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 Speculation behind global commodity price rise

By Ramgopal Agarwala

03/08/08 "
Economic Times' -- - There is now a growing discomfort about the role of speculative finance in the US, the capital of global finance. In an open letter addressed to all airline customers, leaders of airlines in the US have recently requested the passengers to join them in pushing legislation to add more transparency and disclosure in the oil markets.

They argue that "twenty years ago, 21% of oil contracts were purchased by speculators who trade oil on paper with no intention of ever taking delivery. Today, oil speculators purchase 66% of all oil futures contracts, and that reflects just the transactions that are known. Speculators buy up large amounts of oil and then sell it to each other again and again. A barrel of oil may trade 20-plus times before it is delivered and used; the price goes up with each trade and consumers pick up the final tab. Some market experts estimate that current prices reflect as much as $30 to $60 per barrel in unnecessary speculative costs."

Speculators have indeed sharply increased their allocation to commodity markets from $13 billion in 2003 to $260 billion in 2008 and at present they are not adequately constrained by rules about margin requirements and other regulations about buying and selling which apply to equity trades. In fact, there has been further deregulation in the US in recent years with respect to speculative futures trading in oil and commodity indices covering a wide spectrum of commodities including food and metals.

Eminent financiers such as George Soros and powerful US senators, such as Joe Lieberman, are arguing that commodity index speculators are a big part of the increase in commodity prices. Michael Masters, a hedge fund manager in his testimony before the US Congress, has said that gasoline prices could fall to $2 a gallon, half of today's price with legislation barring commodity index funds. There are now more than 10 legislative proposals before the US Congress calling for better regulation of commodity index markets.

At the same time, there are powerful forces in the US against regulation of such transactions. Investment funds managers and investment houses such as Morgan Stanley are benefiting from these speculative activities and they are mobilising public opinion against increased regulations. California's public employees' pension fund, the world's largest, earned a 68% rate of return on its investments in commodity futures and other investors are rushing in commodity markets.

The vested interests are trying to divert the attention from regulation by arguing that other factors, including growing demand from emerging markets such as China and India, is responsible for commodity price increases. This game of blaming emerging economies in which the President of the US has also joined is patently absurd because the rapid growth in India and China has been going on for more than a decade with no increase in commodity prices even in nominal terms and cannot explain the sharp increase in last two years.

Other factors such as drought in Australia and switch of corn to biofuels can explain part of the increase in food prices but none of them can explain increases of more than 100% in many commodity prices in a single year as it has happened in 2007 and 2008. There is little doubt that speculative finance is a key factor in sudden price increases in oil, food and metals in the last two years. Amartya Sen in his classical work on famines pointed out that even when supply situation for food is healthy, famines can occur because of collapse of purchasing power of the common man. Today we are witnessing a phenomenon of food riots caused by food price increases due not to demand-supply imbalance but to greed of speculators facilitated by lax regulatory system in the key trading centre of the world.

Given the play of vested interests in US Congress it is not clear which way the legislation on regulating speculative finance in commodity futures will move. Policymakers in developing countries in which price increase in fuel and food are matters of life and death for the poor cannot remain silent and accept vulnerability to the price fluctuations originating in developed countries' financial markets. This must reflect on what they can do to safeguard their people against the onslaught of the speculators in foreign lands?

Over the long-term, the dominant role of a few commodity markets in the West must be reduced. As the centre of gravity of the world economy shifts to the South and South is becoming a dominant source of both demand and supply for commodities, it must develop its own markets with its own rules.

However, in the short run when the contagion effects of the markets in developed countries are still strong, the South must stake its claim in contributing to reform of the regulatory systems in the developed countries because its vital interests are involved. It should not remain silent when the contagion from developed economies is leading to mass starvation in its economies. It should demand, perhaps through international forums such as G-20, proper regulations in the developed countries so that the greed of the few in developed countries does not lead to misery of the many in the developing countries. It should also use its leverage through institutions such as Opec to persuade the developed countries to check the excesses of speculators which could have adverse effects in the long run on both producers and consumers of oil.

(The author is with RIS, a New Delhi-based research organisation)

Copyright 2008 Bennett Coleman & Co. Ltd

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