<b>Nagesh Kumar:</b> Beyond monetary tightening

Better regulation and transparency in the commodity market are critical to bringing down global price volatility

Nagesh Kumar

Rising food and oil prices are posing a major challenge for policy makers in the Asia-Pacific region. Since August 2010, food prices have risen in various countries between 10 per cent and 35 per cent. Oil prices have increased by 45 per cent over the past year. Concerns have been raised about the impact on vulnerable sections of population and on the poverty reduction efforts of populous countries such as India. In its Economic and Social Survey of Asia and the Pacific 2011, the United Nations Economic and Social Commission for Asia and the Pacific (UN-ESCAP) has projected that an additional 42 million people may stay in poverty in the Asia-Pacific region in 2011 apart from the 19 million already affected in 2010 owing to rising food and oil prices.

It becomes glaring in the context of the limited policy tools that governments have to deal with rising prices. In India, for instance, continued inflationary pressure has forced the Reserve Bank of India to raise policy rates several times in the recent past. Such monetary tightening is affecting the growth momentum in the economy but inflationary pressure has yet to subside. Similar has been the experience of other countries in the region. The inability of monetary tightening to bring down commodity prices makes us wonder whether we are chasing the right culprit.

Supply not keeping pace with the rising demand for agriculture and other commodities and diversion of some food crops towards biofuels, like corn in North America, can explain only part of the commodity price booms of pre- and post-2008-09 financial crisis. The policy responses need to factor in changes in the functioning of the commodity markets that are leading to the rise and increased volatility in prices.

One of the issues discussed at a high-level policy dialogue of central bankers and policy advisers of Asia-Pacific countries on policy challenges faced by them in handling the financial crisis, organised by UN-ESCAP and hosted by the central bank of the Philippines earlier this month, pertained to factors driving commodity price volatility. One discussion related to the evidence put forward in recent studies by the United Nations Conference on Trade and Development (UNCTAD) on increased financialisation of commodity markets in recent times and its impact on the volatility of commodity prices. It was pointed out that a new development in the commodity markets in recent years has been increased presence of financial investors who consider commodity futures an alternative to financial assets in their portfolio. These investors may not have an interest in the physical commodities but hold very large positions in commodity markets and exercise considerable influence on them. This phenomenon, termed financialisation of commodity markets, has accelerated significantly since 2003, as reflected in rising volumes of financial investments in commodity derivative markets, at both exchanges and over the counter.

Beyond monetary tighteningGreater participation of financial investors causes commodity markets to work like financial markets driven by herd behaviour of investors rather than the traditional demand-supply logic of commodity markets. It is clear from the high correlation among commodity, equity and currency markets. Rising commodity prices tend to represent speculative bubbles as in other financial markets rather than rising demand in the real markets.

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If commodity prices follow the logic of financial markets, monetary policy tightening, which is trying to affect demand in the real markets, would have little effect on prices. This reality needs to be factored in the policy responses. Price volatility in commodities will not come down by monetary tightening alone. For this, we will have to take steps to regulate investment in commodity derivatives. But since these markets are connected internationally, action at the national level would not be adequate. This issue should be addressed by the upcoming G20 Cannes summit in November 2011. The G20 summit should consider the recent evidence about the current functioning of the commodity prices and agree to regulate such derivatives trading. Such regulation could cover greater transparency and ability to impose position limits and prohibition of proprietary trading by financial institutions involved in hedging transactions of their clients because of conflict of interest, as recommended by UNCTAD.

G20 could also decide to regulate the diversion of food to biofuels. In the area of oil price volatility, G20, being the group of all major consumers, can match the power exercised over the oil markets by the cartel of producers viz. the Organisation of the Petroleum Exporting Countries (OPEC). OPEC and G20 may negotiate and demarcate a benchmark “fair” price of oil and agree to restrict the oil price movement within a band around it. An additional measure to moderate the volatility in the oil market is to create a global strategic reserve and release it counter-cyclically. G20 should also expedite the implementation of the L’Aquila Initiative on Food Security, which includes provision of financing to developing countries for food security.

As a developing country with a huge population of poor and vulnerable people, India has a huge stake in stabilising food and oil prices. It should mobilise other developing country members and push this agenda at the upcoming G20 summit. The French presidency has been quite supportive of regulating the financial markets and disciplining the speculative activity in the food commodities. By co-ordinating its position with like-minded countries in G20, India would be able to push a consensus on the issue.

The author is chief economist of UN-ESCAP, Bangkok.
The views expressed are those of the author and do not necessarily reflect the views of the UN.  

Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of or the Business Standard newspaper

First Published: Oct 04 2011 | 12:48 AM IST

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