulators should distinguish between traders hedging against genuine commercial risks from non-traditional, market momentum-based speculators interested simply in making gains on price changes. Whereas the US CFTC does this, others, such as the UK Financial Services Authority, do not.

Regulators should recognize that there are fundamental conceptual differences between commodity derivatives and financial derivatives, and they should not be treated as belonging to the same category of instruments. In order to ensure that such regulatory conflation does not occur, it may be appropriate to assign the task of commodity derivatives regulation to a separate institution staffed specifically with experts in commodity markets.

And once this distinction is made, access to commodities derivatives markets could be restricted to traders and specialist brokers: a number of proposals could be considered, such as an outright ban on momentum-based speculation, and the compulsory registration of actors trading on commodity futures markets, in order for such exchanges to exclude financial traders.

Certain regulatory steps could also be taken to reduce the incentives for financial speculation. Among such measures are the establishment of spot platforms, as experimented by the Ethiopia Commodity Exchange; the imposition of compulsory delivery, preventing traders from settling their obligations in cash; and the imposition of higher margins (for instance, from 10% to 30% as down payment), thus forcing speculators to make a larger down payment for their speculation.

Aside from these regulatory changes, suggests De Schutter, strengthening of spot markets may be brought about by investing in better warehousing facilities, communications services and in transport infrastructure. Such steps will not only reduce the influence of non-commercial commodity futures traders, and increase the participation of farmers on such markets, but will also improve the ability of commodity futures to act as price signals.

At the same time, spot market regulation would be necessary in order to ensure that the delivery requirements do not result in hoarding. As illustrated by the cornering of the cocoa market by Armajaro, "our concern should encompass not just financial traders, but also speculation by commercial ones in the form of hoarding."

The Special Rapporteur believed that spot markets should be made transparent, so that the holdings of any single trader are known to all, and that there should be more transparency also about the strategic reserves held by States. Second, strict position limits should be placed on individual holdings, such that they are not manipulative.

There is a role for international cooperation in this regard, said the rights expert, pointing out that the ability of individual countries to feed their populations could be bolstered by setting up food and grain reserves. "The establishment of food reserves would at least assist in addressing the relatively small supply and demand movements or the impact on supply of events such as droughts or floods that speculators latch upon, thus reducing levels of price volatility."

The efficacy of such food reserves would be enhanced if they were established at regional and not just at national level, or if countries exchanged information about their food reserves and insured each other against price volatility by mutualising such food reserves. But improved regulation preventing large financial actors from influencing the commodity futures markets would also significantly limit volatility, added De Schutter.

The rights expert concludes that action to address the dangers of speculation in basic foodstuffs is needed. Although considerable progress appears to have been achieved in this regard with respect to financial reform in the US, most other regions in the world, including the EU, still lag behind, he said.

Although the global stocks of grain are higher now than they were previous to the 2007-2008 food crisis, the financial drivers of that crisis remain largely unchanged. More still needs to be done to curb the negative effects of speculation on basic food commodities. "This is an important source of vulnerability, particularly, for poor net food-importing countries, whose dependency on food imports has been increasing over the years, and who will in the future suffer more balance of payments problems if they are confronted with a new peak in prices over the coming weeks and months."

The Special Rapporteur makes a range of recommendations including that comprehensive reform of all derivatives trading is necessary, given the numerous linkages between agriculture, oil, and other financial markets; and that regulatory bodies should carefully study and acquire expertise in commodity markets, instead of regulating commodity derivatives and financial derivatives as if they were the same class of assets.

Furthermore, access to commodities futures markets should be restricted as far as possible to qualified and knowledgeable investors and traders who are genuinely concerned about the underlying agricultural commodities.

"A significant contributory cause of the price spike was speculation by institutional investors who did not have any expertise or interest in agricultural commodities, and who invested in commodities index funds because other financial markets had dried up, or in order to hedge speculative bets made on those markets."

The rights expert also called for spot markets to be strengthened in order to reduce the uncertainty about future prices that creates the need for speculation. However, these markets must also be regulated in order to prevent hoarding. +