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Commodity price movements:

Understanding causes and consequences
John Baffes >> 14

Business cycles and their relationship with

the commodity economy
Stephan Pfaffenzeller >> 18

Can the commodity economy be decoupled

from the financial sector?
Adam Gross >> 22

Recent trends in global commodity prices

and regulatory responses: Which way now?
Partha Ray >> 28

Commodity cycles :
Follow or cause economic cycles
Robin Roy and Sanjoy Majumder>> 36

Chinas pre-eminence in the

global gold market
Jeffrey M. Christian >> 40

Re-writing the rules of the game:

Evolving contours of global
regulatory regimes to govern
Michael Greenberger and Michael Vesely >> 44

Market as a bail-out institution: Commodity

exchanges in liberalised trade regime
Nilanjan Ghosh >> 50

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The upheaval witnessed in the world economy over the past three years
has left its indelible mark, probably for all times to come, on the way
markets are viewed and studied. In the following pages, ten experts try to
decipher and put forth their insights into and perspectives on the message
that this seemingly unending upheaval carries, particularly, in the context
of the global commodities market.

Even if it were to be shown that unfavourable impacts existed, the

challenge is to calibrate a response that eliminates the price distortion
and volatility exacerbation effects without adversely affecting market
liquidity, and without deterring the participation of arbitrageurs and
those speculators whose participation brings valuable new information
into the market's price formation process.
Adam Gross, Director of Strategy Bourse Africa /
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Commodity price movements:

Understanding causes
and consequences
By John Baffes, Senior Economist, World Bank

The commodity price boom witnessed since early 2005 has been one of the longest
and broadest, post-World War II. This essay concludes that a number of factors formed
what has often been called the `perfect storm'. Some of these factors have more of
a permanent character implying that commodity prices are not only likely to stay
elevated but may also become more volatile.

and likely consequences of the boom. It concludes that

a number of factors formed what has often been called
the perfect storm and that prices are not only likely to
stay elevated but may also become more volatile.

The nature and causes of the boom

The recent commodity boom emerged in the mid-2000s
after nearly three decades of low and declining commodity
prices (see chart 1). The long-term decline in real prices
had been especially marked in food and agriculture.
Between 1975-76 and 2000-01, world food prices fell
by more than 50 per cent in real USD terms. Such price
declines raised concerns, especially with regard to the
welfare of low-income agricultural producers. In fact,
one of the Doha Rounds chief motives (and also one
of its perceived main obstacles) was the reduction of
agricultural support and trade barriers in high-income
countriesa set of reforms that was expected to induce
increases in commodity prices and, thus, improve
the welfare of poor commodity producers (Aksoy and
Beghin 2005, Anderson and Masters 2009). Starting
in the mid-2000s, however, prices of most commod-

ities reversed their downtrend, eventually leading to an
he commodity price boom that began in early unprecedented commodity price boom.
2005 has been one of the longest and broadest The recent boom shares two similarities with the
post-Second World War (World Bank 2009). In two earlier major commodity booms of the post-WWII
2008, crude oil prices peaked at US $147 a period, during the Korean War and the early 1970s
barrel (up over 94 per cent from a year earlier) while rice energy crisis (Radetzki 2006, and Baffes and
prices doubled within just five months. Cotton prices Haniotis 2010).
almost tripled in six months in early 2011, while gold Each of the three booms took place in an environment
temporarily exceeded $1,900 an ounce in late August conducive to high prices including high and sustained
2011. The boom has renewed interest in the long-term economic growth as well as an expansionary macroeco-
behaviour and determinants of commodity prices, and nomic environment, and each was followed by a severe
raised questions about whether prices have reversed slowdown of economic activity. And, all three triggered
the downtrend most of them followed during most of discussions on coordinated policy actions to address
the past century. This essay summarizes the causes food and energy security concerns.

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Yet the recent boom also exhibits some important Table 1: The `perfect storm'
differences from the previous ones. By most accounts,
2001-05 2006-10 Change
it is the longest lasting and broadest in the number of
Crude oil price (US$/barreal, nominal) 33 75 127%
commodities involved. It is the only one that simultane-
Exchange rates (US$ against a broad index of currencies) 119 104 -13%
ously involves all three main commodity groupsenergy,
metals, and agriculturewith its peak showing food Interest rates (10-year US Treasury bill) 4.7 4.1 -14%

and agriculture prices increasing less than the other Funds invested in commodities ($ billion) 30 250 730%
two indices. It was not associated with high inflation, GDP growth, low and middle income countries (% p.a.) 5 5.8 16%
unlike the boom of the 1970s (although the increase in Industrial production, low and middle income countries (% p.a.) 6.3 7.1 13%
food prices had some notable, albeit short-lived, impact Stocks of maize, wheat, and rice (months of consumption) 3.2 2.5 -21%
on inflation). Finally, it unfolded simultaneously with Biofuel production (million of barrels per day equivalent) 0.4 1.3 203%
the development of two other boomsin real estate Yields (average of wheat, maize, and rice, tons/hectare) 3.8 4 7%
and equity marketswhose end led most developed Growth in yields (% change per annum, average) 1.4 1 -32%
countries to their most severe post-WWII recession.
Natural disasters (droughts, oods, and extreme temperatures) 374 441 18%
The recent boom took place in a period when most
countries, especially developing ones, sustained strong Source: World Bank, IMF, FRED, USDA, CRED, IEA, and author's calculations
economic growth. During 2003-2007, growth in devel-
oping countries averaged 6.9 per cent, the highest reached, or moved close to, 2008 levels (see chart 2).
five-year average in recent history. Yet apart from broad The 2010/11 resurgence reaffirms that some of the
and prolonged economic growth, the causes of the recent factors behind the boom have a permanent character,
boom were numerous, including macro and long-term as implying that not only prices are likely to stay elevated
well as sector-specific and short-term factors. compared to recent historical levels but may also be
Fiscal expansion in many countries and lax subjected to higher variability.
monetary policy created an environment that favoured
high commodity prices. The depreciation of the US The way forward
dollarthe currency of choice for most international
commodity transactionsstrengthened demand (and Chart 1: Long-term price trends: 1948-2010
(Real, MUV-deflated, 2000=100)
limited supply) from non-USD commodity consumers
(and producers). Other important contributing factors Korean

include low past investment, especially in extractive 300

commodities (in turn a response to a prolonged period 250

of low prices); investment fund activity by financial Agriculture
institutions that chose to include commodities in their
portfolios; and geopolitical concerns, especially in 150
energy markets. 100

In the case of agricultural commodities, prices were

affected by higher energy prices (energy is a key input
to most agricultural commodities), more frequent than 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008
usual adverse weather conditions, and the diversion of
some food commodities to the production of biofuels Source: Worldbank

(notably maize in the US and edible oils in Europe).

These conditions pushed global stock-to-use ratios of The key question is which of the factors behind the
several agricultural commodities down to levels not boom are more permanent in nature. A considerable
seen since the early 1970s, further accelerating the part of the agricultural commodity price movements can
price increases. Policy responses including export bans be explained by changes in energy prices. Consider,
and prohibitive taxes (especially in the rice market) for example, that during 1986-2003 the nominal
that were introduced in 2008 to offset the impact of energy index averaged 72 and increased to 224 during
increasing world food prices contributed to creating 2004-2009 up by 213 per cent. The agricultural
the conditions for the perfect storm (see table 1 for price index increased by 43 per cent during the two
numerous summary statistics). periods (from 119 to 170), identical to what a 0.20
The weakening and/or reversal of these factors, transmission elasticity would imply when applied
coupled with the financial crisis that erupted in to the energy price increase (0.20*2.17 = 0.43).
September 2008 and the subsequent global economic Although, such calculation is very simplistic since it
downturn, induced sharp price declines across most masks considerable price variation within sub-periods,
commodity sectors. However, prices picked up again in in addition to being supported by strong econometric
2010 and by mid-2011 prices of most commodities had evidence (Baffes 2007 and 2011), it is consistent with /
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the fact that agriculture is an energy-intensive industry. unit of GDP). Strong demand has played an important
For example, at a global level, agriculture is 4-5 times role in energy markets as well (the effect of demand
more energy-intensive than manufacture (see chart 4). of extractive commodities has been discussed often in
Thus, to the extent that energy prices are likely to be the context of the super-cycle hypothesis (Cuddington
elevated, agricultural prices will follow suit. and Jerrett 2008). It has often been argued that
Strong demand has been cited as a factor behind a structural shift has taken place in the demand for
the recent boom. Indeed, as noted above, growth grain by emerging countries, including China and India,
in developing countries (where most of the growth in and especially during the past decade when these two
demand for commodities has been taking place) has countries experienced high-income growth. The June
been very strong. Robust demand has been the key 2009 issue of National Geographic, for example, noted
driver of the increases in metals prices. As chart 4 that as countries like China and India prosper and
shows, metal consumption, especially by China, has their people move up the food ladder, demand for grains
been so strong during the past decade that it effec- has increased. Similar arguments have been advanced
tively reversed the metal intensity of GDP at a global by noted scholars as well. Krugman argued that
level (i.e. the amount of metal consumed to produce a theres the march of the meat-eating Chinesethat is,
the growing number of people in emerging economies
Chart 2: Short term price movements: Jan 2004 - Jul 2011 who are, for the first time, rich enough to start eating
(US$ nominal price indices, 2000 = 100)
like Westerners (New York Times editorial, April 7,
Energy Metals Food
2008). Likewise, Wolf asked So why have prices of
food risen so strongly? and then answered strong
rises in incomes per head in China, India, and other
emerging countries have raised demand for food,
notably meat and the related animal feeds (Financial
Times, April 29, 2008). Indeed, the size of China and
India, which together account for 27 per cent of the
worlds population, implies that even a minor change
Jan04 Jan05 Jan06 Jan07 Jan08 Jan09 Jan10 Jan11
in their pattern of demand growth has a major effect on
Source: Worldbank world market prices. However, it should be noted that
this is not the case in agriculture. In fact, the empirical
Chart 3: Commodity intensities of GDP: 1971-2010 evidence points to the contrary conclusion that food
(commodity use per unit of GDP)
consumption by China and India did not increase during

Energy Food Metals

the boom years. Indeed, Alexandratos (2008:673)
1.00 emphatically stated: their (Chinas and Indias)
combined average annual increment in consumption
(both growth rate and absolute increments) was lower
in the years of the price surges (2002-2008) than the
preceding period 1995-2001.
0 70
0.70 The increasing interaction between the price
movements of energy and non-energy commodities
1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
during the boom brought to focus the impact of growing
Source: Worldbank demand for biofuels, including maize-based ethanol
(mainly in the US) and oilseed-based biodiesel (largely
Chart 4: Energy intensity of agriculture and manufacture in Europe). During the boom, maize and crude oil prices
(cost of energy component measured in 2007, percent)
moved in tandem, pointing to an emerging new and
Manufacture Agriculture
WORLD fixed relationship between them. Obviously, maize and
its use for ethanol moved into the picture as significant
factors affecting price developments. But how much was
the impact, and was there a similar impact in oilseeds,
China resulting from their use for biodiesel? The contribution
India of biofuels to the recent price boom, especially the price

0 3 6 9 12 15 18
spike of 2007/08, has been hotly debated. Mitchell
(2009) argued that biofuel production from grains and
Source: GTAP preliminary release 0, version 8. oilseeds in the US and the EU was the most important
Note: Agriculture refers to crops (i.e., it excludes livestock); it includes both direct energy costs factor behind the food price increase between 2002 and
(mostly fuel) and chemicals (the most important of which is fertilizer). To avoid double-counting,
2008, accounting, perhaps, for as much as two-thirds of
manufacture does not include the rening sector.
the price increase. Gilbert (2010), on the other hand,

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found little direct evidence that demand for grains and About the Expert
oilseeds as biofuel feedstocks was a cause of the price
A Senior Economist with the Development Prospects Group
spike. While it is indeed the case that biofuels is the oof the World Bank, JOHN BAFFES currently manages the
only new source of demand for food commodities, banks
b commodity price forecasting and market monitoring
when examined from a global land perspective, in 2009 process.
p His other responsibilities include research on
m structure and policy reform issues in developing
biofuels accounted for 1.5-2.0 per cent of global area
a OECD countries as well as policy advice to various
allocated to grains and oilseeds. While in the current country
c departments. Since joining the World Bank in 1993,
context of high prices such share is important, it is Mr
M Baffes has worked in several operational departments,
perhaps an exaggeration to argue that biofuels have including
in Mexico, Bangladesh, and various East African
countries. He has written exte
extensively in the areas of economic development, trade, and
been the most important factor behind the post-2005 agricultural economics, and contributes frequently to several internal and external World
increases in food prices. Bank publications. Mr Baffess contributions total over 60 articles in academic journals
While debates have mostly focused on the amount and books. He was a key contributor to the World Banks flagship publication Global
of food crops that have been diverted to the production Economic Prospects 2009: Commodities at the Crossroads. Mr Baffes holds a BS degree
in Economics (University of Athens, 1983), MS in Agricultural Economics (University
of biofuels, and the resulting effect on prices, much of Georgia, 1986), and PhD in Agricultural and Resource Economics (University of
less attention has been paid to a more important Maryland, 1992). Mr Baffes may be reached at
issue linked to this developmentthe level at which
energy prices provide a floor to agricultural prices. In
addition to the prices of these commodities (energy interviews).
and feedstock for biofuels), it involves numerous other Another frequently discussed factor has been the role
elements, including subsidies, mandates, trade restric- of speculation. Among the numerous types of speculation
tions, and sunk costs of the biofuel industry. Therefore, discussed often in the financial and popular press, it is
analysts often use various rules of thumb to express investment fund activity in commodity futures exchanges
a perceived new relationship between the prices of that matters most. Yet, while the views on the effects of
agri+commodities and crude oil. For example, the price this activity on commodity markets are very strong (some
of maize expressed in US$/ton is roughly double that believe that they have caused a speculative bubble while
of crude oil in US$/barrel (thus, $75 a barrel price for others argue that not only they have not affected prices
crude oil would correspond to $150 a ton for maize). at all but they have also injected liquidity in the market,
Other commentators (in the US) have argued that a thus facilitating price discovery), the empirical evidence
price of $3 a gallon of gasoline at the pump is the level has been weak. While the literature on speculation is still
at which the maize price is determined by the oil price. inconclusive, it is unlikely that investment fund activity
The World Bank (2009) reported that crude oil prices will alter long-term price trends. However, it may induce
above $50 a barrel effectively dictate maize prices. higher price variability by exacerbating the length and the
The conclusion was based on the strong correlation amplitude of price cycles.
between maize and crude oil prices above $50 a barrel. To conclude, as analyzed extensively in the liter-
The US Government Accountability Office (2009:101) ature, numerous factors have contributed to the
while acknowledging that economists have disagreed recent commodity boom. Although their relative weight
about the circumstances that would make the 2009 continues to be an area of contention, some of these
US biofuel mandates non-binding (i.e. biofuels become factors have, indeed, a permanent character, implying
profitable at current energy prices), it gave a range of that commodity prices are likely to be elevated and
$80-$120 a barrel (based on anecdotal evidence from more volatile.

