:: Jayati Ghosh

Speculation and the global trade in food crops

Jayati Ghosh

April.7 : For much of the period between mid 2007 and mid 2008, as global prices in oil and other commodity markets zoomed to stratospheric levels, various eminent economists joined bankers, financial market consultants and even policymakers, in emphasising that these price rises were all about "fundamentals" that reflected real changes in demand and supply, rather than the market-influencing actions of a relatively small group of large players with enough financial clout and a desire to profit from changing prices.

In the case of oil, the arguments ranged from "peak oil", which pointed to the eventual (and imminent) problem of world oil consumption exceeding supply and known reserves, at one extreme, to the perfidious actions of the Opec cartel in restricting supply so as to push up prices, at the other extreme. In between were other arguments such as the easing of monetary policy in the largest economy, the United States; the weakening US dollar, which caused oil prices to rise since oil trade is largely denominated in dollars; and rapid economic growth worldwide, but especially in China and India. Such arguments were widespread even though the period when global oil prices more than doubled was one in which total world oil demand had scarcely changed and if anything fell to some extent and global oil supply increased slightly.

Similarly, the dramatic rise in food and other primary commodity prices was also traced to real economic causes and processes, even though 2008 has turned out to be a year of record grain production internationally. In the case of foodgrain and similar commodities, it is certainly true that rising costs of cultivation (partly affected in turn by high oil prices), inadequate policy support for agriculture resulting in falling yields, acreage diversion to produce bio-fuels, reduced government grain stockpiles, crop failures that could be traced to adverse weather conditions related to climate changes, all meant that there were imbalances that could explain some of the price rise.

Nevertheless, even for foodgrains, the very rapid rise in prices over just a few months was hard to explain without bringing in some role of speculation. But even such speculation was excused, on the grounds that this also meant good times for the direct producers, not only oil exporting countries but small farmers producing foodgrains that had become highly valued internationally.

But this argument dissolves completely in the face of the more recent dramatic declines in prices. This is evident from Charts 1 and 2, which plot the average monthly prices of major food and cash crops in world trade since January 2006.

Such wild swings in prices obviously cannot be explained by short-term supply and demand factors or any other "real economy" tendencies. Instead, these acute price movements are clearly the result of speculative activity in these markets. But then what explains all this speculation in the recent past, when it was not so evident before? And what form does it take? Why is it not stabilising, as predicted by so many economic theories?

Global commodity prices have always been volatile to some degree and prone to boom-bust cycles, which is one of the many reasons why developing countries have been encouraged to diversify away from dependence on such exports. As international commodity agreements to stabilise prices declined in the mid 1970s, and financial deregulation became more pronounced from the early 1980s, commodity futures markets emerged. These were supposed to allow for better risk management by different layers of producers, consumers and intermediaries through hedging.

Financial deregulation gave a major boost to the entry of new financial players into the commodity exchanges. In the US, which has the greatest volume and turnover of both spot and future commodity trading, the significant regulatory transformation occurred in 2000. While commodity futures contracts existed before, they were dominated by commercial players who were using it for hedging rather than for mainly speculative purposes.

In 2000, the Commodity Futures Modernisation Act deregulated commodity trading in the US, by exempting over-the-counter (OTC) commodity trading (outside of regulated exchanges) from oversight. Soon after this, several unregulated commodity exchanges opened. These allowed investors like hedge-funds, pension funds and investment banks to trade commodity futures contracts without any position limits, disclosure requirements or regulatory oversight. The value of such unregulated trading zoomed to $9 trillion at the end of 2007, more than twice the value of the commodity contracts on the regulated exchanges.

These actors entered the market in order to profit from short-term changes in price. They were aided by the "swap-dealer loophole" in the 2000 legislation, which allowed traders to use swap agreements to take long-term positions in commodity indexes. There was a consequent emergence of commodity index funds that were essentially "index traders" who focus on returns from changes in the index of a commodity, by periodically rolling over commodity futures contracts prior to their maturity date and reinvesting the proceeds in new contracts.

Such commodity funds dealt only in forward positions with no physical ownership of the commodities involved. This further aggravated the treatment of these markets as vehicles for a diversified portfolio of commodities (including not only food but also raw materials and energy) as an asset class, rather than as mechanisms for managing the risk of actual producers and consumers.

As the global financial system became fragile with the continuing implosion of the US housing finance market, large investors searched for other avenues of investment to find new sources of profit. Commodity speculation increasingly emerged as an important area for such financial investment. At the height of the boom, even on the regulated exchanges in the United States, such index investors owned approximately 35 per cent of all corn futures contracts, 42 per cent of all soybean contracts, and 64 per cent of all wheat contracts in April 2008.Unregulated trade was even larger.

Then, by around June 2008, when the losses in the US housing and other markets became intense, it became necessary for many funds to book their profits and move resources back to cover losses or provide liquidity for other activities.

The result was the excessive volatility displayed by important commodities over 2008 — not only the foodgrains and crops mentioned here, but also minerals and oil.

Such volatility had very adverse effects on both cultivators and consumers of food. This was not only because it sent out confusing, misleading and often completely wrong price signals to farmers that caused over sowing in some phases and under cultivation in others. In addition, it turns out that while the pass through of global prices was extremely high in developing countries in the phase of rising prices, the reverse tendency has not been evident in the subsequent phase as global trade prices have fallen.

So both cultivators and food consumers appear to have lost in this phase of extreme price instability. The only gainers seem to be the financial intermediaries who were able to profit from rapidly changing prices.