Financialization of Commodity Markets Jos Antonio Murillo G20

Financialization of Commodity Markets José Antonio Murillo G-20 Conference on Commodity Price Volatility September 13, 2011

Index 1 Introduction 2 Theory 3 Empirical Studies 4 Concluding Remarks 2

1. Introduction • Level and volatility of commodity prices have increased in recent years. • As a result of this situation, the G-20 created a study group to analyze the factors behind these phenomena. • Main conclusions of this report coordinated by Mr. Hiroshi Nakaso (G-20, 2011): ü The key factor behind this behavior is a change in fundamentals. ü A sharp increase in financialization of commodities has also been observed. The report reviews opposed studies regarding the impact of this event on commodity prices without arriving to a conclusion. 3

1. Introduction General Commodity Price Index in Real Terms (2002=100) Futures and Option Contracts Outstanding in Commodity Exchanges (Number of contracts in millions) Source: IMF. Source: Bank for International Settlements. 4

1. Introduction • What has been the impact of financialization on price levels and volatility? • Theory states that, by providing liquidity, financialization of commodities contributes to the efficient allocation of resources. Nonetheless, volatility could be exacerbated in the presence of certain market failures. • Empirical studies are not conclusive, some find weak evidence of financialization being a driver of observed price developments while others find no relation. • Yet, some voices argue for stricter trading regulations. 5

Index 1 Introduction 2 Theory 3 Empirical Studies 4 Concluding Remarks 6

2. Theory The participation of financial investors in commodity markets is expected to: ü Satisfy the hedging needs of market participants. ü Lower price volatility and add liquidity (Friedman, 1953; Hicks 1939; Kaldor, 1939; Keynes, 1930). ü Enable investors to further diversify their portfolios. ü Improve the quality of price signals (Fama, 1970, 1991). Ø Greater financialization fosters in the medium term the production of commodities. 7

2. Theory Potential market failures: • Market imbalances (G-20, 2011). ü Liquidity adds depth to the market. • Distortion of price signals (Black, 1986; De Long, et. al. , 1990; G-20, 2011; Kyle and Xiong, 2001; UNCTAD, 2011). ü Transparency and timely availability of information. Ø Deeper financialization limits the adverse effects of market failures. 8

2. Theory Theoretical conditions under which speculation could have an impact on commodity prices are (Hamilton, 2009): • Low price elasticity of demand. • For non-renewables, Hotelling principle. However, the same conditions exacerbate the impact of fundamentals on commodity prices. Hence, which is the culprit financialization or the low price elasticity of demand unresponsive supply? 9

2. Theory • Theory has not offered a compelling argument regarding the influence of financialization on prices. • The bottomline is that commodity markets are inherently volatile due to changes in inventories and fluctuating weather conditions. • On balance, the participation of financial investors in commodity markets contributes positively to the efficient allocation of resources. Ø Financialization of commodity markets fosters the efficient allocation of resources. 10

Index 1 Introduction 2 Theory 3 Empirical Studies 4 Concluding Remarks 11

3. Empirical Studies The main issues of the G-20 report on commodities empirical review are: ü Speculation “causes” changes in commodity prices. ü Futures markets lead changes in commodity markets. ü Speculation determines co-movements between futures and spot prices. ü Role of financial bubbles in commodity futures on commodity prices. 12

3. Empirical Studies 13

3. Empirical Studies 14

3. Empirical Studies 15

3. Empirical Studies Conceptual flaws: ü Several refer to the recent price increase period of 2007 -2008. ü Focus on specific commodities. ü Proxies for speculation are open to debate. ü Measuring financial bubbles with explosive components is nonconclusive. ü Studies based on few observations. 16

3. Empirical Studies Methodological flaws: ü Granger-causality tests are not conclusive for causation. ü Recursive testing over moving data-windows has low statistical power. ü Recursive augmented Dickey-Fuller test requires further study. ü Testing for non-stationarity is not appropriate to identify bubbles. 17

3. Empirical Studies Some considerations: • Given the ambiguity of empirical results and their methodological caveats, it is unclear if there are persistent effects of financialization on commodity prices (or vice versa). • As the G-20 report recognizes, still more research is needed in this area, which would greatly benefit from better data. • Additionally, methodological and conceptual misconceptions still need to be addressed. 18

