The New Nation - Internet Edition

John E. Young

As food prices continue to rise, threatening the livelihoods of many poor people around the world, some observers have pointed a finger at speculation as a culprit in the price run-up. What role is speculation playing in the current food crisis and how can markets be calmed?

In recent years, rising prices for basic foodstuffs have further reduced food and nutrition security for many of the world's poorest people, pushing them to the edge of starvation and spawning social unrest in many countries. Rising food prices have also strained the capacity of food aid agencies, spurred a United Nations summit, and drawn extensive worldwide press coverage.

As with previous commodity booms, many have been quick to blame speculators for food-price increases, and in fact, there is considerable evidence of recent increased speculative activity in food markets. Most notably, institutional investors have invested billions of dollars in U.S. commodity futures markets (the largest in the world), betting that food prices would continue to rise. "Even if it is difficult to gauge the real impact of this financial speculation, it has certainly played a role in influencing trading prices," says David King, Secretary-General of the International Federation of Agricultural Producers. "Take for example the fact that in a normal year, trading and movements on the wheat futures market in Chicago represent the equivalent of 20 times the annual U.S. wheat harvest. In 2007/2008, these movements represented the equivalent of more than 80 harvests."

At the same time, commodity futures markets have been plagued by serious technical problems and wildly oscillating prices, which have combined to threaten their ability to fulfill their longstanding role as a risk-management venue for producers and consumers of agricultural products. Many casual observers have fingered speculation as a primary cause of the market turmoil.

Speculative behavior such as food hoarding also has been on the upswing in other areas of the world food economy. Some governments have engaged in what amounts to international hoarding, restricting their exports of food commodities or introducing export taxes in order to fend off price increases in their domestic markets. Other countries, fearing domestic shortages, have engaged in panic buying on international markets, rushing to import food in order to build up reserves even as prices were skyrocketing.

Whether speculation is primarily a cause or a symptom of rising food prices and commodities-market dysfunction is unclear. The more crucial question about the effects of speculation on food markets is whether prices are telling the truth about supply and demand. Are producers, investors, and policymakers receiving the right signals to guide their actions? If they are not, and an agricultural price bubble is underway, the consequences could be severe for farmers and consumers around the world.

What, exactly, is speculation? Technically, it is the purchase (or sale) of something in the hope of profiting from changes in its price. In the context of food markets, two forms of speculation are the most significant:

· the purchase and/or hoarding of commodities in the hope that their price will continue to rise

· the purchase of agricultural futures and options-essentially, bets that prices will either rise or fall-purely as an investment strategy (rather than as a way to manage risk related to the sale or purchase of commodities).

An aggressive form of commodity speculation involves holding large stocks of commodities off the market in a time of shortage in order to drive prices up. Sometimes, speculators will combine hoarding with trading strategies that attempt to create or exacerbate shortages. "Cornering" a market-buying up enough of a commodity to effectively control its price-is the extreme example of such an approach. Formal commodities markets are generally subject to government regulations aimed at preventing such activities, though the effectiveness of such regulation varies widely around the world. Smaller markets are generally more susceptible to manipulation.

In many cases, only analysis after the fact will tell the difference between destructive speculation and healthy, productive investment in commodities and the agricultural sector. While some argue that the large chunks of new capital in the commodities markets have a destructive influence, others say that they simply make the markets more liquid, and thus more efficient, reducing trading costs. Low or declining food prices have long played a major role in keeping agricultural production stagnant in much of the developing world, and international development advocates have been clamoring for increased investment in agriculture for many years. Now, high prices are attracting capital to agriculture. In theory, this should be a good thing. But purely speculative investment is hardly what the development community had in mind.

