New rules of the game

After coordinated action to avert global meltdown, limiting the euro zone crisis and capping the yen, focus should turn to commodities

Mohan Sule

Can we return back to those days of the last decade when interest rates were low, liquidity was aplenty, economies were galloping, the markets were booming and newer companies were emerging on the trading screens to bet on? Look at the landscape now, from east to west. Power outages in Japan have disrupted supply chains across the world. China and India are battling inflation. The uprising in the Middle East has raised fears of prolonged turbulence disturbing the flow of crude. The sovereign debt crisis in the euro zone has spread to Portugal even as the European Central Bank has started increasing interest rates. The dollar is plummeting as the US Federal Reserve is stubbornly resisting calls to do so despite signs of recovery in the face of flat jobs creation and soft housing prices. Stock markets have become volatile as foreign portfolio investment moves in and out in search of arbitrage opportunities. The current turmoil and future uncertainty, however, have not dimmed the luster of commodities, which are continuing their bull run triggered last year in the belief that the worst is over for financial markets after the bail-out of big investment banks. Within the commodities group, bullion and industrial metals, at any given time, move in opposite direction. The upward movement of precious metals is dictated by fears that the good times are coming to an end, while the buoyancy in base metals stems from anticipated economic growth. This time, though, the correlation has come apart.

Gold and silver have become a separate asset class, de-linked from other investment options and assuming a form that suits investors at that point of time: hedge during inflation and an avenue to channel profit from equities. Base metals and oil, however, continue their connection with economic cycles. Just as the futures and options prices of forward contracts influence the cash market, positions taken by various participants for different reasons affect spot prices of commodities, too. The major difference is that while the impact of the sentiments in the stock market is restricted to buying and selling by investors to make or book profit, without making much of a difference on the day-to-day operations of the companies, unless they are preparing to raise capital, trading on commodity exchanges affects the spot prices of consumables, benefiting or punishing producers and users. Derivatives enable investors to bet big as well as cap risks, artificially altering the demand-supply equation. This was amply evident in the rise of crude oil in anticipation of decline in output from Libya, and even Saudi Arabia, on concerns of internal turmoil. Similarly, the Japanese currency took off immediately after the earthquake on expectation of investors who had borrowed in yen to invest in emerging markets liquidating their assets to repatriate back home and insurance companies selling their overseas assets to pay damage claims. Eventually, G7, the group of rich countries, had to pump in yen to cap the rise.

Excluding the concerted action by the European Union to bail out their members defaulting on sovereign debt, this was the second time that a group of countries was acting in unison after the Lehman Brothers’ crisis and resultant economic meltdown, which saw coordinated quantitative easing by central banks and fiscal stimuli by governments around the world. The IMF’s recent pronouncement that it is willing to help emerging countries to manage their capital flows better after all else including interest rate hikes and capital control measures such as taxes have failed is one more step towards institutionalising the process of managing the global economy. As most of the emerging economies save for Brazil and Russia are net importers of commodities, attention should shift to controlling their galloping prices. From the experience of the Organisation of Petroleum Exporting Countries, producers of metals should know that after a point rising prices can be self-defeating, resulting in global slowdown and inflation in the domestic economy. Equity markets have circuit filters. Exposure to stocks in the derivatives segment too is limited to the outstanding shares of a company. There is no such fencing for taking positions in the commodities futures market. Banning trading, as India does quite often, would be a disservice to large consumers who would want to protect themselves from future price volatility. Perhaps compulsory delivery rather than squaring off for contracts bought, at say 5%, above the current spot prices could induct some sobriety. If not, the alternative will be political instability, particularly in the emerging markets.