Machiko Nissanke Department of Economics School of Oriental and African Studies

1. Primary Commodities and Economic Development: New Challenges and Policy Option in the 21st Century Machiko Nissanke Department of Economics School of Oriental and African Studies University of London 16 September 2008

2. Introduction -Backgrounds • The high prices and volatility across primary commodities hit the global community at the time of turmoil of financial markets– Placed commodity issues back at the international policy agenda; • In contrast, the persistent reluctance to acknowledge commodity-related developmental issues and the resultant failure to deal with them effectively in a timely fashion in the 1980s and 1990s entailed a heavy cost to economic development of commodity-dependent low-income DCs; • Maizels (1987, 1992 and 1994) convincingly revealed how the beginning of the debt crisis of poor countries in the late 1970s coincided with that of the ‘conveniently forgotten’ commodity crisis (the depth of which was worse than the Great Depression in the 1930s); • His in-depth and comprehensive analysis of commodity issues and his urge to formulate correct international policy responses to the debt crisis could have led to an early resolution of the protracted debt overhang condition in low-income countries; • Many HIPC and LDCs, mostly in SSA- very high commodity-dependence; • All debt relief efforts, including HIPC initiatives, failed to pay sufficient attention to the plight of commodity-dependent economies- an international poverty trap through a commodity-dependent integration into the global economy in the 1980s and 1990s ; SOAS Commodity Workshop, September 2008

3. Introduction –Backgrounds (Cont’d) • The contrast between commodity-dependent economies and newly industrialising economies through climbing technology and skill-ladders – largely accounts for their divergent growth and development experiences. • Globalisation has not left commodity-dependent countries untouched • Changing landscape governing world commodity markets and production both at the Global and National Levels • At the global level: • High price volatility – a rapid expansion of derivatives markets attracting portfolio investors not engaging in physical commodity trading, leading to a loosening of the demand-supply relationships; • Fundamental demand-supply relationships shifting, originating from fast growing economies (e.g.China and India) for raw materials and agricultural goods • The impact of climate changes shifting the relative composition between food crops, bio-fuels, cash crops – effects on food prices & food security • The changing relative positions between TNCs and producers in GVCs SOAS Commodity Workshop, September 2008

4. Background (Continued) and Objectives • At the national level • Institutional changes affecting agricultural producers in input provisions, access to new technology, extension services and output marketing arrangements; • Producers exposed to high price volatility- costly and imperfect hedging instruments- uneven access • Institutional changes affecting mineral-based economies – privatisation negotiated between TNCs and governments, based on the asymmetric power relationships – mineral rents not accruing much to producing countries • Objectives of the paper • Examine the emerging landscape affecting commodity markets and production • Discuss new challenges, opportunities and development issues in the light of these changes SOAS Commodity Workshop, September 2008

5. Commodity Prices and Economic Development in a Historical Context • Two key issues in the North-South divides : i) the declining TOT (Prebish-Singer Hypothesis); ii) High price volatility and instability; • Explained in terms of fundamental differences on supply and demand sides affecting price formations between primary commodities and manufactured goods (e.g. low income elasticities on the demand side and technology advancement etc for the declining TOT as well as low short-run price elasticities on both demand and supply side for high price volatilities of tree crops and minerals); • Increasing high price volatility due to the closer two-way links between financial and commodity markets (Maizels 1994); • Numerous empirical studies: i) Large price volatility dominating secular decline in real commodity prices; ii) the real commodity price index fell by four-fifths between 1900-1999 (the link between the commodity crisis and debt crisis in the 1980s and 1990s. • large commodity price cycles have become more frequent with shortenedduration and increased amplitude over the recent decades. SOAS Commodity Workshop, September 2008

6. Commodity Prices: Trends and Volatility(1862-1997) SOAS Commodity Workshop, September 2008

7. International Commodity Agreements (ICAs) • The focus of attention of the “commodity problem” mainly on short-term price instability and its effects on export earnings and income of commodity-dependent DCs (Maizels, 1992-1994). • Keynes (1938& 1942)- the importance of establishing buffer stocks for the main commodities (reflecting his deep understanding of the effects of commodity price dynamics on financial &macro performance); • Integrated Programme for Commodities of UNCTAD in 1976 –ICAs (Cocoa, Coffee, Rubber, Suger and Tin)- price stabilisation within a band through financing buffer stocks or export quota; • The collapse of ICAs by the end of 1980s (finally the abandonment of INRA in 1999): • Technical problems with implementation of ICAs and the lack of political and financial support from consuming countries (disagreements over stabilisation bands at the time of sharply declining prices; collective action problems and disincentives, free-rider problems) • CCFF (high conditionality) STABEX, FLEX- pro-cyclical disbursement etc • With the collapse of the ICAs, a shift to the use of risk hedging instruments. SOAS Commodity Workshop, September 2008

