Rethinking Bretton Woods | Sun, Jul 18, 2010
The sustained increases in food prices that took place between 2006 and 2008, resulting in some countries in riots and extreme acts of violence, alarmed the international community and placed the food crisis at the top of the international policy agenda. The Food and Agriculture Organization (FAO) index of food prices rose by 9% in 2006, 24% in 2007 and 51% in the period July 2007 - July 2008. The World Bank reports that the sudden increases in food prices in 2008 had driven an estimated 100 million more people into poverty while the FAO reports an increase of 200 million in the number of people going undernourished.
At that time, the most often heard explanations attributed the price movements to real demand and supply factors, such as, in particular, increases in demand triggered by the greater purchasing power in China and India.
This view was contested by some analysts. Examples of this are a paper by Jayati Gosh and C.P. Chandrasekhar, "Global Crisis and Commodity Prices,"  and another by Institute for Agriculture and Trade Policy paper, "Commodity Markets Speculation: The Risk to Food Security and Agriculture." While these papers did not question the need to pay attention to a number of factors that affected real supply and demand, they asserted the global financial and food crises could not be dealt with separately. They also made it clear that it would be impossible to give appropriate response to the latter without important reforms to address the financial markets dimensions behind price rises.
A number of new studies released in recent months concur on the impact that speculation in financial markets has had on the price movements of agricultural commodities.
A paper by SOMO, "Financing Food: Financialization and Financial Actors in Agricultural Commodity Markets," supports such a conclusion with an examination of commodity exchanges -where derivatives are transparent in terms of prices and risky positions-- and Over-the-Counter derivatives markets that take place outside those exchanges. Then it discusses different investment vehicles whose use has increased: Commodity Indexes, commodity Exchange-Traded Funds and Commodity Index Swaps. The paper traces back the increase in speculation on commodity markets to the growing influence of "non-traditional" speculators. These include hedge funds, pension funds, other institutional investors and large banks, often investment banks, operating as dealers whose defining characteristic is that they have only financial motives and no interest or knowledge on the underlying commodity or their delivery.
In a pair of papers commissioned by World Development Movement, "Speculation in Food Commodity Markets" and "Regulating Speculation in Food Commodity Markets,"  Tom Lines also supports the view that speculation had a large impact on prices of food. "Most of the recent financial investment in commodities has been 'passive' and 'long-only'. In principle, that should not make prices more volatile from month to month, whatever other disruption it may cause on the market. But it will tend to increase prices overall, simply by providing an extra source of demand... It is by this route that price changes on the Chicago futures markets fed into wider, domestic food price movements on other continents in 2007-08."
Like the one by SOMO, the first of these studies contains a typology of the investment instruments that allowed these new forms of commodity speculation. Lines lists among these: Managed futures funds and Commodity collateralized obligations (CCOs). In the first, a 'Commodity trading advisor' (CTA) collects funds from investors, which the CTA then places on the market as though an investment from a single source. There is no index involved and the funds are actively traded. The second is a commodity equivalent of the collateralised mortgage securities that triggered off the credit crisis in 2007. It uses the same 'slice and dice' principle to combine the prices of several commodities into a package in the form of an interest-bearing bond, the principal amount of which is related to the prices of the underlying commodities.
The paper then has a summary of the problems created by these commodity investment vehicles. The study contains not just a typology of the actors in the commodity markets but also makes an attempt at naming who are today the main players in these markets.
The companion paper has a useful summary of the EU and UK regulation of commodity markets and of initiatives to overhaul such regulations currently under discussion in the European Union.
The impact of speculation on commodity price rises also is addressed in a paper written for UNCTAD by Joerg Mayer. The study, "The Growing Interdependence Between Financial and Commodity Markets," as suggested by the title, supports the notion that financial market developments are deeply intertwined now with commodity price dynamics. In direct contrast with the explanation that attributes price increases to changes in fundamentals, the paper concludes that financial investment in commodity trading has caused "commodity futures exchanges to function in such a way that prices may deviate, at least in the short run, quite far from levels that would reliably reflect fundamental supply and demand factors."
According to Mr. Mayer, financial investors in commodity futures markets regard commodities as an asset class, comparable to equities, bonds, real estate, etc. Evidence that this asset class is negatively correlated with stocks and bonds' returns made it a target for portfolio managers seeking to diversify their holdings. His analysis of several markets finds that, however, over time, position taking for speculative reasons has increased.
Additional aspects of the link with the financial crisis are raised in "The Unnatural Coupling: Food and Global Finance," a paper prepared for the Group of 24 by Jayati Gosh.
As the financial crisis brought a sudden fall in commodity prices, the food crisis is widely regarded as over. However, according to that study "the food crisis has actually grown more intense in many developing countries since the middle of 2008." Among these additional effects to consider are currency depreciations -which affect access to imported food--, lower fiscal government capacity to implement interventions-due to less revenue--, and the fall of real wages in relation to food prices-- which means that lower nominal food prices do not necessarily mean lower shares of income being spent on food.
Moreover, after the paper was written the prices have resumed an upward path. According to the FAO's latest food situation update, the Food Price Index went up between August 2009 and January 2010. In May 2010 was up 7 percent in relation to the May 2009 -this continues stable at this level, which is only 23 percent down from the peak reached in 2008 and, thus, still has not gone back to even the historically high 2006 levels.