At the end of March 2008, according to Citigroup, investors worldwide held an estimated $400 billion in commodity futures contracts-about $70 billion more than at the beginning of the year, and twice as much as in late 2005. These investors include commodity index funds, commodity trading advisors, hedge funds, and exchange-traded funds. Many of them are trying to assemble commodity portfolios that replicate the performance of major commodity-price indexes, such as the Standard & Poor's/Goldman Sachs Commodity Index and the Dow Jones/AIG Index. They are doing so for two reasons. One is that commodity investments generally increase in value when other classes of assets decline. The second is that many investors believe that the commodity markets are in the midst of a "super cycle"-a long-term trend that will drive prices higher for years to come.

Since the indexes mentioned above are comprised, respectively, of 12 and 30 percent agricultural products, roughly $48-120 billion of the above investment is in agricultural futures. AgResource Company estimates that index funds alone now have more than $47 billion invested in maize, soybeans, wheat, cattle, and hogs (in U.S. markets), up from $10 billion only two years ago. Combined with growing activity by traditional futures traders, this capital influx has sharply increased the overall size of the futures markets. For example, the number of open futures contracts on the Chicago Board of Trade (CBOT) has increased more than threefold for both wheat and corn in the past five years, and has doubled for soybeans.

Futures markets allow investors to bet on which way commodity prices will move over time. Each futures contract represents a commitment to sell or deliver a specified quantity of a commodity at a given price on a given date. For example, a grain elevator operator may agree in April to buy 40,000 bushels of corn (1016 metric tons) to be delivered in December, after the fall harvest, at a price based on that of the December CBOT futures contract. On the same day, that operator will sell 8 December futures contracts (a standard CBOT corn contract is for 5,000 bushels, or about 127 metric tons of grain)-agreeing to sell the grain at roughly the same price paid the farmer-in order to cover the elevator against a possible fall in the cash-market corn price between April and December. The elevator will deposit a "margin"-perhaps 8 to 10 percent of the contracts' value-with the commodity exchange, in order to cover possible changes in their value. In December, the grain elevator will usually buy another futures contract-one requiring it to purchase the same amount of grain. The two contracts cancel each other out, eliminating the need to deliver grain through the futures market. Any money gained or lost on the futures contract should be offset by gains or losses on the grain purchased from the farmer, since the futures-market price for corn should be the same as the cash-market price when the contract expires. In theory, any divergence between the two prices will be closed by arbitrageurs, who profit by buying in one market and selling in the other.

The transactions described above embody the two most critical purposes of futures markets: price discovery and hedging. Commodity transactions outside the futures markets are often based on the prices established within the markets. Hedging is the process by which those trading in physical quantities of commodities offset their price risks by buying or selling futures contracts.

Historically, most futures-market participants have been hedgers or "commercial traders," seeking to manage risks associated with buying and selling the underlying commodities (see box). Commodity speculators, or "non-commercial traders," have also been active in the markets, making limited, relatively short-term bets on price movements and employing sophisticated trading strategies to benefit from differences in prices for different delivery months. Traditional speculators move in and out of the futures markets in response to supply and demand developments. In contrast, the new, index-related investors in commodities seek to balance risks from other investments, such as stocks, bonds, and real estate. They buy futures without regard to price, until they have met their investment target, which is established in proportion to their investments in other sectors. They also bet only that commodity prices will rise.

While food prices are rising for a number of reasons, there is growing concern that supply and demand do not adequately explain the speed and severity of the price increases. Many blame the flood of speculative capital into the U.S. commodity futures markets, which attract capital from around the globe and set global benchmark prices. The Food and Agriculture Organization of the United Nations (FAO) chief Jacques Diouf has pointed to speculation by "hedge funds, index funds, and so on" as a factor in price increases. So have the head of the U.N. Environment Programme (UNEP), the U.N.'s Special Rapporteur on the Right to Food, prominent politicians in many countries, and well-placed financial analysts. Todd Kemp of the U.S. National Grain and Feed Association told Business Week, "The enormous influx of capital has resulted in the futures markets no longer reflecting supply and demand."