8. Selected Commodity Prices (1957-2005) SOAS Commodity Workshop, September 2008

9. Nominal commodity Price indices (1957-2008) SOAS Commodity Workshop, September 2008

10. Monthly Commodity Pice index by commodity groups (1995-2008) SOAS Commodity Workshop, September 2008

11. Recent Trends: General Observations • The general commodity price index in US dollars from 100 in 2000 to 300 in the mid-2008, but not uniform across commodities; • The sharp rise in the last two years (2006-8) of basic and political sensitive goods, pushing fuel and foodcost, affecting adversely the poor most; • The price of tropical beverages and agricultural materials increased less, but, the prices of vegetable oilseeds and oils (bio-fuel crops) increased sharper than general food crops; • The sharpest increase of all is for mineral commodities (copper, zinc, nickel, iron, aluminium etc.) • The shifts in fundamental demand-supply relationships -a key factor for price movements for commodities over medium term(China and India factors on the demand side, and supply constraints due to subdued investment in the low price periods of the 1980s and 1990s); • Inventories was low at the time of price surge for minerals – asymmetry in inventory and price movements; • The high correlation between minerals, and agricultural vs energy prices SOAS Commodity Workshop, September 2008

12. Inventories and Stock-Price Relationships for minerals SOAS Commodity Workshop, September 2008

13. World Cereal Consumption, Production, Stocks and Prices SOAS Commodity Workshop, September 2008

14. Recent Trends: General Observations (cont’d) • Close interlinks between oil and agricultural commodity prices through higher transport costs and other input cost; • Higher food prices from the abrupt shift in arable land use from food crops towards bio-fuel crops (the Climate-change effect); • Increases in demand for agricultural products from EM economies; • Neglected agricultural sectors, resulting in low investment in agricultural technology and supporting infrastructures: • Over medium term – an entering into a super price cycle? • Realprices of non-fuel commodities still follow a downward trend from a longer historical perspective for 1960-2007; • continuing high price volatility – the rapid growth of commodity derivatives markets since the early 2000 – associated with dot-com babble-burst and the recent upheaval in financial markets – the flight from equities/bonds to commodities as well as inflation hedging; • New actors in commodity markets ( investment funds, pension and hedge funds and sovereign wealth funds); • High correlation across commodities as a result of commodity index trading- noise trading – and less reflective of the fundamentals. SOAS Commodity Workshop, September 2008

15. Primary Commodity Prices: Real and Nominal Real Price Real Price Tend Nominal Price SOAS Commodity Workshop, September 2008

16. Price Volatilities of Non-Fuel Commodities vs Fuel and Manufacturred goods SOAS Commodity Workshop, September 2008

17. Changes in World Market Structures • The need to understand structural changes and institutional arrangements (Maizels 1984);Commodity markets – not text book perfect competitive markets • oligopsonistic and oligopolistic market structures - the relative bargaining power of actors shifting in favour of TNCs (Maizels 1984); • The effects of derivatives markets on commodity price dynamics: • Q: whether futures markets operate as an efficient mechanism for price information and discovery in the presence of powerful trading conglomerate TNCs and portfolio investors with little interests in physical commodities; • Q: Whether price volatility is exacerbated by the entry and presence of speculative noise trading or the prevalence herd behaviour (Pindyke (2004) ; SOAS Commodity Workshop, September 2008

18. A Case study of NYBOT Coffee Markets - A test of the ratio of non-commercial open interest to total open interest -test ofstructural breaks in this ratio & in the relationships between prices and world demand and supply - test of the monthly volatility index of future prices and future trading activities; reflecting new kind players since 2000 SOAS Commodity Workshop, September 2008

19. Evolving Global Commodity Chains (GVCs) and the Price Transmission Process • Actors in commodity producing countries have become marginalized and isolated with withdrawal of institutional support and the subsequent loss of their bargaining power, as vertically integrated TNCs had consolidated their positions over GVCs (production, processing and marketing); • The parallel process of fragmentation and integration has often resulted in a hugely skewed distribution of gains from commodity trade. • The governance structures of GVCs have become buyer-driven with a shift in the distribution of value skewed in favour of consuming countries ; • The widening gap between producer and retail prices for a composite bundle of commodities- showing how much rents can be created and how skewed rents distribution is in commodity chains. • Hedging instruments do not provide a perfect risk management tool -the greater divergence between spot prices and future prices; • Hedging instruments require high liquid resources; SOAS Commodity Workshop, September 2008

20. Evolving Global Commodity Chains (GVCs) and the Price Transmission Process (Cont’d) • An examination of the price transmission mechanisms along coffee supply chains and how different actors are engaged in price risk management • A market consolidation by very large multinational commodity trading conglomerates in green coffee and processing • Conglomerates with own in-house brokerages in futures and options and research departments- engaging in hedging as well as speculations with knowledge of both physical and derivatives markets ( the use of a “price-to be fixed contract, linking to prices on future markets at delivery date through hedging); • Smaller single-commodity trading firms have entered into niche markets, trading in specialty coffees SOAS Commodity Workshop, September 2008