Alexandratos, Nikos (2008). Food Price Surges: Possible Causes, Past ed. A. Aksoy and B. Hoekman. Center of Economic and Policy Research
Experience, and Long-term Relevance, Population and Development and the World Bank.
Review 34: 599-629.
Gilbert, Christopher L. (2010). How to Understand High Food Prices.
Anderson, Kym and William Masters (2009). Distortions to Agricultural Journal of Agricultural Economics 61: 398-425.
Incentives in Africa. Washington, DC: The World Bank.
Mitchell, Donald (2009). A Note on Rising Food Prices. Policy Research
Baffes, John (2011). The Energy/Non-Energy Price Link: Channels, Working Paper 4682. Washington, DC: World Bank.
Issues, and Implications. In Methods to Analyse Agricultural Commodity
Radetzki, Marian (2006). The Anatomy of Three Commodity Booms,
Price Volatility, pp. 31-44, ed. I. Piot-Lepetit and R. MBarek. Springer
Resources Policy 31: 56-64.
Science, 2011.
US Government Accountability Office, 2009. Biofuels: Potential Effects
Baffes, John (2007). Oil Spills on other Commodities. Resources
and Challenges of Required Increases in Production and Use. Report
Policy, 32:126-134.
GAO-09-446. Washington, D.C.
Baffes John and Tassos Haniotis (2010). Placing the Recent Commodity
World Bank, (2009). Global Economic Prospects: Commodities at the
Boom into Perspective. In Food Prices and Rural Poverty, pp. 40-70,
Crossroads. Washington, DC: World Bank. /
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Business cycles and their relationship

with the commodity economy
By Stephan Pfaffenzeller, Lecturer of Economics, University of Liverpool

Volatile commodity markets have historically been analysed against a background

of dualist interaction between a developed economic centre and an underdeveloped
periphery. More recently, commodity price cycles have impacted a more diverse set
of economic regions in more diverse ways and may be showing signs of constraining
industrial sector activity.

he interaction of commodity markets with Yang real commodity prices index by a cumulative total
general economic activity has been a topic of of 59.8 per cent from 2003-2008. This magnitude
lasting interest. Recent dramatic (commodity) exceeds previous price rallies during World War I (by
price developments have further highlighted 34 per cent from 1913-1917), following the end of
the relationship between commodity markets and the great depression (49.5 per cent from 1932-1937)
economic fluctuations. The first decade of the 21 and around the time of the oil price shock (54 per
century saw a sustained increase in the Grilli and cent from 1971-1974).
1. The average annual price data used for these computations are from the Grilli and Yang Commodity Price index in real terms and updated as
in Pfaffenzeller et al. (2007) except Timber data, which have been updated from forestry commission questionnaires from 2003. In this data
set, a large decline is recorded for 1920/1921, but this may be an artefact produced by interpolation and is often modelled as a structural
break (cf. Cuddington & Urzua (1989), Grilli & Yang (1988).
2. GDP growth data where obtained from the Worldbanks World Development Indicators.

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The subsequent 11 per cent price decline is compar- climatic fluctuations in the case of agri-commodities
atively large but not as pronounced as the year-on-year or from increased industrial activity in the centre
(y-o-y) declines observed in 1930 (19.9 per cent), 1975 economies for other raw materials such as minerals
(25.1 per cent) or 1938 (25.8 per cent)1. The year 2010 and metals. This analysis points to the complexity of
saw the largest recorded y-o-y real commodity price cyclical variations in commodity-dependent economies.
increase (24.2 per cent) since 1900. While increased demand from the centre can produce
The commodity price boom of the early 21 century price booms, the peripheral response discussed by
was accompanied by high rates of income growth. World Singer implies a long-term supply reaction that has the
GDP grew by close to 4 per cent for most years after net effect of depressing commodity prices in the long
2003 with east Asia registering growth rates in the run through a supply expansion. What is remarkable
range of 6-12 per cent during the decade 2000-2009. here is the deterministic prediction based on demand
Even after the financial crisis of 2008/2009, East and supply functions, which could be seen as a priori
Asias growth rates merely fell from 12.3 per cent in independent.
2007 to 7.4 per cent by 20092. The cyclical pattern of short-lived price booms
It is, at one level, an obvious assertion, that high alternating with protracted price depressions has
rates of economic growth are driving up commodity received some support from Cashin et al. (1999).
prices. Commodity prices are bound to fluctuate in Cashin and colleagues document that commodity price
response to changes in the supply of and demand booms are shorter lived than price falls, which tend to
for commodities. One should also expect changes in dominate long-run developments. What matters in this
commodity prices to transmit throughout an integrated context is not only the cyclical pattern of commodity
world market. The effects of commodity price changes, prices but also their impact on the business cycles of
their interaction with economic activity generally and commodity-dependent economies.
demand for and supply of commodities more specifi- The impact of commodity price fluctua-

cally will differ regionally depending on a countrys tions on commodity export dependent
economic structure and level of industrialisation. economies has been discussed
A discussion of the relationship between business extensively by McCombie & Thirlwall
cycles and the commodity economy should, therefore, (1993), who see the main impact
consider the interaction between supply and demand of commodity export earnings in At the above rate, 2010
responses and regional economic peculiarities. This loosening the balance of payments saw the largest y-o-y
perspective is crucial not least because it appears constraint: developing countries real commodity
that the structural composition of manufacturing have been assumed to be limited in price rise since
and primary sector specialisation across the world their economic growth by the amount 1900
economy has been changing over the course of the of foreign exchange available, for example,
20th century. Inter-temporal fluctuations in commodity capital goods imports.
prices reflect these changes to some degree. If this constraint is binding in commodity-dependent
For most of the 20th century, the empirical and economies, then economic growth should be directly
theoretical discussion of the commodity economy has dependent on commodity export earnings. If higher
focussed on long-term price trends and their implica- commodity prices lead to higher earnings, one should
tions for commodity exporters. The analysis of cyclical expect economic growth to co-vary positively with
fluctuations has to be seen in the context of these commodity prices. The question of whether such a
long-term developments. relationship would hold only in the long run with
regards to secular trends in commodity prices and
Commodities and developing countries earnings or also over a shorter term is an inter-
& the traditional perspective esting and potentially contentious issue in itself. If
While the arguments of Prebisch and Singer concen- a commodity-based balance of payments constraint
trated on the predicted long-term decline in the does take effect over a medium-term time horizon,
commodity terms of trade, Singer (1950) did comment then one should expect a direct effect on business
on the impact of cyclical fluctuations in commodity cycles in commodity-dependent developing countries.
prices. In Singers analysis, temporary rises in In particular, one should expect higher commodity
commodity prices create an incentive for additional price volatility to translate into amplified business
investment in commodity producing sectors. Since cycles in the affected economies.
these incentives take effect when earnings from This implication for business cycles in the periphery
commodity exports are relatively high, the long-term also highlights a difference between these two strands of
effect was predicted to be an investment bias towards dependency theory. While Singer expected a commodity
the sector in long-term decline. boom to bypass the nascent industrial sector, a
Commodity price booms could be expected from short-term interpretation of balance of payments /
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The relationship
economy. One possible expectation against this
background would, therefore, be a sustained reversal
between business cycles of the historic commodity decline.

and the commodity There are countervailing factors to this recent

tendency though. Rising commodity prices have the
economy appears to shift potential to support exploration of less accessible
from a pattern of primarily non-renewable commodity deposits or to motivate
investment into higher production capacity. The
unilateral causation to one effective manifestation of these investment incen-
of deepened functional tives will of course depend on the persistence of

interdependence. sufficiently high real commodity prices over time, and

these in turn will depend on sufficiently high sustained
demand for commodity inputs in production.
constrained growth would predict a temporary relaxation The notion of the commoditys real price is crucial
of the growth constraint and, thus, a domestic boom. here. Prices of internationally traded primary commod-
In the former case, commodity booms should have ities are conventionally deflated by a developed
little impact on the business cycle within commodity economy manufactured goods price measure such as
dependent developing countries while in the second the MUV-G5 (an index of the unit values of manufac-
case they should accentuate it. This raises the question tured goods exports from the 5 leading industrialised
of how likely the balance of payments constraint is to be economies to developing countries). For commodity
binding. Balance of payments constraint based theories inputs into the manufacturing process, the real price
are weakened if developing economies have access to of a commodity is, therefore, a relative price: in this
alternative foreign exchange sources and if their reserve case, the representative price of the input relative to
position strengthens. that of the output produced.
The economic relationship underlying this relative
Commodities and emerging markets & price measure, in turn, has profound implications for
recent developments the dynamic interaction between commodity prices
Developments during the later years of the 20th and business cycles. Persistent commodity price
century and the first decade of the 21st century booms have the dual effect of incentivising supply
have seen sustained shifts in the structure of the increases and narrowing profit margins. If the latter
commodity economy. It has been observed repeatedly effect is sufficiently strong to substantively constrain
that sources of manufacturing exports are no longer economic activity, it could contribute to a downturn
located predominantly in the most developed centre and, thus, ultimately to a decline in demand for
economies. This tendency has affected not only the primary commodities and a fall in their prices.
inter-temporal pattern of manufactured goods prices This interaction if consistently present could
but also that of primary commodities. High-income simply have the long-run effect of limiting industrial
growth rates in China and India in particular have put activity with a given level of technology in commodity
upwards pressure on primary commodity prices. production. Commodity price declines that are
The traditionally assumed homogeneity of endogenously linked to preceding commodity price
commodity price behaviour has likewise increasingly booms will imply that high relative commodity prices
been called into question with some evidence of may not persist for a sufficient length of time to
product differentiation in commodity categories which generate the required increase in commodity supply.
have conventionally been seen as homogeneous (cf. Put differently, the elevated relative price level
Kaplinsky 2006 for a detailed empirical discussion). needed for a sufficiently extensive supply of primary
Thus, it is no longer generally taken as true that fluctu- commodities may not be sustainable within a given
ations in raw material prices merely reflect how a industrial market process.
dominant industrial sector interacts with a structurally Against this background, the strong upwards
weak primary sector on a global scale. pressure on commodity prices in recent years can
Increased upwards pressure on commodity prices be appreciated in context. The commodity price
can be expected to persist against a background of boom in 2008, followed by a price decline in the
sustained expansion in the leading and emerging wake of the global financial crisis, had already led
Asian economies. Kaplinsky & Morris (2008) highlight to capacity building investment in primary commodity
the fact that, in contrast to previous industrialisation sectors. These investments gave rise to predictions
episodes in East Asia, the emergence of the rapidly of a much more muted price recovery following a
growing Chinese export sector differs substantially renewed acceleration in economic activity later (Inter-
in impact due to the sheer size of the emerging national Monetary Fund 2009). The sharp increase

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in commodity prices seen in 2010 in a situation of About the Expert

continued crisis is, therefore, seen as somewhat
surprising (International Monetary Fund 2011). At LLecturer in Economics at the University of Liverpool. Dr
the same time, it highlights the continued constraint PPfaffenzeller, who is a macroeconomist, has recently
imposed by limited primary commodity reserves ppublished in journals such as Armed Forces and
SSociety, Journal of International Development, World
on world economic activity and the persistence of
EEconomy and Journal of Time Series Analysis. He
upwards pressure on commodity prices. aalso contributed significantly to a number of books
oon economics. Dr Pfaffenzeller may be reached at
Commodity cycles and developing
From the perspective of emerging markets and
developed centre economies, rising commodity prices however, be expected to have lasting implications for
could in principle be seen as quasi-redistributive the nature of cyclical fluctuations. Cyclical instability
changes benefiting commodity-exporting economies. in the domestic economy can generally be expected
On the one hand, one should expect foreign exchange to co-vary inversely with sectoral diversification. To
constraints to be relaxed through commodity directed the extent then that commodity dependence tends
FDI and export earnings. On the other hand, rising to endogenously impede the emergence of more
commodity prices in commodity-dependent economies advanced complementary sectors, one should expect
will likely translate into an improvement in the terms of it to also perpetuate pattern of domestic economic
trade and, thus, make capital imports more affordable. instability in response to fluctuations in export
However, the improvement in the barter terms earnings.
of trade may itself be problematic. Terms of trade Commodity prices had a volatile trajectory with a
improvements will normally take the form of a real weakly declining trend throughout the 20th century
appreciation and, thus, tend to erode export competi- but experienced a sustained recovery during the
tiveness. This phenomenon is most prominently first decade of the 21st century. Considering the
documented in the so-called Dutch disease case, structural changes in the international distribution
where a booming, economically dominant sector of production and trade, a shift from the traditional
erodes the export competitiveness of previously dualist structure between developed and underde-
viable competitive sectors. In the case of commod- veloped economies has been observed. There is some
ity-dependent underdeveloped countries, one should indication that a shift is also underway, from a non-fuel
also consider a similar impact on potentially viable commodity economy, which is unilaterally dominated
nascent export sectors. The suppression of export by centre economy demand pattern to one in which
potential can thus pre-empt growth take-off in small commodity shortages and associated commodity
open but non-industrialised economies (cf. Collier booms can constrain economic activity in the centre.
(2008) for a summary discussion). The relationship between business cycles and the
The interplay between Dutch disease effects and commodity economy, therefore, appears to shift from
economic growth describes long-term phenomena a pattern of primarily unilateral causation to one of
with relevance beyond the business cycle. They can, deepened functional interdependence.

Cashin, P., McDermott, J. & Scott, A., 1999. Booms and Slumps in Kaplinsky, R., 2006. Revisiting the revisited terms of trade: Will China
Primary Commodity Prices. Working Paper of the International Monetary make a difference? World Development, 34(6), pp.981-995.
Fund, (WP/99/115).
Kaplinsky, R. & Morris, M., 2008. Do the Asian Drivers Undermine
Collier, P., 2008. The Bottom Billion: Why the Poorest Countries are Export-oriented Industrialization in SSA. World Development, 36(2),
Failing and What Can Be Done About It, OUP Oxford. pp.254-273.
Cuddington, J. & Urzua, C., 1989. Trends and cycles in the net barter McCombie, J.S.L. & Thirlwall, A.P., 1993. Economic Growth and the
terms of trade: a new approach. The Economic Journal, 99(396), Balance of Payments Constraint, Palgrave Macmillan.
Pfaffenzeller, S., Newbold, P. & Rayner, A., 2007. A Short Note on
Grilli, E. & Yang, M.C., 1988. Primary Commodity Prices, Manufactured Updating the Grilli and Yang Commodity Price Index. The World Bank
Goods Prices, and the Terms of Trade of Developing Countries: What the Economic Review, 21(1), pp.1-13.
Long Run Shows. The World Bank Economic Review, 2(1), pp.1-47.
Singer, H., 1950. U.S. Foreign Investment in Underdeveloped Areas
International Monetary Fund, 2011. World Economic Outlook, April 2011: -the Distribution of Gains between Investing and Borrowing Countries.
Tensions from the Two-speed Recovery: Unemployment, Commodities, American Economic Review, 40(2), pp.473-485.
and Capital Flows, International Monetary Fund.

International Monetary Fund, 2009. World Economic Outlook: Crisis and

Recovery, International Monetary Fund. /
A PwC & MCX Joint Endeavour 21

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Can the commodity economy

be decoupled from the
nancial sector?
By Adam Gross, Director of Strategy, Bourse Africa

Amidst a raging debate on the causal influences of recent commodity price dynamics, the
best ways of addressing financialisation if found producing prejudicial impact could
involve: differentiation between `financial' and `non-financial' participants; eschewing
selective targeting of products and structures which could channel liquidity into
riskier alternatives; separation of financial and non-financial aspects of a commodities
transaction; and exploring ways to satiate investors portfolio diversification demand if
commodities among other asset classes become off-limits for them.

he impact of non-commercial players to the detriment of the commercial commodity chain
particularly, speculators or investors (defined and those dependent on it. The counter-argument has
below) in commodity markets has long usually been to highlight the liquidity, efficiency, infor-
been a source of analysis and debate1. The mational and arbitrage benefits arising from large-
central aspects of contention have been, firstly, price scale non-commercial participation in commodity
discovery and whether the participation of non-com- markets, the classic exposition of which is identified
mercial players moves prices away from an equilibrium with Holbrook Working.
at the intersection of supply and demand (or the Recently, there has been raging debate on the
fundamentals), as per classical economic theory. financialisation of commodities (for example, UNCTAD
Secondly, price volatilitywhether the dynamics of 2009) a modern variant of this theme, which has
speculative market participation exacerbate volatility assumed particular prominence in the context of the
1. See Ann Berg, The Rise of Commodity Speculation: From Villainous to Venerable, in Safeguarding Food Security in Volatile Global Markets,
FAO 2011

