31 July 2015

Why are commodity prices falling?


Commodities aren’t the sexiest parts of global finance, and not many of the young thrusting finance types starting their careers in banking this summer will want to find themselves researching copper mines and the long-term sustainability of Berar’s cotton fields.  Yet oil, copper and steel are the stuff of the global economy; they are particularly important to developing countries, and especially important to those exporting countries in which commodities play an outsize role.

Something dramatic is happening in the commodities market, as the chart below from the IMF, which represents a composite index of prices in agricultural, metals and hydrocarbon markets, shows.

IMF chart

The market peaked in September 2013 and has trended downwards ever since, but it wasn’t until late 2014 that we began to see the precipitous falls reminiscent of the crash during 2008 when the world economy went into recession. The market appeared to stabilise in the first half of 2015, but composites are down 10% this month and are at their lowest level since the crash.

Oil was a big factor last year as US shale gas came on stream and OPEC nations kept output high. Oil prices that today trade at around $50 a barrel could fall further as Iran, which has some of the world’s largest known oil reserves, restarts production as sanctions are lifted.

But a big factor driving the downturn can be found in China, which accounts for about half the global demand for industrial metals. Between 2011-2013, China produced 50% more cement than the United States managed in the entire 20th century. As Zhiwu Chen writes in Foreign Affairs, much of Beijing’s $600bn stimulus after the financial crisis was channelled through local government financing vehicles (LGFVs) that borrowed from state-owned banks using public land as collateral, making possible the country’s “feverish construction of highways, high-speed railways , airports, subways, steel foundries, office parks, and so on”.

But as local government sold off most of the premium land and demand dropped off, the real estate market has suffered, with land sales down 30% since the beginning of the year. This, to a large extent, really is the backdrop for the recent turmoil in China’s stock markets. An editorial in Japan Times earlier this week highlighted the link:

“The Chinese government’s behavior vis-a-vis stock markets has been problematic. Real estate markets started to slump in spring 2014 due to overinvestment. Businesses, banks and local governments that had been engaged in shadow banking practices to promote real estate investments suffered heavily, and the central government guided funds from real estate investments to stock markets. In addition to the series of monetary easing steps, the government permitted individual investors to buy stocks on credit, enabling them to borrow large amounts of funds for stock transactions as long as they deposit a certain amount of money. The state-run media also fanned the stock investment boom.

But after the stock markets became overheated as a result of such steps, the government in mid-June tightened regulations on stock transactions on credit. Since investors are required to deposit additional money if they suffer losses, many of them were overcome with fear and rushed into a selling spree, leading to the market free fall. The government then unabashedly took a series of steps to keep up the share prices, distorting the price formation by market forces.”

At a superficial level it may have seemed wise to encourage state banks to invest in the same asset class that backed the loans that funded the state in some attempt to construct a virtuous cycle of credit, but when real estate markets turned sour in 2014, Chinese banks appeared to be twice exposed, and a series of ham-handed interventions have wrecked China’s financial system since.

As commodity prices tumble, major exporters such as Brazil, Mongolia and Nigeria will suffer, but these countries and others like them may actually benefit in the long term. High commodity prices encourage resource-rich countries to organise their economy around exploiting these resources, and attract large amounts of foreign investment and international demand. These work to drive up the price of the country’s currency and divert resources away from more productive and creative manufacturing and service sectors, making exports more expensive and less competitive in international markets, while increasing the cost of imports.

While some of the recent developments in commodity markets are a reflection of overextension in China, they don’t bode well for the world economy. With growth weak in Europe and unexceptional in the US, the hope was that continuing industrialisation in developing economies around the world, in the BRIC and MINT economies (Mexico, Indonesia, Nigeria and Turkey), would drive world growth. This isn’t happening, and in fact in many places we are experiencing what Dani Rodrik has termed “premature deindustrialisation“. Developing countries are becoming service economies before they’ve had a proper period of industrialisation, and this is particularly pronounced in places like Latin America and Sub Saharan Africa.

In the long term, commodity prices will recover. The majority of the world’s population lives in countries which have not industrialised, and it won’t be long until they do. Hundreds of megacities around the world are taking shape, and all of these will be hungry for steel, copper and oil. Maybe it’s not such a bad time for a young graduate to join a bank’s commodity team after all.

Zac Tate is Deputy Editor of CapX