21. Impacts of Changing Market Structures on Producers • Changes in Institutional environments at the National Level • State-run marketing boards were dismantled or downsized and price stabilisation funds or mechanisms ceased to exist; • Domestic commodity traders and producers are exposed to greater price risks as volatile prices are transmitted from the downstream to the upstream; • International Task Force on Commodity Risk Management (ITFCRM) to promote a application of risk hedging management by actors in upstream; • Issues- the prohibitive financial cost and skewed access to information and high technical barriers for small actors as well as creating an adequate regulatory oversight agency ; • Resulted in geographical fragmentation of marketing activities, and placed small-holders in a weaker position viz private traders in both inputs provisions and marketing of their produce. SOAS Commodity Workshop, September 2008

22. Price Risk Management in Upstream Coffee Chain in Uganda and Tanzania • In the pre-liberalisation period: • in Uganda -a dual marketing system with both private and cooperative channels but controlled all exports under the Coffee Marketing Board. Price risks were borne by the marketing boards: • In Tanzania- marketing was conducted through the cooperative marketing system and all exports went through the coffee auction. Price risk was borne by cooperatives but shared out amongst members through the payment system to smooth out farmers’ income. • In the post-liberalisation period: • In Uganda- most liberalised system. The marketing is dominated by the top 5 companies (all subsidiaries of large MNCs) taking over 70 % of market share: • In Tanzania- the auction system retained and cooperatives remain strong in N. regions: law to eliminate captive coffee prohibiting local traders from profiting at the auction, but again the top 5 MNC subsidiaries’ market share of 68 %. SOAS Commodity Workshop, September 2008

23. Price Risk Management in Upstream Coffee Chain in Uganda and Tanzania • In Uganda, local traders shielded from intra-day price fluctuations, through MNCs hedging, but are exposed to inter-day or weekly swings. To protect their interests, they purchase coffee at stable, but low prices. Producers are offered low farm-gate prices – coffee production has been declining despite increasing world prices. • In Tanzania, where cooperatives remain strong, farmers are protected through the payment system, allowing farmers to smooth income within season to some extent. Auctions take place weekly, so weekly price fluctuations are shared among members. In other areas, gfarmers organise some POs. A tendency to get into niche markets with premium prices (fair-trade marketing etc with the use of forward contracts-Kili-cafe). -Still coffee production falling in Tanzania too. SOAS Commodity Workshop, September 2008

24. Changing institutional environments for coffee and cotton farmers and their consequences in Tanzania • After liberalisation, both sectors suffered from institutional vacuum: In the cotton sector cooperative unions collapsed, while in the coffee sector, cooperative unions and POs survived in N. regions, but facing resource constraints: • In purchasing and processing: • In cotton: no thriving markets with competing traders and ginners. Producers are spatially fragmented and isolated both between and within villages. The poorest hardest hit. • In coffee: Choices between selling traders or coops. More differentiation taken place, smaller holders hit hard. • In input provisions: In both sectors, no reliable supplies- most devastating. Neither the passbook system of CDF for cotton, the voucher system for coffee not working for the poor, exploited by ginners and traders. • In extension services, access to new technology & information: Ukiriguru for cotton and TACRI for coffee under-funded, and no systematic provisions: • Implications for farm-gate prices for cotton and coffee – Farmers are fragmented between and within villages- no competitive integrated market. SOAS Commodity Workshop, September 2008

25. Cotton Prices (World, export and producer Prices) SOAS Commodity Workshop, September 2008

26. Coffee Prices (World, export and producer Prices) SOAS Commodity Workshop, September 2008

27. Managing Resource-Based Economies over Commodity Price Cycles • The economic cycles of commodity dependent DCs are dominated by commodity price movements; • The hypersensitivity to externally originated instability is one of the critical weaknesses of natural resource-rich economies; • An eventual transformation into diversified economic structures is the real solution to the problems; • The “commodity trap” can be overcome only through an effective use of natural resource rents in the transition period; • Successful economic management over the commodity price cycles, are indispensable for the critical intervening period; • Yet, so far, demand management has been pro-cyclical to the direction of both internal and external market forces rather than counter-cyclical; • Dutch-Disease is by no means inevitable, and its symptoms are observed because economies tend to run into short-term absorptive capacity and supply bottlenecks; • The policy of time-phasing is one key - a policy of de-synchronization of the path of absorption from that of income. SOAS Commodity Workshop, September 2008