22 Commodity Insights Yearbook 2011

012-053_CIYB_2011_Exper's Views.indd 22 1/26/2012 1:40:12 AM


commodity price spike of 2006-7 and the subsequent on their assessment of the risk-return properties that
global financial crisis. Are the recent changes in the contain a proportion of commodity futures relative
nature of non-commercial participation in commodity to portfolios that contain only traditional asset
markets adversely affecting price discovery and classes. In short, the three crucial elements are the
volatility? If so, what should be done about these emergence of commodities as an asset class, their
changes? Such questions feature prominently in the role in portfolio diversification, and the increasing
policy discourse for example, at the global level participation of financial investors on this basis.
in the forum of the Group of Twenty (G20) nations
as well as in the practical business of regulating and Recent developments
operating commodity markets around the world. This Data from the Bank for International Settlements
essay analyses the key dimensions of financialisation Quarterly Review (see chart) throws some light on
and evaluates its impact on commodity markets developments during 2005-2010, the period when
before appraising the desirability and feasibility of financialisation is said to have taken place.
reversing the trend, if it exists.
OTC and exchange-traded derivatives volume all
Definitions assets and commodities (non-gold) 2005-2010
First, it is important to set out definitions of important
terms, starting with the general terms before moving to
the key term under review financialisation. Commod-
ities will be taken to include the sectors of agriculture,
energy and metals/minerals, albeit considered here
on a disaggregated basis due to space constraints.
The commodity economy will be taken to refer both
to the market for transacting the physical commodity
and the market for financial derivative instruments in
which commodities are the underlying asset, whether
through exchange-traded central-counterparty-cleared
mechanisms or in over-the-counter (OTC) transactions Note: OTC volume data is measured in terms of notional amounts outstanding in USD billions as in
December of the quoted year; exchange-traded volume data is measured in terms of contracts out-
where two counterparties trade directly. standing in millions as in December of the quoted year; both sets of data have been rebased to 100 for
the year 2005
Commercial participants are considered to be
Source: Bank for International Settlements Quarterly Review, June 2008 and June 2011
individuals or firms with direct exposure to the physical
commodity by virtue of their ordinary business opera-
tions as producer, processor, trader, user or The data shows how the period 2005-2007 saw
consumer of commodities. Non-commercial partici- increases in volumes across OTC and exchange-
pants are considered to be those that do not have traded markets, in general, and for commodities,
such direct exposure, but participate for the purpose in particular. In fact, exchange-traded commodities
of speculation, investment or arbitrage; where specu- witnessed a remarkable increase, though from a lower
lation is defined as taking an uncovered position in base. As with all asset classes, the volume spike
the market with the aim of benefiting from an antici- became a crash between mid-2007 and early-2008
pated price trend, investment is defined as creating a the onset of the global financial crisis albeit with
portfolio of positions across asset classes with the exchange-traded commodities retaining not less than
aim of achieving a targeted risk-return profile, and double the volume compared with 2005.
arbitrage is defined as taking simultaneous positions However, it is notable that OTC commodity volumes
in two related markets to benefit from an identified exhibited a much more torrid crisis. While they also
pricing inefficiency between the two markets and surged during 2007, it is notable that the subsequent
accrue theoretically risk-free profit. easing took OTC activity by end-2010 to half the
The financialisation of commodity markets can be level it had reached by end-2005 (US $2,525 billion
defined, following UNCTAD 20092, in the growing role outstanding by 2010-end compared with $5,100
in commodity markets of financial participants who billion for 2005).
treat commodities as an asset class3, motivated The data, thus, poses the question: Does the
by portfolio diversification considerations that are increase in volumes of exchange-traded commodities
unrelated to commodity market fundamentals, based originate from a transfer of activity from the OTC

2. The Financialization of Commodity Markets, United Nations Conference on Trade and Development (UNCTAD) Trade and Development Report
Chapter II
3. Banque de France, in its Financial Stability Review no. 9 (December 2006, pp 31-38), denes an asset class as bearing three criteria: outper-
forming risk-free returns; low or negative correlations with other asset classes; cannot apparently be replicated by simple linear combinations
of assets. /
A PwC & MCX Joint Endeavour 23

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Thus, there is qualitative support that the trend

represents new types of investment into commodities
a true financialisation. On the other, there is also
support that the trend represents a transfer of activity
from OTC markets to exchange-traded markets a
shift in product structure as participants sought
to protect themselves from counterparty default risk
prevalent in OTC markets by finding new structures
and instruments that, by their consequence, generate
higher exchange volumes.

Product structure
It is undeniable that certain products and struc-
tures for investments in commodity markets shot to
prominence during the last five years. Notably, many
of these structures involved positions on both OTC
and exchange-traded markets, and the structure of
these products may help explain the above data in
this light.
Perhaps, the most striking trend was the rise of
commodity indices, the most well-known of which are
market into exchange-traded marketplace? Or, were the SP-GSCI and DJ-UBS indices, composite indices with
the easing of OTC activity and the surging of exchange- differential composition blending a weighted basket
traded activity unrelated phenomena, driven by of long positions in near-month agriculture, metals
different factors and involving different sets of market and energy commodity futures from across various
participants and, in particular, the completely new exchange venues (or do so synthetically through a
financial investors purported? commodity swap arrangement, per discussion below).
We may look to qualitative factors to add inter- These indices replicate a passive long strategy in
pretative weight to the analysis. On the one hand, it commodity futures. However, a key feature in terms
is clear that the popular view among the investment of market impact is the roll yield as the current near-
community has increasingly viewed the commodities month expires or enters delivery period and the indexs
space as ripe for increased asset allocation. In the position must be rolled into the following month. It is
pre-Crisis years, commodities were being touted as also important to note that those organisations that
an emerging asset class4 with characteristics that maintained the indices received hedger exemptions
made it a lucrative bet for all market conditions. from speculative position limits in key jurisdictions,
Investments into agriculture, base metals and energy enabling theoretically limitless accumulation of the
instruments were a proxy bet on the hyper-growth passive long positions that such indices replicate.
emerging economies, a diversified commodity index The earliest of such indices were founded in the
was described as a means to attain portfolio insur- mid-1980s, but the most significant volume devel-
ance5 and providing a hedge against inflation, while opment occurred in the mid-2000s, as demonstrated
gold retained its long-standing safe haven status. in a 2008 staff paper of the US derivatives regulator,
On the other hand, we see that the crisis, particu- the Commodity Futures Trading Commission (CFTC),
larly following Lehmans insolvency, led to a dramati- which quantified index investment by institutional
cally heightened sensitivity to the risk of counterparty investors in excess of US $200 billion by 2008, up
default, driving trade volumes into exchange-traded from $15 billion in 20036.
marketplaces where counterparty risk was virtually A second area of focus in some literature7 has
eliminated through the mechanisms of a central been the rise of commodity return swaps, an OTC
counterparty clearinghouse. This was dramatically instrument in which banks and other sophisticated
illustrated by the smooth winding up of Lehmans financial institutions swapped cashflows with clients
exchange positions compared with the many years and (commercial hedgers or speculative participants
billions of USD spent unwinding its OTC obligations. such as hedge funds), in which the floating leg of the
4 A particularly noteworthy contribution was Gorton and Rouwenhorst (2004) Facts and fantasies about commodity futures (NBER Working
Paper 10595)
5 Ibbotson Associates (2006) Strategic Asset Allocation and Commodities; available:
6 CFTC Staff Report on Commodity Swap Dealers and Index Traders with Commission Recommendations
7 See Berg 2011, per footnote 1

24 Commodity Insights Yearbook 2011

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swap is defined by the price, especially for energy nowadays compiles more extensive statistics and
and metals products. The swap writer usually lays off more disaggregated classifications on the positions
the exposure arising from the swap in the commodity of large traders in its Commitment of Traders (COT)
futures market, thus generating volume in both the and Supplemental reports, the analytics as to what
OTC and the exchange-traded marketplace. While actually causes price movements, as opposed to what
notional outstanding of commodity swaps and other causes a non-directional increase in liquidity, remains
commodity OTC products increased from $5,100 the subject of intensely contested debate.
billion by end-2005 to $8,405 billion for 2008, as For the purposes of this paper, the author points
mentioned above, volumes post-crisis subsequently on index investment to Irwin and Sanders (2010)9,
slumped to $2,525 billion by end-2010. who identify a range of studies that find statistically
A third area of focus has been High Frequency significant conclusions on both sides of the debate
Traders (HFTs), a subject of debate not just with respect as to whether and the extent to which index and other
to commodities but for every asset class in the wake financial investors have impacted commodity prices.
of the so-called flash crash of May 2010 although Irwin and Sanders themselves tend to be sceptical
certain extreme and abnormal market movements about distortionary effects arising from index
have also been observed in the commodities sphere.8 investors. A strong counterblast may be found in two
High-frequency traders use electronic systems that UNCTAD reports of 200910.
send orders and execute trades based on algorithmic
programs, typically exploiting arbitrage opportunities Decoupling: desirability and feasibility
for very high volumes of small profit-making opportu- In a nutshell, if products and instruments such as
nities or investment strategies dependent on being commodity index and swaps investment distort price
ahead of the market with an informational advantage. discovery away from the fundamentals and exacerbate
The literature on HFTs as applied to commodity volatility, then to that extent, their presence may legiti-
markets specifically is more limited than for the other mately be discouraged or controlled to eliminate the
two instruments, likewise the volume or proportion unfavourable impacts.
of overall trade. However, anecdotal evidence shared However, even if it were to be shown that such
with the author suggests that HFT may range between unfavourable impacts existed, the challenge is to
30-40 percent of total volume on some of the leading calibrate a response that eliminates the price distortion
global commodity exchanges, slightly lower than for and volatility exacerbation effects without adversely
equities and financial futures. affecting market liquidity, and without deterring the
participation of arbitrageurs and those speculators
Market impact whose participation brings valuable new information
Studies of the impact of various kinds of financiali- into the markets price formation process.
sation (in commodity markets) on the markets tend to The first challenge arises if regulators pursue
assess two metrics: price volatility and price discovery. selective targeting of particular products or struc-
Specifically within the latter, the subject of correlation
is an important issue. The hypothesis that is often
tested is the level of correlation between commod-
ities and non-commodities, or between different
commodity sectors, as financialisation increases.
This is identified as arising from the fungible nature of
investor inflows that can be deployed and redeployed
across asset classes per the perceived evolving risk-
return characteristics of each.
Space constraints preclude a thorough exami-
nation or assessment of the many analyses and
research papers that have investigated the purported
causal impact of financialisation. Such studies differ
according to the nuances of statistical method, in
particular, the key challenge of differentiating defin-
itive causation from mere correlation. While the CFTC

8 E.g. an 8% fall in 15 seconds, followed by prices bouncing back within minutes, in the natural gas market (see Reuters 2011 )
9 The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results; OECD Working Paper 27
10 See footnote 2 above, as well as The Growing Interdependence Between Financial and Commodity Markets, UNCTAD Discussion Paper
no. 195 /
A PwC & MCX Joint Endeavour 25

012-053_CIYB_2011_Exper's Views.indd 25 1/26/2012 1:40:19 AM


About the Expert given that systems for dematerialising warehouse

receipts to readily tradable electronic instruments are
ADAM GROSS is the founding Director of Strategy
increasingly widespread could be at least equally
a Bourse Africa Limited, a new pan-African commodity
e and multi-asset trading platform promoted by problematic, leading to hoarding and physical market
F Technologies Group and African institutional distortion. There is no doubt this is becoming an
in has a background comprising corporate strategy, increasingly popular strategy and many large investment
in development and commodity exchanges. As a
banks appear to be moving towards holding large-scale
c strategist, Mr. Gross contributed to the devel-
o of global best practices in operations, management, commodity inventories in proprietary facilities.
m and strategic positioning of some of the worlds The third challenge lays in the nature of investment
leading multinational companies
compan across industry sectors. In particular, he assisted with within the Post-Crisis environment. As correlations
the strategic development of the Multi Commodity Exchange of India. As a member of the within and across asset classes have increased
United Nations Secretariat, Mr. Gross featured as a specialist on commodity exchanges
and remained high, and as volatility has risen, the
with the United Nations Conference on Trade and Development (UNCTAD). At UNCTAD,
he worked in various emerging markets to analyse the impacts of commodity exchanges quest for diversification becomes simultaneously
on economic and social development in the context of these markets. Mr. Gross may be more challenging yet more important. Diversification
reached at remains of vital importance to the many public institu-
tions such as governments and public pension funds,
and the wider investing public, who have critical need
tures. For example, attention may focus primarily on to avoid over-exposure to volatile assets such as
squeezing the volume generated by commodity indices stock markets which in mid-2011 have been rising
and indeed proposals have been made, including by and falling as much as 10% in a day. If commodities
the CFTC itself, to remove the hedger exemptions become off-limits, are there viable diversification
provided to the index managers. This would mean that strategies that may be pursued in other assets? (And
such managers become bound by speculative position literature has highlighted, for example, the dangers
limits that apply to many commodity futures contracts of bubbles in other assets such as real estate, which
in leading venues. This may remove the viability of was of course a key contributing factor to the origins
the commodity index altogether, or fragment large of the global financial crisis in the first place.)
benchmark index structures into micro-indices. It may On the other side of the debate, the impact
push volume out of commodity indices into different of 'financialisation' on commodity prices remains
structures altogether, such as OTC commodity return highly contested. Some suggest the price dynamics
swaps, thus reversing the trend documented in witnessed over the last 5 years are more reflective of
the BIS data above that has seen volume growth structural changes in the global economy, especially
in the more transparent and more closely regulated the rise of the 'BRIC' economies, coupled with supply
commodity futures markets and volume shrinkage in constraints that have hindered an effective response.
the OTC market. A trend that is in line with widely In this analysis, the key is to remove bottlenecks to
stated policy goals of key markets such as the EU, the increased production of agricultural products, step
US, Japan and others. up exploration and development activities in the
Should policymakers seek to squeeze financial minerals and energy sectors, while investing in new
participation in OTC swaps, as well as in other clean technologies that reduce the commodity inten-
commodity futures investment strategies siveness of economic growth. However, if,
aside from commodity index investment, as critics contend, 'financialisation'
a second definitional challenge would has been the key trend driving price
arise: whether a clean-cut distinction
can be made on the one hand
between financial investors and
other market participants and, on
$200bn Was the institutional
dynamics - with effects including the
distortion of price discovery and the
exacerbation of volatility - then it is
important to ameliorate prejudicial
the other, between the financial investors' index investment effects on sectors of critical impor-
and the commodity aspects of a
by 2008, up from tance for the global economy and on
$15bn in 2003.
commodity transaction. It may seem the livelihoods of millions, especially
relatively straightforward to classify, for in the developing world. While increasing
example, a fund that buys paper without correlation of commodities with other asset
taking delivery of the asset, as a purely financial classes would over a medium to long term horizon
transaction. However, many commodity trading firms render commodities a less attractive destination
and traditional commodity speculators follow exactly for 'financial' investors - a seemingly natural stabi-
the same strategy. Moreover, such an approach risks liser - that may not be of much comfort to those
encouraging a financial investor to buy and hold the seeing their staple foodstuffs becoming increasingly
physical commodity an increasingly viable option unaffordable.