In the United States, prominent critics such as hedge-fund manager Michael Masters, former U.S. commodities regulator Michael Greenberger, and Goldman Sachs chief economist Jim O'Neill, argue that the large, new, index-driven investments in commodities are driving up prices out of proportion to market fundamentals. They point to a major problem that has recently affected several U.S. agricultural commodity markets: the failure of futures and cash-market prices to match up when futures contracts expire. When futures and cash prices for commodities do not converge, futures contracts do not provide an effective hedge against price risks. This problem has occurred often enough in recent years for some in the agricultural sector to describe the futures markets as "broken." It can add up to very large losses when prices move the wrong way. One Missouri grain trader told the New York Times that he lost $940,000 last fall when his futures hedge on a million bushels of soybeans did not match up with the cash market.

Price volatility has also been a major problem in agricultural commodity futures markets. In the first few months of 2008, volatility in several key agricultural futures markets was very high-triple the historical monthly averages for wheat and soybeans, and double for corn. High volatility means that those who trade in futures have to put more money down in order to maintain their hedges. If they do not have the cash-or an adequate source of credit-the commodity exchange will cancel their contracts and seize the funds they already have on deposit. Many market participants have found it increasingly difficult to obtain enough credit since global credit markets tightened in response to the U.S. sub-prime mortgage collapse.

The combination of price convergence problems and high volatility has made the commodity exchanges less reliable gauges of future prices, and has lessened their usefulness as risk-management venues for agricultural producers and consumers.

Many economists argue that speculation cannot be blamed for such problems, pointing instead to technical concerns regarding futures contracts, such as where grain is to be delivered, and whether there is adequate storage available for those who would like to make money on price differences between cash and futures markets. They are also skeptical of a link between futures-market speculation and rising food prices. In a recent Wall Street Journal survey of economic forecasters, only 11 percent of respondents pointed to speculation as the most important factor in food-price increases. Furthermore, Princeton University economist Paul Krugman has argued that futures-market speculation cannot be exerting upward pressure on cash prices for commodities, unless high futures prices are leading to hoarding, and he finds no evidence in official statistics on stocks of agricultural commodities that such hoarding is occurring. The chairman of CME Group-the operator of the Chicago futures markets-Terry Duffy told Reuters that "to say that the speculator or the hedge funds or other participants are the root of the problem is really misguided."

However, political scientist Robert Paarlberg counters that hidden hoarding may well be a significant factor in the global agricultural economy. He says that small behaviors-such as household hoarding of rice in Asia, or importers who buy half a year's supplies in a panic in January or February, instead of spacing their purchases over six months-can add up to very significant numbers when multiplied by millions of families or thousands of firms. He cautions that it is simply too early to know whether hoarding is a significant factor, especially given the time lag involved in most statistics.

Some hoarding is definitely occurring. Expatriate Filipinos in Canada are sending 40-pound bags of rice to family members in the Philippines. Even American consumers have stocked up on some commodities-especially rice-in response to limited availability. In addition, governments around the world have been cracking down on grain hoarders. Peru's prime minister "declared war" on food-price speculators in March. In India, large rice warehouses in New Delhi and Mumbai have been raided by police. In the Philippines, criminal syndicates have been caught reselling large quantities of grain originally intended for subsidized sale by the government to the poor.

Ironically, it is national governments themselves that may be the biggest hoarders. Export bans are the most significant way in which food stocks are kept off international markets. At least 29 countries recently have put sharp limits on their food exports, in order to build up reserve stocks and keep prices low in their domestic markets. These include 14 countries that have put limits on rice trade, and more than a dozen that have limited corn exports. Several major producers have also curbed wheat exports. In response to this, Rajat Nag, the managing director of the Asian Development Bank, declared "[The] banning of exports is no different from hoarding at a national level."

Strong, sustained commodity market movements virtually always attract speculation. Noted investor Warren Buffett has observed that fundamentals start most major market trends, and then speculation takes over. Policymakers now face the challenge of limiting speculation that distorts markets without discouraging healthy investments in agriculture. Their key goals will be to promote transparency and reduce opportunities for market manipulation at all levels of the world's food markets, from local to global.