The view that financial speculation on commodity -including agricultural commodity-prices had a large impact on price rises is also espoused by Jan Kregel in "Financial Markets and Specialization in International Trade: The Case of Commodities."
An additional angle Kregel's piece brings to attention is the impact that commodity price increases have on the structure of the economies of Latin American countries. The result has been a combination of current and capital account surpluses that have brought rapidly increasing foreign exchange reserves and appreciating currencies. "Thus, financial market conditions are producing real changes in the production and export structure of most Latin American countries - changes that are not sustainable and produce substantial disruption when they are reversed. In particular, the bubble in commodity prices is reflected in what should be considered a bubble in real exchange rates throughout the region."
The Role of Financial Regulation and the US Financial Reform bill
Not surprisingly, thus, many of the proposals for addressing the food crisis have to do with re-regulating commodity futures markets.
The main measures recommended in the papers mentioned above can be classified into three broad categories:
One category involves measures to improve transparency of derivatives trading, especially OTC derivatives. Some of these reforms cannot be enforced unless all exchange and clearing entities are regulated- -and either all derivatives transactions are pushed onto such entities or those trading OTC derivatives are required to report such transactions to some public agency.
A second category includes measures that would establish speculative position limits for traders (by commodity and by value of contract) and margin requirements. The purpose of such measures is to make speculation more difficult and to increase its costs.
The third category are measures that would reduce or ban altogether the participation of some actors in commodity derivatives trading, such as banks that can rely on government-insured funds to speculate in markets or exchange-traded funds.
In addition to these measures, which are generally applicable in major financial centers, Gosh mentions some measures that developing countries could attempt to use to mitigate the effects of price movements. She recommends banning commodity futures markets in countries where public institutions play an important role in such markets and capital controls as a way to prevent inflows that enter the market with speculative purposes.
Several of these analyses consider the deregulation of US commodity futures markets after year 2000, with the Commodity Futures Modernization Act, a critical juncture. This legislation, as described by Gosh, "effectively deregulated commodity trading in the United States, by exempting over-the-counter (OTC) commodity trading (outside of regulated exchanges) from CFTC oversight. Soon after this, several unregulated commodity exchanges opened. These allowed any and all investors, including hedge funds, pension funds and investment banks, to trade commodity futures contracts without any position limits, disclosure requirements, or regulatory oversight."
Against this context, the recent process to overhaul financial legislation in the United States obviously raised great expectations. However, after the bill emerged from the conference process - conference is a part of the legislative process where "conferees" from both the House and Senate meet to reconcile different versions of a bill passed in those respective Chambers-the picture is a mixed one.
The bill will require a large portion of derivatives transactions to be standardized and traded in public and electronic exchanges to increase transparency and to go through central clearing houses to ensure risks being built are also transparent. However, there are exceptions to these provisions for "nonfinancial companies" using the contracts to hedge risk. Non-cleared derivatives still have to be reported. They will seemingly be subject to higher margins, too, though the exact scope of the respective provision is still under debate and may be narrowed in its application.
The bill also mandates the establishment of speculative aggregate position limits across different markets for all contracts, and capital and margin requirements for dealers. Earlier in the process it was feared the legislation would authorize, rather than mandate, regulators to impose such limits (this was the language used in the House version). In this regard the bill out of conference is an improvement. Obviously, the legislation could not state what those requirements will actually be in practice, a not minor detail that will be essential that regulators get right, if the requirements are not to become meaningless.
If passed as legislation, the current bill will also require banks to spin off derivatives operations into separately capitalized units and ban them from proprietary trading with bank capital. But these rules have been so narrowed with exceptions that their effect on banks' ways of doing business will be quite limited. The restrictions on derivatives operations do not cover interest and exchange rate swaps, as well as some investment grade products. Interest rate swaps alone constituted, to go by figures the BIS provided in late 2009, 70 percent of OTC derivatives trading. The banks will also be able to keep hedge funds and private equity fund units in house. They are allowed to invest up to 3 percent of bank capital in them, and to engage in proprietary trading of their own to hedge bank's risk and facilitate clients' needs.
An additional point to mention is the important role that the regulators will play in clarifying myriad details that the legislation leaves open, and doubts remain the Commodity Futures and Trade Commission, with its 600-person staff, is adequately resourced to carry such burden.
To those who have argued that a thorough reform of financial markets in major financial centers is a crucial part of the response to the food crisis, the US legislation will remain a step in the right direction. The measures that developing countries might be able to implement on their own to curb such impacts remain as essential as ever.
 Available at http://www.networkideas.org/featart/dec2008/Global_Crisis.pdf
 Available at http://www.iatp.org/tradeobservatory/library.cfm?refID=104414
 Links to both papers are available at http://www.wdm.org.uk/report/speculation-and-regulation-food-commodities
 This UNCTAD paper is available at http://www.unctad.org/en/docs/osgdp20093_en.pdf
 Available at http://www.g24.org/jg0909.pdf
 Gosh, J. The Unnatural Coupling: Food and Global Finance, p. 11 (available at http://networkideas.org/working/dec2009/wp03_08_2009.htm).
 See FAO Food Outlook, June 2010.
 This study is available in Spanish in book published as a result of the consultation, in turn available at http://www.coc.org/node/6542