26 Commodity Insights Yearbook 2011

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A PwC & MCX Joint Endeavour 27

012-053_CIYB_2011_Exper's Views.indd 27 1/26/2012 1:40:23 AM


Recent trends in global commodity

prices and regulatory responses:
Which way now?
By Partha Ray, Professor of Economics, Indian Institute of Management - Calcutta

Of late, commodity prices have

been on a roller-coaster ride,
experiencing steep increases until
the advent of the global financial
crisis and, subsequently, followed
by a nose-diving in 2008. In probing
the possible reasons behind the
phenomenon, this paper traces
the role of various forces such
as growing demand, speculation
and global liquidity, and discusses
the various global regulatory

rom the year 2000 until the advent of
the global financial crisis, commodities
markets had been on a levitating journey.
Various reasons have been put forth for this
consistent upward movement of commodity prices that
lasted close to a decade. Growing physical demand for
commodities; supply shocks such as adverse weather
and geopolitical risks; speculative investments by
financial investors, and globally accommodative
monetary conditions all have been talked about. The
nose-diving of commodity prices in 2008 brought the
key issue of presence of fundamentals versus specu-
lation to the fore once more. This was followed by a
number of regulatory responses across the advanced
countries from Dodd-Frank in the United States to
legislations for central clearing in the European Union
(EU). At the current juncture when commodity prices
are again on the rise, a legitimate question: which way
are commodity prices headed?
What are the constituents of the catchall term
called commodities? Admittedly, commodities are
heterogeneous in nature. While at a broad level of

28 Commodity Insights Yearbook 2011

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aggregation, commodities can be segregated into Chart 1: Long Term Trends in Global Commodity Prices
energy and non-energy, they include items as diverse
(US dollars, 2000=100)
as food and beverages, industrial inputs, crude oil
(petroleum), natural gas, coal and various metals. Often
their demand-supply configurations and pricing trends
are different. What have been the long-term trends in
commodity prices? What has been the recent trajectory
of commodity prices? Have the recent regulatory
actions been steps in the right direction? This essay
seeks to address some of these questions.
For expository convenience, the present essay is
organized as follows. Sections 2 and 3 are devoted
to long-term and recent trends in commodity prices.
Regulatory initiatives are taken up in section 4. Instead Source: Worldbank

of presenting any concluding observations, section 5

is in the nature of crystal ball grazing, and speculates Recent trends
the shape of things to come in commodity markets. What have been the recent trends in commodity
prices? As per recent data from the IMF, global growth,
Long-term trends after experiencing a dip in 2009, registered a fast
As a perspective, it may be useful to start with the recovery in 2010 thanks to the well-coordinated
long-term trends in commodity prices. After an initial rescue packages adopted globally. Admittedly, this
period of lull, commodity prices started rising during growth has been primarily supported by the emerging
the 1970s. This got reflected not only in oil and markets like China, India and Brazil. Interestingly,
energy prices, but also in the prices of non-energy, while the global growth has staged a comeback, the
including food and metals. Nevertheless, despite the spectre of inflation has been visible in some of the
fluctuations over the thirty-year period of 1970-2000, EMEs. In fact, commodity prices have experienced a
volatility in commodity prices was range-bound. very sharp rise during 2010, and if the current trends
Commodity prices shot up from the early 2000s to continue, commodity price inflation could be close to
the beginning of the great recession in 2008 when 30 percent in 2011 (Table 1).
energy prices index fell to 214 in 2009 from 342 in
2008. With the recovery in sight, commodity prices Table 1: Global Growth and Inflation
have started rising since then (Chart 1).
A key feature of international food and energy 2008 2009 2010 2011
price movements is that it is difficult to predict their GDP Growth 2.8 -0.7 5.1 4.0
direction and persistence. In fact, the International Consumer Price Ination 6.0 2.5 3.7 5.0
Monetary Funds forecast performance has indicated Commodity Price (2005=100) 181.9 115.8 148.1 200.8
(27.6) (-30.0) (26.1) (29.2)
that as prices started fluctuating substantially around
2005, the forecasts became more inaccurate and
Note: Figures in brackets are year-on-year percentage changes.
missed the turning points in 2008 and 2009. Interest- Source: International Monetary Fund, World Economic Outlook Database,
ingly, futures markets forecasts do not perform much April 2011.
better than a random walk forecast of commodity
prices (IMF, 2011). The recent increases in commodity prices have
Three major explanations are offered to explain generated heated debate in academia and policy circles
this phenomenal increase in commodity prices since alike. Increasingly it is asked whether speculation
2000s. First, there is an influential thinking that caused unwarranted increases in the cost of energy
increased demand from fast-growing developing and food. There are two opposing views (Tang and
countries BRIC countries, primarily China is playing Xiong, 2010). An influential view sees the whole issue
an important role in high commodity prices (Helbling in terms of supply and demand and rationalizes the
et al, 2008). It is also well documented that these spurt in commodity prices in 2008 in terms of the rapid
countries are accounting for larger shares of annual growth of emerging economies such as China. After all,
oil consumption growth. Second, there is another prices later fell sharply as the demand faded with the
viewpoint that excess liquidity and low interest rates advent of the global recession (Krugman, 2008).
have been contributing to oil price increases (Calvo,
2008). Third, there is yet another explanation that Commodity prices & energy, metal
sees speculation as a key responsible factor behind and food
the upward movement in commodity prices. While commodity prices in general and food and fuel /
A PwC & MCX Joint Endeavour 29

012-053_CIYB_2011_Exper's Views.indd 29 1/26/2012 1:40:25 AM


prices in particular have risen dramatically since 30 percent. With OPECs spare capacity at about 6
2000. Food and fuel prices peaked in 2008 at levels million barrels /day and substantial known reserves,
80 percent and 250 percent above the levels in 2000 the oil market does not appear be affected by resource
(IMF, 2011). Commodity prices have surged since their scarcity. In fact, oil production continues to grow in
lows during the depth of the financial crisis. Since both OPEC and non-OPEC regions.
end-2008, energy prices have more- than doubled, As far as world oil demand is concerned, since
but still remain well below their former peaks (Chart early 2003, China seemed to have surpassed OECD
2). Metals prices are up almost 170 percent while countries. Interestingly, the dramatic fall in OECD oil
agriculture and food prices are 77 and 60 percent demand during 2008Q1 - 2009Q2, recovered quite
higher, respectively (World Bank, 2011). fast and surpassed China in the fourth quarter 2010
(Chart 3). Hence, the China factors alone cannot be
Chart 2: Recent Trends in Commodity Prices (2000=100): held responsible for increased oil demand.
Major Components

Chart 3: World Oil Demand

Source: Worldbank
Source: International Energy Agency; World Bank

Fuel prices
Crude oil prices have recovered from the crash of late Food prices
2008. Apart from the technological advancements, The issue of food and agricultural prices is much
major factors determining the future of energy prices more complex. Food prices have recovered from
include the role of financial investors in fuel markets, their low of 2009 (Chart 4). Low stocks and uncer-
inventory levels and political turmoil in the Middle tainty about stock levels in some parts of the world
East and North Africa region. Besides, going forward contributed to the 2007 - 2008 food price increases.
the energy sector is bound to face environmental Climatic factors have also contributed to the price
challenges that could affect its long-term outlook rises in 2007- 2008 and again in 2010 (G-20,
(Table 2). As far as worlds known oil reserves are 2011). In 2008, a tight market situation for wheat
concerned, OPEC countries account for 72 percent of was aggravated by drought in Australia, an important
the global total. However, OPECs production share of supplier of wheat to world markets. Canada, another
total world liquid fuels is slightly below 40 percent important supplier, also experienced weather related
and its share of crude oil production is little above low yields for several crops. More recently, drought

Table 2: Trends in Energy Price Indices Chart 4: Agricultural and Food Prices
2006 2007 2008 2009 2010
Energy Price Index1 119.2 131.7 184.5 116.5 146.7

Petroleum Price index2 120.5 133.3 181.9 115.8 148.1

Natural Gas Price Index3 115.3 116.9 173.7 109.6 113.3

Coal Price Index4 104.4 137.6 265.9 148.8 206.0

Memo: Petroleum Price 64.3 71.1 97.0 61.8 79.0

(US$ /barrel) 2

Notes: 1. Includes Crude oil (petroleum), Natural Gas, and Coal Price Indices.
2. Simple average of three spot prices: Dated Brent, West Texas Interme ate,
and the Dubai Fateh. Note: Food prices includes Cereal, Vegetable Oils, Meat, Seafood, Sugar,
3. Includes European, Japanese, and American Natural Gas Price Indices. Bananas, and Oranges Price Indices; agricultural raw material price include
4. Includes Australian and South African Coal. Timber, Cotton, Wool, Rubber, and Hides Price Indices.

Source: International Monetary Fund, World Economic Outlook Database, Source: International Monetary Fund, World Economic Outlook Database,
April 2011 April 2011.

30 Commodity Insights Yearbook 2011

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followed by fire in the Russian Federation, fears about lative stabilizing theory of Friedman (1953) suggests
the Australian and Argentinean crops, and several that profitable speculation must involve buying when
downward revisions of US crop forecasts in late 2010 the price is low and selling when the price is high.
and early 2011 have brought soaring prices. Besides, It, thus, predicts that irrational speculators (or noise
the role of increased demand arising from increase traders, who trade based on irrelevant information)
in population and rising living standards in a number will not survive in the marketplace. Such views have,
of emerging market economies like China and India however, been challenged in recent times. Illustra-
cannot be ruled out. Illustratively, for India, it has been tively, it has been shown that noise traders might have
shown that increasing demand for proteins arising as an impact on prices if they hold large share of assets
an inevitable consequence of rising affluence is a regardless of their survival in the long run (Shleifer
major responsible factor behind recent surge in Indian and Summers, 1990).
inflation (Gokarn, 2010). The nature of commodity markets has undergone
Apart from these short-term factors, long-term a transformation since 2000. With the deregulation
factors such as under-investment in agricultural sector of over-the-counter (OTC) derivatives in early 2000s,
and neglect of agriculture in a number of countries there have been enormous inflows of capital into
have been held responsible behind high food and these markets. The rise in crude oil prices and the
agricultural prices. A recent UNCTAD report candidly increased number of financial participants in the oil
observed: futures market over 2000-2008 bears testimony to the
Agricultural production has suffered from chronic ever-rising phenomenon of speculation. Indeed, over
underinvestment for several decades in many areas the last decade, the trade volume of financial instru-
of the world. This is due in part to the low commodity ments linked to oil (and commodities, in general) has
prices of the 1980s and 1990s that discouraged increased sharply on both commodity exchanges and
investment. In addition, agricultural production in many
developing countries was disrupted by government Chart 5: World Metals Consumption
neglect and underinvestment, often in response to
policies imposed by international financial institu-
tions that dismantled State support to the agricultural
sector. Further damage was wrought by the heavily
distorted nature of the international trading system
that required many developing countries to open their
markets, while continuing to allow developed countries
to depress their agricultural prices through massive
subsidies. The outcome of this neglect and underin-
vestment has been a lagging supply response and an
increased vulnerability of production, notably to the
Source: World Metal Statistics.
effects of climate change (UNCTAD, 2011; p. 9)
Table 3: Trends in Metal Price Indices
Metal prices (2005=100)
Growing demand for minerals from China and other 2006 2007 2008 2009 2010 2011
Asian economies has marked the minerals markets Copper 1 183.1 194.0 189.4 140.5 205.0 250.3
for the past decade. In fact, since the days of the Aluminum2 135.4 138.9 135.6 87.8 114.3 130.7
global economic crisis in 2008, China has surpassed Iron Ore3 119.0 130.3 219.0 284.6 521.9 629.2
the OECD countries in terms of worlds leading metal
Tin4 118.5 196.3 250.0 184.2 275.8 368.9
consumer (Chart 5).
Nickel5 163.3 251.3 143.1 99.3 147.6 160.6
Although the crash in commodity prices in late
2008 affected minerals prices, they seem to have Zinc6 236.6 235.4 136.5 120.1 156.5 164.4

recovered and most mineral prices are again above Lead7 132.2 264.7 214.8 176.5 220.5 257.1
long-term averages (Table 3). Uranium9 170.7 355.3 229.8 167.1 164.6 210.4

Speculation versus demand pressure: Notes: 1)Grade A cathode, LME spot price, CIF European ports
Who is the real villain? 2) 99.5% minimum purity, LME spot price, CIF UK ports
3) China import Iron Ore Fines 62% FE spot (CFR Tianjin port)
An important issue that has come to the fore in the 4) Standard grade, LME spot price
5) Melting grade, LME spot price, CIF European ports
context of recent commodity price hikes is the role of 6) High grade 98% pure
speculation/speculators in commodity markets, which 7) LME spot price, CIF European Ports
8) u3o8 restricted price, Nuexco exchange spot
has always been a source of controversy. What does
Source: International Monetary Fund, World Economic Outlook Database,
the theory say in this regard? The traditional specu- April 2011 /
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OTC markets.1 In fact, the market share of financial Chart 7: Correlation Coefficients between
traders has more than doubled, from less than 20 MSCI AC World Index S&P GSCI
percent of all open futures and futures-equivalent
option positions in 2000 to over 40 percent in 2008.2
Furthermore, the total value of various commodity-
related derivative instruments purchased by institu-
tional investors has increased to more than $2 trillion
in mid-2008 from an estimated less than $100 billion
in 2000 (Masters, 2008; Chart 6). Nevertheless, the
spectacular growth of commodity index funds, worth
over $200 billion in 2008, is viewed as a major factor
behind the recent price spike.3
Source: Author's calculation from Bloomberg data.

Chart 6: Gross Market Value of Second, there have been some technical works
Commodity Derivatives to quantify the impact of each of the major factors
behind commodity prices.5 It has been indicated that
while the recent (January 2009 to January 2011)
commodity boom was driven by growing physical
demand for commodities and globally accommodative
monetary conditions, the earlier commodity boom
(January 2007 to June 2008) occurred as substantial
capital flows (from asset markets such as securiti-
zation and stock markets) entered commodity markets
(Table 4) a phenomenon that has been termed as
flight to simplicity (Kawamoto and others, 2011).
Source: Bank for International Settlement.

Notwithstanding such a phenomenal increase in Table 4: Contribution of identified shocks

commodity derivatives, the effects of financialisation to change in global commodity prices (%)
(of commodities) on commodity markets are difficult Source Jan Jan
07-'08 '09-'11
to isolate from price movements. In fact, there is no
1) Physical demand for commodities -17.7 +122.1
consensus on this issue of impact of financialisation on
2) Future demand for commodities and the +3.8 +14.2
the commodity economy (UNCTAD, 2011). There have effect of investors' risk appetite
however been some evidences of this phenomenon in
3) Supply shock in physical commodity markets +106.4 -66.7
recent times, of which two deserve special mention. and investment ows into nancialised
commodity markets
First, empirically, there has been an increase in
4) Monetary policy shock +7.5 +30.4
cross-market linkage, between the commodity market
and the stock market. This is reflected in increasing Total 100.0 100.0

correlation between the returns from the respective

indices, for example, the global equity index (MSCI Source: Kawamoto and others, 2011; p. 12

AC World Index) and the commodity index (S&P

GSCI).4 This could have been caused by the increased Wide volatility in commodity markets evoked
co-movements between commodity markets and regulatory reactions in the US as well as in the EU.
stock markets due to large fluctuations in the global In order to appreciate the future of the commodity
economy during the financial crisis as well as by the economy, it is necessary to delve into some of these
financialisation of commodities (Chart 7). regulatory changes.

1 For instance, the open futures positions held by nancial traders (hedge funds and non-registered participants) grew sharply from about
45,000 contracts in the second half of 2000, to more than half a million futures in 2008.
2 Vansteenkiste (2011) empirically tested the presence of speculation in commodity prices by estimating a markov-switching model with time-
varying transition probabilities over the period January 1992 - April 2011 and found that for the earlier part of the sample (up to 2004) that
fundamentals have been the key driving force behind oil price movements. Thereafter, trend chasing patterns appear to be better in capturing
the developments in oil futures markets.
3 The investors who allocate a portion of their portfolios to investments in the commodities futures market have been termed Index Specu-
lators. It has been pointed out that these investors behave very differently from the traditional speculators that have always existed in this
marketplace (Masters, 20o8).
4 These are correlation over a cumulatively increasing time span, with xed starting point as January 1, 1990. Thus, the point corresponding to
01-03-1990 in the horizontal axis refers to correlation coefcient calculated over January 1, 1990 to March 1, 1990.
5 Kawamoto and others (2011) estimated a vector auto-regression (VAR) model over the period January 2000 through January 2011 to analyze
factors behind changes in global commodity prices. Their VAR model consisted of four variables, viz., world industrial production, global stock
prices, global commodity prices, and the global short-term interest rate.