Index 1 Introduction 2 Theory 3 Empirical Studies 4 Concluding Remarks 19

4. Concluding Remarks • Over-regulation on financial commodity markets leads to inefficiencies and negative welfare effects. • Deepening of financialization allows better risk-sharing and enhances better allocation of resources in commodity markets. • The challenge is to extend markets and facilitate the flow of information among participants, including regulators. • Policies should improve market transparency, data availability and timeliness. • The existence of these markets during this period of volatility has helped producers and consumers hedge against price fluctuations. 20

References Black, F. (1986), “Noise”, Journal of Finance, 41, 529 -543. Buyuksahin, B. and Robe, M. A. (2011), "Speculators, commodities and cross-market linkages", Available at SSRN: http: //ssrn. com/abstract=1707103. CFTC (2008), “Interim Report on Crude Oil. Interagency Task Force on Commodity Markets”. De Long, J. B. , Shleifer S. , Summers L. H. and Waldman R. J. (1990), “Noise Trader Risk in Financial Markets”, Journal of Political Economy, 98(4), 703 -738. Fama, E. F. (1970), “Efficient Capital Markets: A Review of Theory and Empirical Work”, Journal of Finance, 25, pp. 383 -417. ––––––– (1991), “Efficient Capital Markets: II”, Journal of Finance, 46 (5), pp. 1575 -1617. ––––––– (1998), “Market Efficiency, Long-Term Returns, and Behavioral Finance, ” Journal of Financial Economics, 49, pp. 283 -306. Friedman M. (1953), “Essays in Positive Economics”, Chicago Press. G-20 (2011), “Report to the G-20 Study Group on Commodities”, July 2011. 21

References Gilbert, C. L. (2010), "Speculative influence on commodity future prices 2006 -2008", UNCTD Discussion Paper 197. Hamilton, J. (2009), “Causes and Consequences of the Oil Shock of 2007 -08, ” NBER Working Paper 15002. Hart, O. D. and Kreps, D. M. (1986), “Price destabilizing speculation”, Political Economics, 94(5) pp. 927 -952. Hernández, M. and Torero, M. (2010), "Examining the dynamic relationship between spot and future prices of agricultural commodities", IFPRI Discussion Paper 00988. Hicks, J. R. (1939, 2 nd ed. 1946), “Value and Capital: An Inquiry into Some Fundamental Principles of Economic Theory”, Oxford: Clarendon Press. IFPRI (2009), “When speculation Matters”, IFRPI Issue Brief 57 February 2009. IMF (2008), “Global Stability Report. Financial Stress and Deleveraging Macro-Financial Implications and Policy”, Annex 1. 2. October 2008. Irwin, S. H. and Sanders, D. R. (2010), “The impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results”, OECD Food, Agriculture and Fisheries Working Paper No. 27. 22

References Irwin, S. H. , Sanders, D. R. , and Merrin, R. P. (2009), “Devil or Angel? The Role of Speculation in the Recent Commodity Boom (and bust)”. Journal of Agricultural Applied Economics, 41(2): 393 -402. Kaldor, N. (1939), “Speculation and Economic Stability”, The Review of Economic Studies, 7(1), pp. 1 -27. Kawamoto, T. , Kimura, T. , Morishita, K. and Higashi, M. (2011), "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage? ", Bank of Japan Working Paper 11 -E-3. Keynes , J. M. (1930), “A Treatise on Money”, Vol. II: The Applied Theory of Money. London: Macmillan & Co. Kilian, L. and Hicks, B. (2009), “Did Unexpectedly Strong Economic Growth Cause the Oil Price Shock of 2003 -2008? ”. Korniotis, M. G. (2009), “Does Speculation Affect Spot Price Levels? The Case of Metals with and without Futures Markets”, Finance and Economics Discussion Series. Divisions of Research & Statistics and Monetary Affairs. Federal Reserve Board, Washington, D. C. Kyle A. S and Xiong W. (2001), “Contagion as Wealth Effect”, Journal of Finance 56(4), 1401 -1440 23

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