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Big plans, zero execution in 2010

By Abheek Barua
January 05, 2011 15:02 IST
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Since this is time of the year for resolutions, I thought I'd take the opportunity to review some of the promises that governments and policymakers made last year.

I seem to remember that we were promised that 2010 would be the year of action that would build on the post-crisis soul-searching of 2009.

However, while the list of resolutions for 2010 was indeed impressive, the scorecard of execution is dismal to say the least.

Take the G20 meetings that were meant to get the grandees of the developed and developing world together to set aside their national differences and agendas, and create a blueprint for coordinated action both in economic policy and regulation. Alas, none of this happened.

G20 meetings last year degenerated into a sort of a grand junket for stressed out global leaders where the tepidness of dialogue couched in layers of political correctness could only be matched by the tameness of post-dialogue press conferences.

Other policy efforts, such as those by the US and the UK to cap bank bonuses, were either too timid or, as in the case of the European banks' stress tests, simply bizarre.

Irish banks, one needs to remember, that are now guzzling bailout funds to stay afloat had all passed the test.

I see one critical area where the collective might of governments across the world needs to exert itself urgently. I refer here to the problem of "financialisation" of commodity markets. It's an ugly word but it does capture the essence of what drives commodity markets these days that, in turn, has become the bane of macroeconomic policymaking across the world.

I must add here that it is hardly a new problem but it's one that global policymakers have done precious little about in the past. The G20 incidentally plans to take up the issues of financialisation and commodity inflation when it meets next in France in 2011. But given the G20's track record, it's unlikely to come up with earth-shaking initiatives.

But earth-shaking regulatory change is what we need if we are to tackle this problem effectively. Here's why.

Commodities are essentially industrial inputs and their prices should follow the demand for these products and the supply of these commodities. "Financialisation" describes the phenomenon in which these commodities are traded in the same way as financial assets like stocks and bonds. Much of this trading happens in the derivatives market - like futures and options - in which market players use loans (leverage) to bet on future prices.

The result is that instead of following diktats of underlying demand and supply, prices of commodities are often driven by completely extraneous factors such as money supply and liquidity. How else can you explain a situation where the price of a barrel of oil shoots up close to $100 a barrel when growth in large tracts of the developed world is barely limping along?

How does it affect macro policymaking? Let's just quickly build a scenario for the global economy as in the next couple of years and see how "commodities-as-assets" could impinge. First, the syndrome of two-track growth in which developing economies experience much higher growth rates than the developed economies is likely to persist for a while.

The Fed and the European Central Bank will continue to follow easy monetary policy both to prevent growth from collapsing and to lubricate their financial system that still remains creaky.

Easy liquidity will chase commodities. Their prices will continue to move up without any substantive changes in the underlying demand and supply balance and present the threat of rising inflation.

Central banks in the emerging world will be forced to tighten money supply, hike rates and dampen growth in the process. The end result could be global recession redux. Evidence shows that the US and Europe are unlikely to respond positively to the monetary massage and growth is likely to remain weak.

Emerging economies that were seeing considerable traction in their growth rates will begin to wilt as rising interest rates begin to bite. By the end of 2011 or the middle of 2012 we could see economic slowdown across the world yet again.

Governments have two options. The first is to accept liquidity-fuelled commodity inflation as fait accompli, let central banks lean on inflation and accept the inevitability of a slowdown. The second is to tackle the problem at its very nub and try and delink commodity prices from the cycle of liquidity.

This will mean curbs on "speculative" trading in commodities. This effectively means that pure financial investors will have restricted access to the commodities market. The goal would be to ensure that these markets are limited to "genuine" users of commodities - producers, extractors and manufacturers - essentially to hedge price risks.

How do they do this? For one, it has to involve collective effort and coordinated regulation. It would be somewhat ironic if, say, the US were to limit access to the Chicago futures and options exchange only to have, say, London or Dubai grab this opportunity to ramp up their markets by offering freer access to speculative trades.

If forums like the G20 manage to get consensus on this, then we can get to the next stage of limiting access to commodity trading. This can perhaps be done in two ways.

There could be direct curbs on participation in these markets. (The US futures trading commission has tried to restrict the number of oil futures that individual investors can hold).

Alternatively, banks can be asked to limit funding for speculative commodity trades (remember most of the speculative positions are financed through cheap loans). The ultimate objective could be to move the bulk of commodity transactions to specialised, well-regulated OTC markets that are limited to actual commodity users.

All this is easier said that done. Commodity markets' volumes run into hundreds of billions of dollars and it would be unrealistic to try and extinguish them overnight. However, the fact that regulators have done very little in the past to control "financialisation" does not mean the status quo should continue. Some decisive and coordinated regulation this year might not mean the end of commodities as assets but it will be the first step in bringing sanity back.

The whiff of tough regulation ahead will shave off some of the froth in their prices that might go back to following the basic demand-supply principles of Economics 101.

The author is Chief Economist, HDFC Bank. The views expressed are personal

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