32 Commodity Insights Yearbook 2011

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Agri-commodities are now

In the US, position limits are already set in certain
markets and position reporting (at least for the larger
positions) has become a common practice. Besides, among the underlyings of financial
because of the Dodd-Frank Wall Street Reform and
Consumer Protection Act, the US Commodity Futures
derivatives, whose use is spreading
and Trading Commission (CFTC) is in the process of uncontrollably. The financialisation of
writing rules to regulate the swaps marketplace. The agricultural markets, even if it does not
Dodd-Frank Act includes many important provisions
and two overarching goals of reform: bringing trans- explain everything, is a contributory
parency to the swaps market and lowering the risks of factor in price volatility and food
this market to the overall economy. The Act introduced
swap trading and clearing requirements; clearing of
insecurity for the most vulnerable.
deals through designated exchanges and facilities;
minimum capital requirements and aggregate position While the crisis had many causes, it is evident that
limits across OTC and exchange-traded derivatives; unregulated derivatives, called swaps, heightened risk
as well as position limits for physical contracts.6 In on Wall Street and played a central role in the nancial
particular, it flagged agricultural swaps as an important crisis. Developed in the 1980s, swaps, along with the
area where newer rules would be framed. regulated futures market, help producers, merchants,
In the EU, new legislation was passed to increase and other companies to lower their risk by locking in
the central clearing of OTC derivatives and ensure the the price of a commodity or an interest rate, currency
robust regulation of central counterparties. Besides, or other nancial index. Over the last thirty years,
the EU conducted a review of market abuse legislation however, the swaps market had remained unregulated
to clarify the notion of inside information in the context and grew in size and complexity that far outstrips the
of commodity markets, to extend the regulation to futures market; it is now seven times the size. Swaps
OTC markets and to introduce the notion of attempt added leverage to the nancial system with more risk
to manipulate market. backed by less capital.7
Interestingly, there is a dominant view that More recently, the G-20 has taken up issues relating
commodities markets performed well during the 2008 to commodity price volatility and started focusing
crisis and the commodity price movements of 2008 on energy and agricultural commodities, Four critical
were simply an accurate reflection of the pricing senti- areas have been highlighted: (a) improved regulation
ments of market participants in accordance with an for commodity financial markets; (b) Increased trans-
irrational but herd-like behaviour on the part of parency for physical commodity markets; (c) better
investors in commodity markets (UNCTAD, 2011). prevention and management of food crises; (d) stronger
An important impact of financialisation of commod- hedging instruments to provide better protection for the
ities markets is the increased interdependence of poorest populations against excessive price volatility.
these markets. This is reflected in the growth of It is pertinent to remind ourselves of what French
commodity index funds. In the given scenario, often President Sarkozy said in his remarks to G-20 Agricul-
there is clamour for regulation of commodity markets. tural Ministers,
Contrarians, however, argue that increased regulation Agricultural commodities are now among the under-
would only result in reducing liquidity in commodity lyings of financial derivatives, whose use is spreading
markets, thereby impairing their price discovery and uncontrollably. The financialisation of agricultural
risk mitigation functions. markets, even if it does not explain everything, is a
How do we see the future of regulation in the contributory factor in price volatility and food insecurity
commodities market? Of course, official views have for the most vulnerable. It opens the door to the manipu-
firmed up against derivatives. Illustratively, CFTC lations (Sarkozy, 2011).
Chairman Gray Gensler, in a recent address, was quite If such views capture the mood of global regulators,
candid in his critique on derivatives as he said: the extent of regulation over the derivatives market in

6 The Dodd-Frank Act reviewed various aspects of derivative markets. These include: (a) comprehensive Regulation of Swap Dealers & Major
Swap Participants (such as, denitions of a Swap Dealer); (b) clearing (such as, Governance & Possible Limits on Ownership & Control); (c)
trading; (d) data (such as, Swap Data Repositories Registration Standards); (e) enforcement, and (f) position limits.
7 Interestingly, imposition of position limits in the U.S has evoked strong reactions from the Futures Industry Association (FIA) of the U.S. Illus-
tratively, Mark D. Young, on behalf of FIA, in his testimony on the August 5, 2009 CFTC Hearing on Price Discovery, Position Limits and Hedge
Exemptions went on say:
Human nature tells us that those who are well-capitalized and looking for commodity market price exposure - as a hedge against expected
ination, for example - would, all other things being equal, choose a market without rigid limits, rather than a market with such limits. No one
is saying this is certain to happen, but enough people are saying this could happen that migration risk should not be relegated to the boy
who cried wolf category (Young, 2009). /
A PwC & MCX Joint Endeavour 33

012-053_CIYB_2011_Exper's Views.indd 33 1/26/2012 1:40:28 AM


the sublime world of undergraduate price theory to the

About the Expert mundane and sleazy world of Bollywood villains hoarding,
DR. PARTHA RAY is currently
D where does the reality lie? Going forward, this question is
PProfessor of Economics at the Indian assuming importance.
Institute of Management, Calcutta.
The story of the post-2008 growth trajectory tells
HHaving worked in the International
MMonetary Fund, Washington DC, and us that the contribution of the emerging markets in
the Reserve Bank of India, Mumbai, general and of China in particular is going to stay. In such
hhe has been involved in applied a scenario, there are elements of truth in the popular
eeconomic research and policy-
mmaking for nearly two decades. picture of archetypal emerging market as a metal or
EEducated in Kolkata, Mumbai and energy guzzler. Consequently, increased demand for
Oxford, Dr Ray has contributed extensively on issues related to commodities from the emerging markets is here to
the financial sector and monetary policy in professional journals
stay. Nevertheless, because of the global financial
and various other publications in India and abroad. Dr. Ray may
be reached at crisis, there has been clamour for increased and more
effective regulation of financial sector. The world of finan-
cialisation of commodities will be no exception to it.
general and commodities derivative market is going to At the same time, faced with the possibility of another
be more pervasive. recession, there could be all-out stimulus measures on
the part of the advanced countries and, consequently,
Which way now? there could be considerable expansion in global liquidity.
Undergraduate price theory teaches us that that price of Thus, regulatory efforts curbing speculative tendencies,
a commodity is determined by its supply and demand, increased demand for commodities from emerging
which is function of a set of fairly standard factors. Never- markets and possibility of excess global liquidity all
theless, in the classic image of any Bollywood movies of are going to interact and determine the shape of things
the 1950s and 1960s, the price of a commodity is often in commodity markets. In the immediate future, the
seen as the outcome of the villains hoarding actions buoyancy of commodity markets will crucially depend on
and selling commodities at a premium and selling in the the durability of global economic recovery and on how the
black market was seen as the ultimate evil act. From Euro-area debt crisis gets resolved in the days to come.

Calvo, G. (2008): Exploding Commodity Prices, Lax Monetary Policy, Krugman, Paul (2008): Fuels on the hill, The New York Times, 27
and Sovereign Wealth Funds, VoxEU, 20 June, available at http://www. June.
Masters, Michael (2008): Testimony before the Committee on
Friedman, M. (1953): The Case for Flexible Exchange Rates, in Essays Homeland Security and Governmental Affairs, US Senate, 20 May.
in Positive Economics, pp. 157-203, Chicago: University of Chicago
Sarkozy, Nicholas (2011): Speech at the Opening of the meeting of G20
Agriculture Ministers on 22 June 2011, available at http://www.g20-g8.
G-20 (2011): Price Volatility in Food and Agricultural Markets: Policy com/g8-g20/g20/english/for-the-press/speeches/nicolas-sarkozy-
Responses, Policy Report including contributions by FAO, IFAD, adresses-a-speech-to-the-g20.1402.html
IMF,OECD, UNCTAD, WFP, the World Bank, the WTO, IFPRI and the UN
Shleifer, A. and L. Summers (1990): The Noise Trader Approach to
HLTF, 2 June 2011, available at
Finance, Journal of Economic Perspectives, Vol. 4(2), pp. 19-33.
Gensler, Gary (2011): Financial Institutions in the New Regulatory
Tang, Ke and Wei Xiong (2010): The Financialisation of Commodities,
Environment: Opportunities, Constraints and Global Challenges,
vox - Research-based policy analysis, available at
Remarks of CFTC Chairman at the Georgetown University Conference,
available at
opagensler-90 Vansteenkiste, Isabel (2011): What Is Driving Oil Futures Prices?:
Fundamentals Versus Speculation, ECB Working Paper, No. 1371.
Gokarn, Subir (2010): The Price of Protein, Inaugural Address at
Special Conference in honour of Dr. Kirit Parikh at IGIDR, Mumbai United Nations Conference of Trade and Development (UNCTAD)
on October 26, 2010, available at (2011): Report of the Global Commodities Forum 2011 -Advanced
Speeches/PDFs/TPRIPR261010.pdf Copy, Geneva: UNCTAD.

Helbling, T., V. Mercer-Blackman, and K. Cheng (2008): Riding a Wave, World Bank (2011): Global Economic Prospects, Washington D.C:
Finance and Development, March, available at World Bank.

International Monetary Fund (2011): World Economic Outlook, Young, Mark D. (2009): Written Testimony of Mark D. Young, Kirkland
September 2011, Washington D.C: & Ellis LLP on behalf of the Futures Industry Association, before the
CFTC Hearing on Price Discovery, Position Limits and Hedge Exemp-
Kawamoto, Takuji, Takeshi Kimura, Kentaro Morishita and Masato Higashi
tions, August 5, 2009 available at
(2011): What Has Caused the Surge in Global Commodity Prices and
Strengthened Cross-Market Linkage?, Bank of Japan Working Paper,
No. 11-E-3, May.

34 Commodity Insights Yearbook 2011

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A PwC & MCX Joint Endeavour 35

012-053_CIYB_2011_Exper's Views.indd 35 1/26/2012 1:40:31 AM


Commodity cycles:
Follow or cause economic cycles
By Robin Roy, Associate Director, and Sanjoy Majumder, Senior Consultant, Financial Services, PwC

Historically, studies have shown that the commodity cycle is positively correlated
to the economic cycle. However, there is no definitive evidence demonstrating that
economic cycles cause commodity cycles or vice-versa. Over the last five years, as
commodity prices have become increasingly correlated to financial assets and more
used for portfolio diversification, the relationship between economic and commodity
cycles has been weakening.

their sovereign debt obligations. This is likely to lead to

a contagion impact worldwide and, in turn, affect asset
prices and commodity markets. Interestingly, in the
midst of these developments, in the current economic
cycle, commodity prices have been significantly higher
than expected. The question that arises is: whether
commodity prices have become immune to economic
cycles and a new world where the linkages between
markets and economic cycles have weakened consid-
erably has emerged. It may be still early to arrive at a
definitive conclusion. However, a look back at history
and analysis of the performance of commodities vis--vis
the real economy can throw some interesting insights.

Reasons for economic and commodity

cycles and their relationship
Economic cycles refer to the cyclicality in an
economy, as exhibited in an economic expansion and
economic contraction and are generally divided into a
recession, trough, expansion, and peak. Studies have
shown that economic cycles are generally of 42-54
months in duration. However, it has been increasingly

difficult to predict economic cycles nowadays with
ommodities have always been an important increasing integration among economies globally and a
cog in economic or business cycles of plethora of external factors impacting the same.
the world economy. The financial crisis of Different reasons can be attributed to the formation
2008 had led to a recession in the global of economic cycles:
economy, prompting governments to announce bailout Supply shocks due to a disturbance in production
packages and policies to help businesses sustain, resulting from factors including natural disasters,
around the globe. While the developed economies climate changes, fluctuations in prices of raw
were significantly impacted by the recession, the material, technological advances, etc;
emerging economies like India and China despite Demand variation resulting from economic
having encountered a slowdown in the real economy (consumption) needs including monetary easing
managed to grow at a much faster rate. At a time and exchange policy;
when the world economy enters the recovery mode, Demand from the private sector, including changes
the fear of double-dip recession lurks on the horizon, in consumer spending and preference of private
as several European economies are unable to service investments.

36 Commodity Insights Yearbook 2011

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Transmission of the economic cycle happens copper and lead follow a 20-year cycle the latest cycle
through international trade and financial markets started in 2001. As demand for base metals increases,
(including commodities), thus impacting the overall producers begin adding capacities to meet the growing
global economy. demand. However, as there is a gestation period in
Studies have shown that the formation of commodity attaining the enhanced capacities, the heightened gap
cycles is positively correlated to the economic cycle and between demand and supply leads to increased prices.
is mainly due to the cyclical demand of commodities In the 2004-2008 cycle, demand for steel was driven by
arising from government expenditure on infrastructure China (Beijing Olympics), in particular, and a shortage in
and capital expenditures of enterprises, thus pushing iron ore and coking coal as mining companies failed to
prices of commodities. However, whether commodity respond to the rise in demand in time. IMF reported that
cycles follow economic cycles or vice-versa has been Chinas share of overall growth in global consumption
always a point of debate. Economic boom has generally of industrial commodities between 2002 and 2005
led to a rise in commodity prices, though there have was massive 51 percent for copper, 48 percent for
been cases where supply shocks due to a particular aluminium, 110 percent for lead, 87 percent for nickel,
commodity, say oil, has led to economic recession (e.g. 54 percent for steel, 86 percent for tin, 113 percent
the US in the 1980s). for zinc, and 30 percent for crude oil. The US Energy
The boom in commodity prices is also a function Information Administration has forecasted a 47 percent
of real interest rates in the economy, which in turn is a increase in global demand from 2003 to 2030, with
major factor in their co-movement. Studies have shown non-OECD Asia (including China and India) accounting
that such co-movements that were more prominent in for 43 percent of that increase.
1970s and 1980s demonstrated a declining trend in Similarly, the downturn in prices of base metals
1990s and again became prominent in the beginning can be explained from contraction of demand, higher
of the current decade. The upward co-movement in supply due to overcapacity formed during Chinas infra-
commodity prices is likely to place commodity import- structure demand in the period of 2004-2008 as well as
dependent countries under considerable inflation withdrawal of investment funds from financial markets
pressure. Commodity producers will try to augment as economies like China, India, Brazil and others
capacities through investing with an increase in real tightened their monetary policies and, thus, reduced
interest rates, leading to increased supply, which in liquidity in the markets
turn will lead to a drop in prices. Comparatively higher Precious Metals: These are naturally occurring rare
returns on bonds (a competitive asset class) could metals of high economic value such as gold and silver.
lead to less speculation, in turn reflected in decreased This category of assets behaves in a very different way
commodity prices. In countries like India and China, than other categories (commodities). Gold prices have
economic activity has been robust despite manifold risen significantly in the last ten years; even the most
increases in commodity prices something that leads bullish forecasts have not been able to anticipate the
to the conclusion that high commodity prices will be the extent of price rise! Other precious metals have followed
trend in the near future. suit. The major reason is that gold is looked upon as
If we take a close look at individual commodity a substitute for cash and, as the world economy is
verticals, we can divide them into some distinct in doldrums, the central banks and investors find it a
categories, helping us analyze the key factors in safe investment haven. The demand for actual gold has
continued hardening of commodity prices, as follows: strengthened over the years due to increased demand
Energy/Oil: While the prices of oil-centric energy from China and India. However, the increases in its
commodities have had a direct impact on the world price have outraced the actual physical demand as
economy (oil supply shocks brought recession in
developed economies like the USA) since 1990s, the Chart 1: Gold Prices
relation between oil prices and the economy at large
seems to be weakening. The reserve to production
ratio has not improved over the years and the cost
of production is increasing with time as exploration
costs rise. This, coupled with the increasing demand
from emerging economies and speculation in financial
markets, led to an upward cycle in oil prices in the last
decade. While there was a considerable decline in
2009, it was still above the long-term average of around
US $20-25.
Base Metals: Studies have shown that base metals
(metals that oxidize or corrode easily) such as iron, Source: /
A PwC & MCX Joint Endeavour 37

012-053_CIYB_2011_Exper's Views.indd 37 2/9/2012 12:03:13 PM


instruments like exchange-traded funds (ETFs) gain in the previous decades. Prior to 2000, co-movement
popularity. In fact, high prices have actually hurt, albeit between commodity prices and the equity and debt
slightly, the real physical demand for gold. This shows markets was hardly evident, even though liquid
the intrinsic difference between precious metals and futures contracts on commodities were traded.
other commodities. The price movement of commodities was much
Agri-commodities: The behaviour of agricultural more dependent on the actual supply and demand.
commodities related to food has been somewhat However, after the equity market crash in 2000, the
different from other sets including metals and energy trend changed as commodities were thought of an
commodities. Food cycles are generally linked to drought effective instrument for reducing portfolio risk through
and flood cycles and the impact of monsoon, especially diversification. The entry of large financial investors
for a country like India. However, markets also look at in commodity markets has been responsible for the
productivity, government policies, demand patterns and financialisation of commodities and that has led
world politics. Studies have shown that the agricultural to increasing correlation of commodity prices with
composite index has always underperformed markets in asset markets such as stocks and bonds. Investors
the last 30 years, though in the past few years the trend putting money on commodity index futures are less
seems to have shifted in favour of agri-commodities. concerned about the actual supply-demand scenario
For example, S&P agricultural index, a composite of all than producers or consumers as they are constantly
agri-commodities, has been underperforming the Dow rebalancing their portfolios based on market expec-
index since 1975. Productivity of agricultural commod- tations. Evidence of this correlation can be seen
ities has not kept pace with the increase in demand as in the aftermath the financial crisis of 2008. The
developing countries like India and China have regis- phenomenon of oil prices peaking at $147 in early
tered unprecedented growth. Besides, in countries like 2008 and then falling back to $48 in 2009 had more
India supply chain issues and speculation in markets to do with a downturn in equity markets rather than
have aggravated the problem. the actual supply-demand conundrum.

Chart 3: OPEC quota and crude oil

Chart 2: Food Prices Index quarterly production.