28. Macroeconomic Management over Commodity Price Cycles • Intertemporal optimal allocation of resources is an issue of intelligent portfolio management of a whole range of domestic and foreign assets and liablities in the light of the current and the expected return‑risk structure over the commodity price cycle; • A call for a strategic approach to fiscal and financial management of mineral rents over a medium term price cycle of commodities; • Decisions over the inter-temporal portfolio allocation of rents for smoothing an absorption path as well as over the spending and expenditure patterns i.e. the sectoral allocation between tradables vs non-tradables or domestically produced goods vs imported goods, in view of avoiding to aggravate various critical supply bottlenecks. • Allowing a time to build supply capacity to move PPF outwards. • The role of exchange rate policy combines with an appropriate monetary framework with a view of intra-cycle movement of the real exchange rate. • Taking into account the tendency of Dutch Disease Syndrome induced by market forces; SOAS Commodity Workshop, September 2008

29. Exchange Rate Management • The centrality of a coordinated policy framework to work out appropriate exchange rate management and monetary policy regimes not only for a short-run stabilisation purpose, but also for avoiding the detrimental long-term effects of a commodity boom; • Allowing a flexibility but managing with a view of controlling and reducing volatility in a countercyclical manner • Evaluation- the proposals for the Inflation Target framework for monetary policy under a floating regime and the commodity currency(Peg the Export Price,PEP) regimes for exchange rate managementthe inflation; • IT regime with a pure floating; a nominal anchor to be provided by a credible institutional commitment to the IT regime( with intermediate regimes vanishing under the impossible trinity)– transparency and accountability; • Fear of floating prevails in EMs, so operating with an escape close for CA management; • In LDC, fear of floating coming not from a high pass-through rate or liability dollarisation but from fear of macro instability from CA development; SOAS Commodity Workshop, September 2008

30. Exchange Rate Management (cont’d) • Exchange Rate Protectionism – actively using exchange rate as a development policy tool (Korea, Chile and Botswana) for attaining a desirable CA position on a sustainable basis by keeping exchange rate at competitive levels to pursue export-led growth; • The IT regime may subject economies to large swings and shifts in the real exchange rate. • The PEP (Commodity Currency) Proposal by J. Frankel- peg – to peg to the real price of main export commodity (or commodity index- PEPI)-,i.e. to stabilise “the price of local currency in terms of commodity” ; • “PEP delivers simultaneously a nominal anchor as promised under a fixed exchange rate regime and automatic adjustment in the face of commodity price fluctuations on world markets as promised under a floating regime”. • PEP- the export price targeting instead the Inflation Targeting based on CPI , to take into account TOT shocks; • Operationalising PEPs – it can be set with in a band on a monthly basis, rather than daily operations; • Many questions to be answered about suitability as a counter-cyclical instrument on a basis of simulation analyses. SOAS Commodity Workshop, September 2008

31. Changing Landscape Governing the Mining Sector and Macroeconomic Environments – Zambia vs Chile • Privatisation of mining industry in Zambia and Chile; • In Zambia, ZCCM privatised with a small share allocated to the government; TNCs benefiting from very low royalties and low taxes on profits; contribution of mining rents to the fiscal budget- marginal. • In Chile, CODELCO privatised, but negotiated to retain government’s share of 40% and fair tax rates constantly renegotiated; Fiscal surplus is saved in a sovereign fund offshore, according to the structural budget rule set with a view of medium term copper price forecasts to relieve short-run absorptive capacity constraints • Monetary and exchange rate regimes • In Zambia: aggregate monetary target with a floating regime only to smooth out extreme short-run volatility – now a move to the IT regime is under consideration: Exchange rate is not deployed as a development tool ( See Bova’s econometric study of the inflation-appreciation trade-off revisited). • In Chile: active management of exchange rates with in a band till 1999, and a shift to the IT regime with a escape clause to keep CA in balance. SOAS Commodity Workshop, September 2008

32. Comparative Analysis of Real Exchange Rate Movements (Chile and Zambia) SOAS Commodity Workshop, September 2008

33. Concluding Remarks • The hypersensitivity to externally originated instability is one of the critical weaknesses of commodity-dependent low income countries ; • The real answer to the “commodity Trap” – transformation into diversified economic structures, which require rigorous investments in production capacity and physical and social infrastructures. • Call for a strong commodity sector, where the process of activelearning-by-doingexperiences and accumulation can take place; • The new landscape emerging under globalisation tend to discourage this process of learning and accumulation; • The institutional environments facing commodity producers both at the global and domestic levels in SSA have weakened the capacity and resiliency of small holders and mining industries; • The need for strengthening international and domestic institutions governing commodity trade and production throughout commodity chains; • more active forms of cooperation and joint action with TNCs to accelerate the learning process; • The renegotiation of distribution of mineral rents and more regulations over transactions on derivatives markets. • Calls for a more innovative compensating financing facilities as ex-ante debt relief mechanism. SOAS Commodity Workshop, September 2008