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Is speculation fuelling the rise in commodity prices?

Is speculation fuelling the rise in commodity prices?
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First Published: Fri, Apr 08 2011. 10 55 PM IST

Jayachandran/Mint
Jayachandran/Mint
Updated: Fri, Apr 08 2011. 10 55 PM IST
Recent Surge in International Commodity Prices—Impact of Financialization of commodities and globally accommodative monetary conditions By Yasunari Inamura, Tomonori Kimata, Takeshi Kimura and Takashi Muto, Bank of Japan, international department.
Jayachandran/Mint
There are two views about the recent surge in commodity prices. One of them is that growth in emerging markets is fuelling the demand for commodities. The other viewpoint is that commodities have become like any other asset class for investors and the rise in prices is because of investors piling in. Speculative demand, rather than supply-demand fundamentals are responsible. Which is the correct view?
The authors say the rapid rise of emerging economies is certainly the primary reason for the increase in commodity prices. They say global commodity prices behave as a thermometer for the global economy. Indeed, copper is sometimes known as “Dr Copper” because of its relationship with the health of the global industrial economy. The price of commodities is, therefore, linked to the global output gap, or the difference between actual and potential growth. The authors, however, find that the recent hike in commodity prices has diverged “from its historical relationship with the global output gap”.
The reason is that speculative flows into commodities lead to a sharper price rise. True, this too can be seen as reflecting underlying fundamentals, because what these investment flows do is reinforce the trend. However, the authors point out that “when coupled with a prolonged low-interest rate environment, enhanced market expectations may entail a reduction in risk perception of investors who view commodities as an investment asset class. This causes commodity prices to significantly deviate from the level explained by fundamentals, otherwise called a ‘bubble’”.
Global monetary conditions have been loose since the beginning of the century, and rates in emerging markets too have lagged “behind the curve”. The upshot is higher commodity prices. The paper says that while individual central banks may feel it is not in a position to influence commodity prices, the failure of collective action leads to higher-than-expected demand for commodities. This, in turn, may lead to expectations of higher prices in future, leading to speculative inflows.
The authors draw attention to the fact that in recent years the size of the commodity futures markets, as measured by the market value of open interest, has become larger than that of equity-linked index futures markets. Institutional investors with a long-term perspective, such as pension funds and insurance companies, too, have started investing in commodities. The view that commodities are an asset class is what is termed the financialization of commodities. The investment and speculative flows have amplified price changes, thus “increasing positive correlation between the return on commodities and that on other financial assets such as equities. The corollary of this changing process is that commodity prices are becoming less related to supply-demand conditions of each commodity, but increasingly subject to the effects of portfolio rebalancing by financial investors”.
Moreover, rapidly rising commodity prices may have destabilizing effects on economies, particularly when they develop into a vicious circle of rising inflation, which, in turn, leads to further investment in commodities as an inflation hedge that drives their prices higher, and so on.
While it may not be possible to separate the impact of structural change in emerging markets and the impact of investment flows on commodity prices, there is little doubt that periods of loose monetary policy exacerbate the price increase.
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First Published: Fri, Apr 08 2011. 10 55 PM IST