Source: FAO and PwC analysis Source: nergy Information Administration, USA and study by Jean Lapierre

Commodities are mostly natural resources and, as Impact of commodity prices on

such, are limited. The past decade, or so, has seen an economic variables
unprecedented rise in commodity prices and commod- Commodity price movements have a significant impact
ities relationship with economic cycles have weakened on macroeconomic variables of the economy. The rate
to some extent. Several reasons can be attributed to of change of commodity prices, at an individual or
this. Demand for certain commodities such as oil has aggregate level, is directly linked to importing units,
significantly increased in emerging countries like China domestic consumers and wholesale price levels.
and India. So is the case with metals, as economic Economies like India, which is heavily dependent
activities in these countries have increased enormously, on commodities like oil, will continue to face signif-
the cost of producing commodities has risen manifold icant fluctuations in consumer and wholesale prices
and integration of financial markets has also become depending on the behaviour of global commodity
coherent which can factor in any impending supply/ prices. Apart from the direct impact on prices, indirect
demand shocks impacting commodities. commodity price fluctuations have an impact on unit
manufacturing costs and, perhaps, even on labour
Commodity prices and other costs. The increase in commodity prices may lead to
financial assets higher wages; however it may not be true at all times.
In the last decade, the relationship between the The inflation models that work in the US perform
movement of commodity prices and that of other poorly in Germany or Japan. A study by Perry in 1975
financial assets has dramatically changed vis--vis found that import prices and the GDP deflator affected

38 Commodity Insights Yearbook 2011

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wage behaviour in Germany, but that the prices had no About the Experts
such impact in Japan. Sachs in 1979 confirmed this
ROBIN ROY, Associate Director, Financial Services, PwC.
result. The underlying model explained a far smaller A postgraduate from IIM Kozhikode, Robin Roy is currently
proportion of wage inflation in Germany and Japan AAssociate Director, Financial Services, PwC. His experience
than the US. The possible reason can be that labour eencompasses a broad range of financial services segments
ssuch as banking, asset management and insurance. Mr Roys
markets are different. Long-term contracts do not ccore experience has been in the corporate, SME, consumers
extend from one year to the next; there are no formal aand multi-channel banking models. He has been involved in
cost-of living escalator provisions; and bargaining is a number of banking-related projects, covering strategy and
pprocess improvement areas. Prior to joining PwC, he worked
more centralised in the US (World Institute for Devel- in banks in various capacities for 20 years, the last position
opment Economic Research, WIDER papers WP88). president of retail banking & financial services in a foreign bank
being an executive vice preside
Besides, governments, such as Germany, have a in India. Mr Roy also served as managing director of a financial services company involved
in insurance and other financial products. He has authored several articles in leading
strong voice in determining labour wages. newspapers and magazines in India. Mr Roy may be reached at
Several studies have shown that the change in
commodity prices has a causal relationship with SANJOY MAJUMDER, Senior Consultant, Financial
S Services, PwC. A postgraduate from IIM Calcutta and a
several macro-economic indicators such as GDP, bbachelor in engineering from Jadavpur University, Calcutta,
interest rates and money supply, industrial activity S Sanjoy Majumder is currently Senior Consultant, Financial
and capital expenditures, employment and wages, S Services, PwC. He has more than 11 years of experience with
aaround eight years in the area of financial and risk analytics,
and currency movements. The PwC report World in m market feasibility studies, business process re-engineering
2050 points out that countries that are heavy users aand equity research. In his earlier job, Mr Majumder was
of energy and commodity as inputs may lose out, given le
leading a team of analysts responsible for financial planning,
pprofitability analysis, cost analysis, business research and
the upward pressure on the relative prices of these risk management
management. Prior to tha
that, he was doing equity research in different areas for a
commodities due to rapid growth in China, India and US investment banking firm covering technology, biotech and semiconductor firms. Mr
other emerging countries, while OECD countries have Majumder may be reached at
the potential to gain.
Fluctuations in commodity prices lead to infla-
tionary and deflationary trends in national and inter- to the US dollar. As the US dollar declines, there is
national business cycles. Globally, as the developed a strengthening of commodity prices as investors
nations, yet to recover fully from the recession, have (in forex assets) seek higher yields from alternative
been adopting a wait and watch monetary policy, asset classes such as commodities and vice versa.
demand from China and India has been keeping A study by two Indian economists and a chart thereof
commodity prices on the higher side. As economies far clearly demonstrates this. Oil prices have increased
and wide are becoming increasingly integrated globally, much more in USD terms than in euros, indicating
countries like India are being increasingly impacted by that USD has depreciated vis--vis the euro.
commodity prices. In the past couple of years, India In countries like India, the rupee-dollar equation
has had an average inflation of more than 9 percent measured by the real effective exchange rate (REER)
with food inflation rising to around 17-18 percent, along vis--vis international commodity prices determines
with moderate fuel inflation with the prices having the actual commodity prices. A real effective exchange
jumped more than 40 percent for petrol and around rate (REER) adjusts nominal effective exchange rate
20 percent for diesel in the past year. The strong (measured by inverse of asymptotic trade) by appro-
growth that we have witnessed in the last few years priate foreign price level and deflates by the home
(GDP growth during 2005-2010 was over 8 percent, country price level.
on an average) has led to a substantial increase in
the demand for commodities related to food items and Economic cycles may lead to
energy. Despite this we have not paid enough focus commodity cycles, making prediction
on improving agricultural productivity, which declined important
in this period. The growing linkage between commod- It is extremely difficult to predict economic cycles on
ities and financial markets has led to a speculation the basis of commodity price indicators alone. If there
trend and this also has contributed to inflating prices. is a supply shock arising from international supply
This has, cumulatively, led to inflation, prompting the disturbances or a substantial dip in production of
countrys central bank, the Reserve Bank of India, to commodities, it will impact the global economy leading
adopt a tight monetary policy in order to reduce money to a slowdown and if sustained, even recession. In
supply. However, this has not been much effective, as, conclusion, in the current world economy, the cadence
with demand yet to moderate, supply-side constraints and movement of commodity cycles and economic
have kept prices on the upside. cycles (reflecting the real economy) has been on a
Commodity prices have an impact on currency divergent track in the last 5 years is more becoming
too. The prices are generally negatively correlated co-related to financial markets. /
A PwC & MCX Joint Endeavour 39

012-053_CIYB_2011_Exper's Views.indd 39 2/9/2012 12:03:15 PM


China's pre-eminence
in the global gold market
By Jeffrey M. Christian, Managing Director, CPM Group

China has become the largest producer and consumer of gold in recent
years. It also has become a major producer and user of silver. This is in
line with China's rise to pre-eminence across industrial sectors, and is
the direct consequence of a long-term Chinese government programme
to promote the development of domestic producing and consuming
industries, as well as domestic markets tied into international markets
for these metals.

hina has become the worlds largest gold
mine producer, one of the largest refiners
of gold from scrap, and the largest market
for gold in fabricated products, including
jewellery and the use of gold in electronic compo-
nents. Most of this has occurred within the past
decade, after decades in which the government held
back the Chinese gold market.
As recently as 1996 Chinese mine production of
gold was around 4 million ounces a year. This year,
it will be around 11.8 million ounces. Combined
fabrication and investment demand for gold was 7.6
million ounces in 2000; this year it will be around
21.8 million ounces.
China has become the major producer and
consumer of gold. It may become a major market at
some point in the near future. How Chinese market
participants, exchanges, and government agencies
approach this almost inevitable transition will be
critical to gold market participants around the world.
For example, at present, there is a strong impetus to
making 99.99 per cent pure gold (4-9s) good delivery
standard in Shanghai. This is in contrast to the 99.50
per cent good delivery gold standard in the London
interbank market and the New York Commodities
Exchange. an effective and efficient approach towards working
Importantly, the government has actively with industrial groups and companies to promote and
encouraged developing gold mining, refining, and strengthen domestic markets for gold, in stark contrast
fabricating industries within China. This is part of a to government postures in some other countries.
broader programme to encourage economic devel- While the fruits of these efforts have only truly
opment across industries, to develop domestic emerged over the past decade, government efforts
consumer markets for goods and services, and to to foster such industrial development, including
seek to increase the portion of the Chinese economy moves towards effective regulations, date back to the
based on domestic economic conditions. As part of economic reforms initiated by the Chinese government
this programme, the Chinese government has taken under Deng Xiaoping in the late 1970s. We personally

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worked on a multi-volume report related to gold and by now, this historical fact has been driven home to
silver market reforms, and moves toward a convertible most people around the world.
yuan, in the early 1980s for the Chinese government. In the ultra-long run, the rise of China and India
The government organisation we worked with at that as major world economic agents over the past two
time pointed out that the government envisioned such decades and into the future represents a return to
moves to be spread over three or more decades. It historically typical patterns. Europe and North America
has been interesting to see how the reforms initiated grew rapidly from the 1830s onwards, as the effects
in the early part of this century were closely in line of the Industrial Revolution took hold. China and India
with those under discussion a full two decades earlier. opted out of the industrialisation process for most of
The contrast between such an effectively run and the ensuing 170 years, but now they have embraced
managed market economy and the political disarray the concept that economic development, industriali-
that has turned the European and US governments sation, urbanisation, the conversion of agrarian farming
into fiscal nightmares cannot be ignored as a lesson patterns into more mechanised and efficient agricul-
that has gone unlearned in other parts of the world. tural operations, and other trends all have tremendous
Growing in economic clout social, economic, and other benefits for most members
Indeed, the emergence of China as a major gold of society. This is a long-term process that can suffer
market is part of a much larger economic trend. The setbacks and reversions, sometimes lasting decades.
country is becoming a much more important part of It is unlikely to be reversed, however, except in the
the world economy, in every aspect from manufac- direst global economic and political scenarios.

Mine production
Chinese gold mining has undergone a dramatic trans-
formation in the last 50 years, rising from
around 250,000 ounces a year between
1950 and 1959 to around 2.0 million
ounces by 1984 and then to around Chinas gold
5.0 million ounces a year by the mining expansion
late 1990s. The growth in Chinese has been facilitated by
production accelerated after that, stepped-up exploration
as the quickened pace of economic of its geological
reforms in the country took hold. By resources.
2007 China was producing 8.7 million
ounces a year, replacing South Africa as
the worlds largest gold producing country.
Chinas gold production is estimated to be 10.9
million ounces in 2010, and is forecast at 11.8 million
ounces in 2011.
New primary gold mines are starting up, while
existing mines continue expanding. In the early
1990s, the Chinese government de-centralised
control over production. Recognising the restraints on
technology and capital within the country, the Chinese
government opened gold exploration and development
to foreign companies in 1994. Increases in the flow
of private capital, relatively low-cost skilled labour, and
technological advances enabled Chinese gold mine
turing to consumption of raw materials, consumer production to grow at a compounded annual growth
goods, and services. rate of 8.5 per cent from 1990 through 2007.
Table 1 shows the relative contributions of the Chinas gold mining expansion has been facili-
top 10 economies to global economic output in three tated by stepped-up exploration of its geological
periods: 2009, projected 2030, and historical 1820. resources. China had a total of 200.6 million ounces
The revelation that in 1820 China accounted for of gold in recoverable resources by 2009, according
32.9 per cent of global economic output, and China to Ministry of Industry and Information Technology
and India combined shared a half of world economic figures. Expectations are that reserves and resources
activity might have surprised many European and are many times the proven levels, given that much
North American audiences just a few years ago. But of the country has not been systematically explored /
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demand that year. Fabrication demand is forecast to

rise further to 14.3 million ounces in 2011.
As in many parts of Asia, in China gold jewellery
is both a luxury good used for adornment and a
form of gold investment and savings. While jewellery
has been an important part of Chinas gold market
for centuries, it was limited for a few decades from
1949 into the 1980s by efforts by the Communist
government to discourage gold jewellery investment
as well as personal consumption of non-essential
goods. Chinas gold jewellery market began to take
off in the late 1980s, when the central government
started allowing greater amounts of private sector
gold to be allocated to jewellery manufacturing.
Chinese gold jewellery consumption remained firm
while globally gold jewellery demand was declining
during the global financial crisis in 2008 and 2009.
Chinese net exports of gold-containing jewellery and
jewellery pieces, in gross weight, declined by 10.4
per cent in 2008 and 26.3 per cent to 3.4 million
ounces in 2009. Due to robust sales of jewellery in
domestic cities, Chinese gold jewellery fabrication
demand managed to grow 8.0 per cent in 2008 and
6.3 per cent in 2009 despite the declines in exports
of gold jewellery.
for gold and other resources and, even at known and In 2010, consumption of gold jewellery in China
operating deposits, the practice is not necessarily to is estimated to have risen by 9.2 per cent year-on-
drill and prove reserves and resources as western year to 12.2 million ounces. Gold jewellery demand is
mining companies tend to do. forecast to reach 13.3 million ounces in 2011, up 8.9
per cent from 2010 levels.
Secondary supply Use of gold in electronics grew at a compounded
Gold jewellery is the largest source of scrap gold in annual growth rate of 9.2 per cent from 3,30,922
China, as it is worldwide. Demand for gold jewellery ounces in 2000 to 730,475 ounces in 2007, and now
rose in the 1980s and early 1990s, when Chinas roughly one million ounces a year is used in these
economy started taking off and at a time when financial products. Gold also is used in dental alloys in China.
markets and banks were viewed with greater suspicion Alloys based on nickel, cobalt, and other base metals
by investors than they are today. As the possession of were commonly used in the past, but dental and
gold jewellery became more prevalent in urban China, medical use of gold is now rising in China. Perhaps
the business of recovering gold from scrap jewellery 71,430 ounces of gold will be used in dental and
boomed. There are no official statistics on scrap gold medical applications in China in 2011.
recovery in China. CPM Group estimates that Chinese
secondary gold recovery is currently happening at Investment demand
around 3.1-3.3 million ounces a year. There is strong demand within China for physical gold
in the form of bars, coins, and medals. A large number
Fabrication demand of Chinese investors prefer physical gold to paper
China also has become the worlds largest consumer investments because of its tan-gibility and ease of
of gold, surpassing India in recent years. Chinas trading. Over the past four years, Chinese investment
demand for gold in both jewellery and investment demand has grown at a compounded annual growth
categories has been growing rapidly in recent years. rate of 68.2 per cent, reaching 5.6 million ounces
Its annual gold consumption rose from 2001 to 2010 in 2010. In 2011, Chinese investment demand is
at a compounded annual growth rate of 7.5 per cent. forecast to increase by 34.7 per cent to 7.5 million
Chinas gold fabrication demand comes from jewellery ounces, fuelled by continued investor interest for gold
(the most, in line with the rest of the world), electronics, amid high inflation.
and dental and medical sectors. It is estimated that Chinese citizens have always been active gold
fabrication demand in 2010 stood at 13.1 million investors, even when gold ownership was officially
ounces, around 17.3 per cent of global gold fabrication discouraged, from 1949 to 2000. There was a very