Reforming commodity markets is an important first step. In the United States, where the world's largest markets set global benchmark prices, domestic regulatory decisions have worldwide implications. A federal task force led by the Commodity Futures Trading Commission is considering possible reforms to the futures markets. Some of the most likely initiatives include:

· implementing technical reforms-especially those related to commodity delivery-in order to tighten links with cash-market prices

· requiring more comprehensive and detailed reporting of transactions, in order to make it easier to determine how speculation is affecting markets

· re-examining limits on the size of speculative positions, especially for index-fund investors

· revising margin requirements (requiring investors to provide larger "down payments" on futures contracts)

· reforming the laws governing pension funds and limiting their ability to invest in commodity futures

Reforms to improve transparency are crucial because they should enhance understanding of how and when markets are affected by speculation. However, reforms that could take some traders out of the futures markets are more controversial. A recent University of Illinois study concluded that increasing margins, for example, "may well be counter-productive in terms of price levels or market volatility." Fewer traders can mean less liquidity, which can make a market less efficient.

While futures markets are often disparaged as venues for speculative activity, countries with limited or nonexistent formal markets for agricultural products should not discount their potential benefits. Small farmers in developing countries desperately need real investments not only in agriculture itself, but also in the institutions and infrastructure that underpin healthy agricultural economies. Unpredictable prices are among the farmer's greatest enemies. As International Monetary Fund chief Dominique Strauss-Kahn argues, "We t need a new approach to risk mitigation and insurance at the level of both individual farmers and countries," including "robust futures markets." Freer agricultural markets offer the promise of greater potential rewards for producers, and, in turn, greater food supplies, but the increased output only comes when farmers invest more labor and capital, and thus risk more. Futures markets-and free, transparent cash markets, on which they must be founded-can be a key component of a suite of institutions and products that can help agricultural producers and consumers manage production and price risks.

While politicians tend to highlight criminal prosecutions of hoarders-or high-profile shutdowns of commodity markets-quieter, often slower efforts to establish, and more effectively oversee, formal markets may be more important ways to reduce the influence of speculation on domestic agricultural markets. The recent opening of the Ethiopian Commodities Exchange, led by IFPRI researcher Eleni Gabre-Madhin, is a good example. One Ethiopian grower told the Wall Street Journal that if his country had had such an exchange in 2003, "maybe we wouldn't have had the famine," since greater access to markets might have led to more consistent planting and harvests. Strong oversight is also important. While the Indian (and Chinese) government's recent temporary suspension of futures trading in some agricultural commodities has received considerable attention, it is not clear that it will do much to reduce food-price inflation. It may be more important for Indian authorities to focus on reforms that improve market transparency, argues Indian business journalist G. Chandrashekhar.

As IFPRI director general Joachim von Braun points out, real shortages in the world food markets are the fundamental problem, but excessive speculation is now a cause for concern, because "without properly functioning markets the incentives for investment will not translate into stimulating production and the poor are hurt by any increased price volatility." The small-farm producers in the developing world are often the ones who end up suffering the most from market instability.

The complex problem of speculation needs a set of complex solutions. In the long run, investment in agricultural production is key for reducing the incentive for speculation. Another important route to reducing the influence of speculative behavior on food prices is international trade reform. Export restrictions and other forms of hoarding can affect food markets as much as any other speculative activity. Moreover, the current low levels of grain reserves need to be addressed. A recent report by von Braun and Maximo Torero, director of IFPRI's Markets, Trade, and Institutions Division, proposes that a "virtual grain reserve" be established to help calm markets through the futures market. It is an innovative approach to creating a global reserve that would solve the problem countries face of insuring against abrupt price increases and supply disruptions without building up physical stocks of food-actions that can, by themselves, drive up prices.

(Source: IFPRI supported by the Consultative Group on International Agricultural Research (CGIAR)