42 Commodity Insights Yearbook 2011

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active informal market for gold within China during About the Expert
those years, which exists even today. In the early
JJEFFREY M. CHRISTIAN, Managing Director and
1990s, in advance of a large official devaluation of the F
Founder of CPM Group, has been a prominent analyst and
yuan, there was a massive wave of gold investment aadvisor on precious metals and commodities since the
demand within China, which in fact may have involved 1970s. In 1986, after six years with Goldman Sachs and its
ccommodities trading arm J. Aron & Company, Mr. Christian
larger volumes of gold being bought in both bar and
founded CPM Group through a management buyout of
jewellery form than the high volumes of gold demand what was the Commodities Research Group at Goldman
over the past few years. Sachs then. CPM Group provides research, consulting,
investment banking, asset management, and commodity
management services to corporations, governments, and
Information institutional and individuals with exposure to precious and base metals, agricultural,
While China has been an important part of the global and energy commodities. He has advised the World Bank, the United Nations, the
gold market for many years, the data on gold secondary International Monetary Fund, and numerous governments. Mr. Christian may be reached
supply and demand trends within China have lagged
the growth of the market. Gold is a secretive market
around the world, and the ability to gather credible data
on gold demand and scrap refining within China was at this time. The Chinese refiners wanted the base
hampered until recent years by government actions. metals, and exported the by-product silver and gold
As a result, statistics regarding gold scrap recovery after it was recovered from the concentrates.
and demand have been particularly unreliable in the In the past five years, these usage patterns
western market. Based on CPM Groups involvement shifted again and there were strong increases in silver
as advisors to Chinese agencies, it was clear that the demand from other industries. As a result, China has
available guesses in the market on demand trends become a net importer of refined silver once more,
within China were not accurate. CPM Group has now since 2006. Annual net imports have risen to around
been able to integrate Chinese gold market supply 100 million ounces in 2010, a trend that is unlikely
and demand statistics into its model of the global to reverse in the near future. This shift to net imports
gold market, by developing fabrication and investment comes at a time of increased mine and refined output.
demand estimates for the Chinese market for the It does not reflect a decline in domestic production.
past 10 years.
Not just China, actually
Not just gold? Finally, it is not just China that is enjoying an economic
As alluded to above, it is not just gold in which China renaissance and, consequently, witnessing its demand
has moved to a pre-eminent position over the past for gold, silver, and other commodities increasing. As
decade. With the unleashing of its domestic economy, I wrote in my 2006 book, Commodities Rising, there
the country has become the largest, or one of the are billions of people elsewhere who have been let
largest, producer and consumer of many goods. out of their economic cages and have been freed
China also is excelling in silver supply and demand. to become investors and consumers, consequently
It is the third largest silver producing nation, having boosting demand for these metals, over the past two
increased silver production from around 2 million decades.
ounces a year in the early 1980s to more than 104 India has participated strongly in this trend,
million ounces projected in 2011. Now, its silver use although not as dynamically as has China. Other
is one of the largest, if not the largest. It is projected countries, from Brazil and Argentina to Russia to
that China will use around 177 million ounces of silver countries in central and eastern Europe, also are
in fabricated products and buy another 15 million experiencing strong growth.
ounces in investment products in 2011. The differences between the growth rates of China
China was a net exporter of silver for most of the and those of other countries reflect a number of
period from 1949 to the 1990s. It became a small net factors including one important factor mentioned at
importer for a time in the late 1990s, before resuming the start of this essay. The Chinese government has
as a large net exporter from 2001 through 2006. At been executing a very effective industrial programme
that time there were significant shifts in silver use to develop the gold and silver mining, and gold and
in photography in China, which led to a reduction silver using industries in China, while governments of
in domestic silver use in that industry. As a result, other countries have been less effective in promoting
large amounts of silver were not purchased for use in the growth of these very profitable industries within
film and paper any longer and, thus, exports began. their economies.
Additionally, there also was a large increase in silver (This article is derived from a special chapter on
refined from base metals concentrates from both the Chinese gold market in CPM Groups Gold Yearbook
domestic and foreign copper, lead, and zinc mines 2011) /
A PwC & MCX Joint Endeavour 43

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Re-writing the rules of the game:

Evolving contours of
global regulatory regimes
to govern derivatives
By Michael Greenberger, Law School Professor, University of Maryland,
and Michael Vesely, JD, University of Maryland

The US Dodd-Frank Act is intended to reduce the riskiest aspects of

previously unregulated derivatives trading by increasing capital and
transparency requirements and requiring mandatory clearing and
exchange-like trading. Because major non-US regulators have tended to
model their regulatory frameworks after the basic statutory premises of
Dodd-Frank, immediate implementation in the US of robust Dodd-Frank
regulations should likewise facilitate universal regulatory standards,
thereby preventing worldwide systemic risk. Thus, US implementation
should proceed promptly and not await the several years for worldwide

he reverberations of the 2008 economic to foreign jurisdictions. These advocates are thus
shockwave unleashed, in large part, by seeking delays of years in Dodd-Franks implemen-
the wholly unregulated worldwide over-the- tation while awaiting worldwide action.
counter (OTC) derivatives market are still These calls for delay of Dodd-Frank court a repeat
shaking the global economy. The Dodd-Frank Wall of systemic worldwide economic disaster and, ironi-
Street Reform and Consumer Protection Act (Dodd- cally, compromise the potential for unified financial
Frank) is intended to reduce the riskiest aspects regulation among nation-states. If the US share of
of derivatives trading through increased capital derivatives trading (estimated at $300 trillion notional
requirements, transparency, mandatory clearing, and value) remains undercapitalized and opaque for years
exchange-like trading. If properly implemented, Dodd- to come, another economic downturn caused, for
Frank would remove the US portion (about one-half) of example, by the European sovereign debt crisis, could
the worlds $600 trillion notional value market from lead to an economic collapse far worse than the one
being the prime engine of systemic risk. that followed the Lehman Brothers bankruptcy. This
Yet, representatives for the worlds large banking is because countries are running out of remedies and
interests now insist that Congress and US financial money to prevent a repeat of the Great Depression.
regulators have moved too far, too fast in passing and Further, immediate implementation of robust
implementing regulation of derivatives products under Dodd-Frank regulations would facilitate, rather than
Dodd-Frank. jeopardize, universal regulatory standards. Non-US
In order to check this perceived unnecessary regulators have tended to model their own deriva-
expedition these banks and their allies have urged that tives regulation after the basic regulatory premises
US regulatory agencies delay the implementation of underlying Dodd-Frank; this kind of reliance on fully
Dodd-Frank until non-US regulating entities, especially implemented US templates is likely to continue as an
the European Union, are able to act in unison with increasing number of countries develop and implement
the US. Wall Street argues that consistent, interna- financial reform models.
tional regulation will keep traders from fleeing the US Moreover, the extraterritorial effect of Dodd-Frank

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will, in and of itself, tend to establish uniform, global capital to make the insurance payments; taxpayers
standards for derivatives. Dodd-Frank requires deriva- were called upon to make the insurers whole by paying
tives traders who wish to participate in US markets to them trillions of dollars.
develop internal practices that comply with US trading Moreover, the problems associated with deregu-
requirements, even if the financial trader is located in a lated markets were not constrained to naked CDS
foreign country. In this respect, Dodd-Frank functions as alone. When financial institutions were unable to
a cross-jurisdictional regulatory regimeglobal banks meet their CDS obligations, they became exposed to
have to comply with Dodd-Frank requirements if they and defaulted on tens of thousands of other deriva-
wish to operate in US financial marketsso that any tives-based and undercapitalized opaque obligations.
delay in its implementation threatens to fractionalize, These cascading defaults revealed the interconnect-
rather than ensure, the unity of financial regulations. edness of all derivatives instruments and, further,
underpin there must be an effective regulatory regime
The financial world pre-Dodd-Frank Act to address all types of derivatives and not just CDS.
It is hardly disputed that unregulated derivatives were
a primary cause of the 2008 financial crisis. At the Passage of Dodd-Frank
heart of this meltdown were the naked credit default In July 2010, the US Congress passed the Dodd-Frank
swaps (CDS), instruments that exposed market partic- bill, whose preamble pronounces its purpose as:
ipants to unprecedented levels of risk. These instru- To promote the nancial stability of the United
ments essentially provided insurance on subprime States by improving accountability and transparency in
mortgage risk to those who did not even hold the nancial system, to end too big to fail, to protect the
subprime investments, permitting these investors to American taxpayer by ending bailouts, [and] to protect
recover 100 cents of the dollar of the insured risk consumers from abusive nancial services practices.
(defaulting mortgage investments owned by others) Title VII of the Dodd-Frank Act, entitled Wall
by paying premiums as low a onehalf per cent of Street Transparency and Accountability, is designed
the amount insured. The insurers did not have the to regulate the derivatives market. It generally /
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imposes clearing, reporting, and trading requirements reach an end-2012 goal for implementing reforms, but
in that previously unregulated market. This title is still urged substantial concrete steps.
constructed around a philosophical framework that Going forward, the FSB will continue to highlight
requires: adequate capitalisation by large derivatives areas where differences in approaches may foster
dealers and end-users, clearing for almost all transac- or facilitate opportunities for regulatory arbitrage.
tions, collateralisation, and transparency. Although the FSBs commitment to financial reform
is encouraging, the delays in establishing worldwide
Moving forward with Dodd-Frank financial regulations mean that implementation is a
Despite the threat of underfunding the relevant long way off. Given that the US market constitutes
regulatory agencies and delays in those agencies half the worlds $600 trillion derivatives market, any
implementing Dodd-Frank, the statute has already delay in US financial reform leaves the global economy
increased the power of regulators over the market and vulnerable to the demonstrated risks associated
is already helping prevent systemic economic failures. with opaque and under-capitalized trading practices.
Major market participants have already begun altering Instead, the US should continue to develop the
their operations in order to prepare for the upcoming necessary regulations as quickly as is feasible and
proposed requirements. For example, many Wall rely on Dodd-Franks sweeping extraterritorial scope to
Street firms are already establishing frameworks that establish international standards to prevent a repeat
will allow them to comply with clearing and exchange- of the systemic economic deterioration of 2008.
trading mandates. Again, Dodd-Frank establishes international
standards for the regulation of derivative transactions.
Global coordination under G20 Section 722(d) of the Act states that the statute applies
The nations at the Pittsburgh G-20 summit of to swaps that either have a direct and significant
September 2009 agreed that all standardized OTC connection with activities in, or effect on, commerce
derivative contracts should be traded on exchanges of the United States or contravene such Dodd-Frank
or electronic trading platforms and cleared through regulations that prevent evasion of the statutes provi-
central counterparties by end-2012. In April 2011, sions. Therefore, Dodd-Frank should require non-US
the Financial Stability Board (FSB) issued a report banks that transact swaps with US counterparties to
indicating that some jurisdictions may not be able to abide by Dodd-Franks regulatory requirements.

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Moreover, non-US traders whose derivative regimes of the US and Europe, it is extremely unlikely
activities significantly impact US commerce are also that these regions will adopt regulations that are
subject to Dodd-Frank regulations. Thus, swaps significantly different from one another.
transactions by global financial entities on foreign
exchanges would appear to be subject to Dodd-Frank Derivatives regulation in Asia
regulation if they have a direct and significant effect There are no proposals for pan-regional regulation of
on US commerce. Delaying Dodd-Frank will delay its derivatives in Asia. Regulation will likely proceed on a
substantial extraterritorial and unifying effect. country-by-country basis.
In Japan, the Financial Instruments and Exchange
Regulatory overhaul in the EU Act is the primary legislation responsible for regulating
Following the G-20 Pittsburgh mandate, on September derivatives. The recent amendments to this act also
15, 2010, the European Commission issued the contain provisions similar to those contained in Dodd-
European Market Infrastructure Regulation (EMIR), Frank, including requirements of transparency, exchange-
a proposal for regulation of OTC derivatives that is based clearing, and capital adequacy. Japanese
similar to Dodd-Frank. EMIR requires that derivatives regulators appear largely receptive to Dodd-Frank and
trades be reported to trade repositories, which will are following a similar timeline to the EU regarding the
be required to publish aggregate positions and share implementation of these new regulatory requirements.
this data with regulators. EMIR also requires that In India, an amendment to the Forward Contracts
all standardised derivatives transactions be cleared Regulation Act (FCRA), 1952, which is expected
through central counterparties (CCPs). As the holders to be passed in the next session of Parliament ,
of substantial risk, CCPs would be subject to strict will strengthen regulation greatly by extending the
regulation. As is true of Dodd-Frank, EMIR exempts authority and autonomy of the commodities market
non-financial users hedging commercial risk from regulator Forward Markets Commission (FMC).
the clearing requirements, but unlike Dodd- The amendment will allow introduction of an
Frank, this exemption only applies if the
Dodd- array of new products and facilitate entry
Frank is the
entitys trades fall below a certain right mechanism of large institutional participants such
threshold. to regulate derivatives as mutual funds, banks and foreign
The EU Commission is currently properly; it is already being institutional investors (FIIs) into the
intending a vote on a final draft followed in numerous parts commodities market. This is very
soon. A number of important of the world and implemen- crucial to the next-level growth of the
issues still need to be resolved, tation will only bring these commodities market as a bouquet
nancial instruments
most importantly whether the new of new products and new big-ticket
further under
reforms should cover just OTC deriva- control. participants are going to infuse much
tives or all derivatives. The European needed liquidity into the system.
Central Bank and many large industrial Alarmed at the effect of speculation on
companies are concerned that the new regulations price volatility and the contributions of derivatives to
could damage bank liquidity, and continue to push the 2008 financial crisis, Chinese regulators remain
for exemptions from clearing requirements, similar to extremely cautious about the process of opening up
those granted under Dodd-Frank. Until a consensus their commodity exchanges to foreign investment.
can be reached on the proposed rules, they cannot Therefore, it is fair to expect that China will be more
be negotiated in the European Parliament. However, conservative in regulatory policy than the US under
it now appears that the EU will ultimately fashion a Dodd-Frank. Further, China certainly does not appear to
regime very similar to Dodd-Frank. be a jurisdiction to which derivatives traders will flock
The Markets in Financial Instruments Directive to escape the early implementation of Dodd-Frank.
(MiFID) constitutes another EU attempt at financial
regulation. The MiFID is a non-binding directive that Conclusion
dictates the regulation of all financial instruments The misuse of derivatives was one of the primary causes
within the EU. A key aspect of MiFID is its incorpo- of the 2008 economic collapse. Fortunately, Dodd-Frank
ration of Dodd-Frank style reporting obligations, trans- is a regulatory framework that will prevent similar future
parency, and exchange-like trading. calamities. The Acts extraterritorial impact will require
Many market observers and participants are foreign traders with US customers to alter their behaviour
concerned that a lack of coordination between so that it is consistent with the statutes mandates.
regulation in the EU and the US may lead to increased European regulators have already used much of Dodd-
costs and loopholes that could be exploited in order Frank as a model to regulate their own markets, thereby
to avoid the intent of regulations. However, because suggesting prudence in large banks, worldwide, adopting
of the general similarities between the regulatory Dodd-Frank principles in advance of EU regulations. /
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Because regulators in Asia are moving indepen-

About the Experts dently and without a pan-regional structure, the US
should not wait for Asia to implement regulatory
te Futures, Options and Derivatives at the University reform. Moreover, key countries in Asia, including
o Maryland School of Law, has served as Technical Advisor India and China, will, when they open their markets to
to the United Nations Commission of Experts of the President generic derivative trading, likely provide a regulatory
o the UN General Assembly on Reforms of the International
regime that is much tougher than Dodd-Frank.
M and Financial System; and as a member of the
In Energy Forums Independent Expert Group In addition, arguments that increased Dodd-
p recommendations to the IEFs 12th Ministerial Frank regulation will cause investors to move funds
M 2010 Meeting. He became Director-Trading and to less heavily regulated markets ring hollow. Many
M at the Commodity Futures Trading Commission
(CFTC) in 1997 and served through 1999. He also served on the Steering Committee of
major trading venues give every indication that they
the Presidents Working Group on Financial Markets and as a member of the International will follow Dodd-Frank. Other important venues do not
Organization of Securities Commissions Hedge Fund Task Force. Professor Greenberger allow derivatives trading at present. Many smaller
was asked to testify before House and Senate oversight committees on the effective countries that may continue unregulated markets have
implementation of Dodd-Frank and present at three different roundtables sponsored
by CFTC and SEC staffs. He filed over 20 comment letters on proposals by regulators little liquidity or otherwise expose traders to extensive
implementing Dodd-Frank. He has also authored several chapters and scholarly articles risk from trading malpractices. Dodd-Frank is the
about Dodd-Frank. Professor Greenberger may be reached at mgreenberger@law. right mechanism to regulate derivatives properly; it is
already being followed in numerous parts of the world
and implementation will only bring these financial
MICHAEL VESELY joined the Center for Health and
H Security as a staff attorney in February 2007. instruments further under control. Moreover, while
S then he has written extensively on derivatives and complaining about Dodd-Frank large banks seem with
o financial instruments. This work has included preparing less fanfare to be adopting it, knowing that universal
te before numerous committees in both the United
S Senate and House of Representatives. Mr Vesely has
adoption is inevitable.
a worked on economic security issues for both the State (The authors would like to thank Jung Lee, J.D.,
D and the Department of Homeland Security. Mr George Waddington, J.D., Trudy Henson, J.D., Anthony
V may be reached at
Villa, J.D., and Joshua Prada for their invaluable contri-
butions to this article.)

Jeremy Grant, Brooke Masters & Nikki Tait, European Groups Fear OTC
STREET REFORM AND CONSUMER PROTECTION ACT: TITLE 7, DERIVA- Derivatives Plan, FINANCIAL TIMES, July 14, 2011, available at http://
TIVES, 2 (Congressional Research Service August 30, 2010), available
at html#axzz1SlUtNRGW.
Financial Stability Board, OTC DERIVATIVES MARKET REFORMS: 10
European Commission, Public Consultation: Review of the Markets
PROGRESS REPORT ON IMPLEMENTATION, April 15, 2011, 1-7, in Financial Instruments Directive (MiFID), Directorate General Internal
available at Market and Services, December 8, 2010, available at http://ec.europa.
r_110415b.pdf. eu/internal_market/consultations/docs/2010/mifid/consultation_
Financial Lobbies Warn on Inconsistent Derivatives Rules, REUTERS,
July 6, 2011, available at
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L.
5 derivatives-trading-idUSL6E7I61NE20110706.
No. 111-203, 722(d)(i)(1), 124 Stat. 1376 (2010). 12
Rachel Armstrong, Asias Derivative Reforms Set to Heap Pain on
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L.
6 Banks, REUTERS, April 18, 2011, available at
No. 111-203, 722(d)(i)(1), 124 Stat. 1376 (2010). article/2011/04/18/idINIndia-56405320110418.
European Commission, Making Derivatives Markets in Europe Safer and 13
Financial Services Agency, Government of Japan, New Regulation of
More Transparent, IP/10/1125, Brussels, September 15, 2010, available OTC Derivatives in Japan, October 2010, available at http://www.cftc.
at gov/ucm/groups/public/@aboutcftc/documents/file/gmac_100510_
5&format=HTML&aged=0&language=EN&guiLanguage=en. fsag.pdf; CFTC, Derivatives Reform: Comparison of Title VII of the Dodd-
Frank Act to International Legislation, October 5, 2010, available at http://
Nicki Tait, Brussels Delays Decision on OTC Rules, FINANCIAL
TIMES, July 4, 2011, available at
2F0%2F9504c274-a656-11e0-ae9c-00144feabdc0.html&_i_ George Mathew, Optimistic About Parliament Passing FCRA

referer=#axzz1REbE4Cqc and Matt Cameron, Deconstructing EMIR, Amendment Bill in Next Session, Indian Express, June 27, 2011,
RISK MAGAZINE, July 1, 2011, available at available at
magazine/interview/2080962/deconstructing-emir. parliament-passing-fcra-amendment-bill-in-next-session/809040/2.

48 Commodity Insights Yearbook 2011

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A PwC & MCX Joint Endeavour 49

012-053_CIYB_2011_Exper's Views.indd 49 1/26/2012 1:40:52 AM


Market as a "bail-out" institution:

Commodity exchanges in
liberalised trade regime
By Nilanjan Ghosh, Head Research & Strategy, MCX

It is time one appreciated that use of commodity derivatives is particularly necessary

in an increasingly liberalised environment, and the market itself, rather than the
government exchequer, can act as a more sustainable bail-out institution against its
own vagaries. In a broader perspective, it is important to realise that the commodity
derivatives market, besides facilitating price discovery and price risk management,
plays a much larger role against the socio-institutional backdrop of a liberalised
economic regime. Therefore, it is necessary to nurture institutions like commodity
exchanges so as to enable them to play such a transformational role effectively.

robably no other economic institution has traded in international and domestic markets have
exerted a wide-ranging influence on human been subject to violent price fluctuations, exposing
society like markets. Despite immense commodity-dependent, developing countries to
contribution in every aspect of human extreme uncertainties and economic instabilities.
endeavour, markets have received their share of Such price risks are inherent in market forces.
censure, apart from appreciation. For some markets While affecting various stakeholders in the interna-
have proved bountiful, while for others they turned tional commodity ecosystem including governments,
out to be ruthless! While they have showered wealth producers, processors, traders, financial institu-
on many, their vigorous volatility has pauperised tions, and so on, at a macro-level, the precarious
countless people. This is true for all sorts of markets, movements of commodity prices enfeeble economic
including international markets for commodities. growth, skew purchasing power, and result in lop-sided
As is commonly known, agricultural commodities development. Consumers, the last link in the value

50 Commodity Insights Yearbook 2011

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chain, are hit severely by the uncertainty that affects particularly of agricultural commodities, is that only a
household budget planning keep aside the problems limited number of exporting countries dominate inter-
of price rise due to supply-side problems. national trade4 [Pal and Wadhwa (2007)]. Even for a
This has prompted governments, worldwide, to widely produced crop such as rice, the share of the
manage commodity price risks. Governments and top five exporters is more than 76 percent and for
central banks have come up with multi-dimensional all cereals, the share is almost 75 percent5 [Pal and
responses. On the one hand, central banks and Wadhwa (2007)]. This lop-sided trading pattern, which
treasuries have attempted to tackle fluctuating applies to most primary commodities, does not allow
foreign exchange needs and changing fiscal condi- any supply shocks in major exporting countries to be
tions1. Another set of policies deals with government absorbed by the market system. Hence, supply shocks
intervention in commodity markets in order to protect in these countries can have a very high impact on
consumers, producers, processors, traders, etc. aggregate supply and, hence, on international prices.
These attempts, being involved with government funds Apart from international trade dynamics, prices of
and governmental intercessions, have mostly been many commodities reveal a high degree of volatility
classified as Keynesian in nature. The schemes, caused by time lags between production decisions and
so far, include buffer stocks, buffer funds, commodity market delivery, delayed and inappropriate responses
agreements, or government intervention in by producers to price signals, and inelastic
commodity markets. Internationally, there supply and natural shocks. As suggested
is little evidence of success of such High price by Gilbert6 (1999), commodity price
schemes. Buffer funds have gone volatility is caused cycles are characterised by flat
bankrupt, as evidenced in Australia by time lags between bottoms punctuated by occasional
and Papua New Guinea. Buffer production decisions sharp peaks, i.e. periods of low
and market delivery,
stocks have not proven effective, as prices endure longer than price
producers' delayed and
can be seen by the large accumu- inapt responses to price spikes.
lations under the US and EU farm signals, and inelastic Even in the context of domestic
programmes in the late 1980s. Inter- supply and natural trade in India, there are inherent risks
national commodity agreements have shocks. in production management. These risks
lapsed, as in the cases of coffee, cocoa, are endogenous to the market system,
tin, and sugar. And government intervention has and should be attributed to oversupply, lower
been costly, with unintended consequences, thereby demand, and change in technology. For many crops
placing unnecessary pressure on the government for example, coffee, rubber, tea, and tobacco, the
exchequer2 [World Bank (1999)]. growers did not know when to stop, shift, and diversify
On the other hand, proponents of market forces as the information and analyses mechanisms were
have traditionally advocated commodity derivatives not perfect7 [Raipuria (2003)]. The problem of infor-
markets to have helped traders and manufacturers mation asymmetry is rampant in Indian agricultural
in coping with price risks arising from unknown future marketing, as stated by Ghosh8 (2008).
changes in commodity prices3 [see Venkataraman There are two types of commodity price fluctua-
(1965), Pavaskar (1975 and 2004)]. tions, according to Cashin and Pattillo9 (2000). These
are short-term (under four years for half the shocks
The market dynamics effects to dissipate) and long-term (where there are
The traditional high volatility of international permanent effects). This distinction is important for
commodity prices can be attributed to a number of informing policy responses: short-term shocks should
demand- and supply-side factors. From the supply be dealt with by saving or borrowing, whether by the
side, a distinguishing feature of international trade, private or the public sector, or through market-based

1 World Bank, Using Markets to deal with Commodity Price Volatility, PREM Notes, World Bank, Washington D.C., 1999.
2 World Bank 1999, op. cit.
3 L.S. Venkataraman, The Theory of Futures Trading, Asia Publishing House, Bombay, 1965.
Madhoo Pavaskar, Economics of Hedging, Popular Prakashan, Mumbai, 1975.
Madhoo Pavaskar, Commodity Exchanges Are Not Stock Exchanges, Economic and Political Weekly, 39 (48), 2004, pp. 508285.
4 P. Pal and D. Wadhwa, Commodity Price Volatility and Special Safeguard Mechanisms, Economic and Political Weekly, 42 (5), 2007, pp.
5 Ibid.
6 Ibid, p. 419.
7 C. Gilbert, Commodity Risk Management for Developing Countries, Paper prepared for the Third Meeting of the International Task Force (ITF)
Meeting held in Geneva, June 2324, 1999.
8 K. Raipuria, Price Stability and Futures: Need for a Macro-development Framework, Economic and Political Weekly, 38 (51), 2003, pp. 5330.
9 N. Ghosh, Price Discovery in Commodity Markets: Floated Myths, Flouted Realities, Commodity Vision, 1 (3), 2008, pp. 33- 38,. /
A PwC & MCX Joint Endeavour 51

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Agri-commodities are
now among the underlyings
of financial derivatives,
whose use is spreading
uncontrollably. The
financialisation of agricultural
markets, even if it does
not explain everything, is a
contributory factor in price
volatility and food

risk management mechanisms, such as insurance. efficient and viable for risk management and price
Long-term shocks require permanent changes in the discovery is the use of derivatives/futures if there
economy10 [Page and Hewitt (2001)]. is wide stakeholders participation. The use of such
The big challenge of price volatility and the an instrument is particularly and even more
capacity to cope with it poses major policy concerns. necessary in an increasingly liberalised environment.
Such uncertainties and risks posed by fluctuating Derivatives (futures) markets can complement
prices can threaten the performance of the commodity and even substitute traditional policy instruments
sector through reduction in investments and export generally used to cope with price volatility13 [World
earnings, and greater dependence on imports. While Bank and UNCTAD (1996)].
Pal and Wadhwa11 (2007) keep on arguing in favour of The two major functions of a derivatives/futures
special safeguard mechanisms (SSMs) in agriculture market are price discovery and price risk management
under WTO, the above arguments against subsidisa- (hedging). The notion of hedging or price risk management
tions clearly indicate that SSM regimes are in no way is well explained in textbooks of finance and economics.
sustainable and can at best provide temporary relief. To hedge or manage his/her price risk, a participant
With agriculture becoming liberalised over time, one takes an equal and opposite position in a derivatives or
has to face the vagaries of the market mechanism. futures market vis--vis his/her spot (physical) market
Yet, one has to understand that an insulated system exposure (position). That is, if the hedger has taken a
cannot do any good to the agriculture of emerging short position in the physical market, he/she should
economies. It harnesses inefficiency, sends out wrong take a long position of the same size in the futures
price signals at wrong times, and reduces growth and market to hedge against the price risk.
competitiveness of the agricultural sector. Thus, the prices discovered through such a
markets price discovery mechanism reflect infor-
Commodity derivatives market: A "bail- mation about the market. In the process, the price
out" institution level established in the open market can represent
No doubt, of the various types of risks that an accurate depiction of the market conditions of a
loom large over the agricultural sector, price risk of specific commodity, which include the role of private
liberalised agriculture is the prime. Today, academi- players, government policies, etc.
cians and policymakers emphasise the distinction Ideally, commodity derivatives/futures exchanges
between programmes that attempt to alter the distri- facilitate integration futures and cash prices,
bution of prices domestically or internationally, thereby leading to overall efficient price formation.
and programmes that deal with uncertainty using This can happen in two ways. First, in the context
market instruments12 [World Bank (1999)]. Impor- of non-conformity of the two markets because of
tantly, one has to appreciate that the market itself, excessive speculation, market players can simulta-
rather than the government exchequer, can act as neously take equal and opposite positions (long or
a more sustainable bail-out institution against its short) in the futures and the physical markets and
own vagaries. A market mechanism that is more bring the markets to conformity. Second, during

10 P. Cashin, and C. Pattillo, Terms of trade shocks in Africa: Are they short-lived or long-lived? IMF Working Paper,. Washington, DC, IMF, 2000.
11 S. Page, and A. Hewitt, World commodity prices: Still a problem for developing countries? Overseas Development Institute, 2001.
12 P. Pal and D. Wadhwa, 2007, op.cit., pp. 41727.
13 World Bank 1999, op. cit.

52 Commodity Insights Yearbook 2011

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delivery, players can demand to receive or deliver the About the Expert
physical product through the exchange; the threat of
DR NILANJAN GHOSH, SVP and Head of Research
which makes the futures and cash prices converge. & Strategy at MCX, has been extensively working in
As futures contracts are traded on exchanges that the
th commodity derivative markets space. A natural
are anonymous public auctions with prices displayed resource
re economist and econometrician by training and
a PhD from IIM Calcutta, Dr Ghosh is also the General
for all to see, these markets perform the important
S of the Indian Society for Ecological Economics
function of price discovery. (2010-12).
(2 His prime research interests and contribu-
Prices of many commodities so discovered on tions
ti are in the domains of economics of water resource
the Chicago Board of Trade (CBOT) are taken as the confl
c icts, ecological economics, and commodity markets.
H co-edited a MacMillan publication, Environmental
reference prices for trading worldwide. For example,
Governance, which is hitting the stands shortly. Before MCX, Dr Ghosh was associated
soybean oil futures contract at National Board of Trade with TERI University, New Delhi. He visited School of Social Sciences, Vxj University,
(NBOT) in Indore follows that of the CBOT. Several Sweden, for research and teaching in December 2008. A Lead Author of the UNEPs
commodity exchanges around the world have, time and flagship publication, Global Environmental Outlook 4, Dr Ghosh has also served
as an expert reviewer for several first-rate journals. His publications include books,
again, emphasised their roles in price discovery at the 25-odd research papers in peer-reviewed journals, working papers, review articles, and
international or the local level. All exchanges eventually popular writings. Dr Ghosh may be reached at and
endeavour to carry out effective price dissemination,
thereby reducing the information asymmetries, which
can minimize the adverse selection and moral hazard interests of eastern cities like New York with the
problems in transactions. Information and commu- hinterland of the west, thereby ensuring a constant
nication technology has definitely played a crucial flow of commodities over a large geographical
role in this context. Such attempts have been well expanse. The importance of CBOT thus emerges from
documented for Dalian Commodity Exchange (DCE) the changes in institutional practices in the domain
in China, Bursa Malaysia (which is often claimed to of agricultural marketing as well as from the impacts
have discovered the prices of Malaysian palm oil), and it has had on the socio-politico-economic stratum of
Tokyo Commodity Exchange or TOCOM (which provides human existence.
a benchmark for price discovery in Middle East Crude
Oil) (UNCTAD 2009)14. Concluding remarks
Generally, an insulated economy, unaffected by the forces
A change in socio-economic processes of international trade and finance, reveals divergence
In a broader perspective, it is important to realise in prices in the local economy from those prevailing
that the commodity derivatives/futures market plays globally. This phenomenon increases the basis risk for
a much larger role in the socio-economic-institutional any commodity a situation when local agricultural
backdrop, apart from its dual roles of price discovery prices do not move in line with prices in international
and price risk management. As an institution matures (derivatives) markets. One may reduce basis risk with
and develops, it brings along changes that are social, greater alignment and exposures to international trade.
economic, physical, and philosophical. Evidences Some developing countries including Argentina, Brazil,
galore in international experiences of commodity China, Hungary, India, Malaysia, the Philippines, Russia,
derivatives market development to testify this fact. and South Africa, have established commodity deriv-
The evolution of the Chicago Board of Trade (CBOT) ative markets to deal with basis risk and international
from 1848 in the USA is a well-documented case in price volatility. The success of agri-commodity futures
this regard (Cronon 1991; Saha 2011) . The devel- in various other countries in dealing with international
opment of CBOT needs to be located within several agricultural price volatility, and helping in local price
other developments. A combined dynamics of enabling discovery, does prove a case for a developing nation
factors included new investment in infrastructure like India to encourage further development of the agri-
(railroads and telegraph), the burgeoning settlement commodity futures market. One also cannot ignore the
and colonisation of the hinterland of the Great West, critical role of this market in the broader spectrum of
the increasing volumes of grain production, and socio-institutional changes. As a developing nation, as
passage through the commercial hubs to find the we move towards trade liberalisation in compliance with
distant markets. The evolution of CBOT also needs the WTO norms, the impending challenges, no doubt,
to be seen in the context of the dynamics of inter-city are enormous. Yet, one cannot close ones eyes to
rivalry. Chicago emerged as a preferred city playing the window of opportunities that invariably accompany
a critical role in linking up the broader commercial these challenges.

14 World Bank and UNCTAD, 1996, op. cit.

15 UNCTAD (2009): Development Impacts of Commodity Exchanges in Emerging Markets (New York and Geneva: UNCTAD).
16 Cronon, W. (1991): Natures Metropolis: Chicago and the Great West. New York: W.W. Norton and Co.
Saha, B. (2011): An Institutional Reading of the Very Early History of the Chicago Board of Trade: What it means for What we need to Study
about Indian Futures Market, Commodity Vision, 5 (2), 56-64. /
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