Finance and farmers:
Hunger games
25 March 2013. A
World to Win News Service. As enormous amounts of investment are sifting into
agricultural-related activities, instead of solving the food problem there are
dire consequences for the world's people and the planet. The capitalist system,
which can only work through the obscene accumulation of wealth in the hands of
a tiny handful of people, is the main reason why getting adequate nourishment
continues to be such a problem for so much of the world's population.
In AWTWNS 130225 we
examined the consequences of the land grab going on in Africa and elsewhere. To
look at the question of food from another angle, we are reprinting the
following excerpts from an article that appeared in the West Bengal-based journal Sanhati (no. 11, 1 December 2012).
Here Ramaa Vasudevan gives her views on one of the new factors keeping "a
billion families hungry and impoverished", the role played by financial
speculation and the food commodity markets. The full article, including the
footnotes, is at www.sanhati.org.
Introduction
The pernicious impact of rising food prices across the globe has exacerbated the global food crisis. The effects of climate change on crop harvests, the impact of agro-industry on farming practices and food security, the pressure of growing demand for food from the rising middle classes of Asia, the competing claims of the bio-fuels industry and the tensions created by the ongoing corporate land-grab in Africa are of course integral to understanding how the food crisis was engendered. But the price shock cannot be explained solely on the basis of these structural factors that shape the supply and demand for food.
Apart from the underlying structural factors there is clearly something more going on. This something else is the role of finance – the banks that have been betting recklessly on food prices.
Finance has seized commodity markets and overwhelmed their functioning. Apart from transforming the structure of food production globally, this reign of finance has also fundamentally altered the manner in which food markets work. Before telling that story, however, a brief discussion of the commodity futures market would be useful in clarifying the link between the role of finance and the food price hike.
The futures market
A futures contract is a tradable agreement to buy or sell a specified quantity of a commodity at a future date. Futures in agricultural markets have a long history and in theory play a crucial role as a hedge against unexpected price movements. For the seller of the commodity like a wheat farmer, the agreement to supply the good at a future date (a short position) at the price locked in by the future contract is a hedge against any fall in the price. For the buyer – say a flour producer – on the other hand, the contract to acquire the good in the future (a long position) insures against any spike in price. For the advocates of futures markets, a well functioning market, besides helping to offset risks of price volatility, is also regarded as helpful to the process of price discovery – allowing buyers and sellers in the actual physical market to gauge the price prevailing in the markets, and make sensible decisions about production and delivery. As futures prices rise above spot [immediate delivery] prices, the argument goes, producers will start expanding production, while buyers will try to stock up in the present so that spot prices rise and future prices tend to fall. Futures price and actual spot price would, in this scenario, tend to converge and so the prices prevailing in the futures market serve as useful benchmark for pricing actual trades in the spot market, particularly in the context of globalized integrated markets.
Though futures may have been devised to facilitate actual physical trade, the prospect of returns brought in speculators who did not need any actual hedge [in this case, investment] in the actual physical commodity. The speculator, in the ideal world of mainstream economic theory, takes on the brunt of price risk while providing more funds and liquidity to the market, for instance by buying wheat futures from a farmer when flour mills and other buyers are not in the market, in the hope of making a profit from price movements. Unlike the hedge contracts of the actual physical traders, which are one time transactions where they either deliver the good or sell the future before the delivery date, speculators trade these futures many times. The commodity futures market is a peculiar hybrid of these two types of traders and its evolution in the recent decades reflects the process by which finance has come to dominate this global market.
Financialization of commodities
In the postwar period, the focus of policies to stabilize agricultural and other commodity markets shifted to price support and public buffer stock policies. After the crisis of the seventies, however, futures markets were promoted as the favoured strategy for stabilizing commodity prices. In 1974 the Commodity Futures Trading Commission was set up to regulate commodity futures and option markets in the United States and for a while the markets remained tranquil.
In 1991 Goldman Sachs came up with an innovation that would transform the market. The bankers devised the Goldman Sachs Commodity Index, a weighted average of the future prices (based on contracts of between one to three months) of a basket of twenty-five commodities including agricultural goods, livestock, energy and metals. The wizardry of financial engineering transformed a mathematical construct into an engine of easy earnings! Other banks, like J.P. Morgan in 1994 set up similar index funds. The GSCI index was followed by the Dow Jones –AIG index (now Dow Jones U.B.S index). Index speculation began to pick up.
The rise of the index speculator
Investors were caught up in the search for new avenues of profit in the wake of the dot com bust were drawn into a favoured way investing called index swaps. They were touted by the dealers as an "asset class" in their own right, and had the added "virtue" of performing well when equities [stocks] went into a downturn and when inflationary pressures picked up. They were offered to clients, including pension funds and mutual funds, with the promise of "equity-like" returns and risk diversification, and the swap-dealers grew richer on the proceeds. With the collapse of the housing bubble, and the unravelling of the architecture of fancy and arcane financial products that was built around the housing bubble, commodities became even more attractive market. Over the counter commodity derivatives trade, which had been growing steadily through the decade surged sharply in 2007-8 before plunging as financial markets imploded. Speculation in commodity derivatives rose against the backdrop of a falling dollar.
The big impetus, however, came from the growth of index speculation. In 2008, 85-90 percent of index speculators traded through swaps and four swap dealers – Goldman Sachs, Morgan Stanley, J. P. Morgan and Barclays – controlled about 70 percent of commodity index swap positions. Exchange traded funds are another way for investors to bet on commodity indices. The added wrinkle is that investors can buy and sell shares in the fund. The growing dominance of index speculators and the concentration of the market for commodity derivatives in the hands of a few big banks has transformed the commodity futures market completely.
The long shot
Futures markets were supposed to provide a hedge against risk and facilitate price discovery. In an ideal world "traditional" speculators would enter into both long positions and short positions, so that the pressure on prices would in the normal course swing either way. In stark contrast the index speculator enters only into "long positions" and quite often intend to maintain these positions for a long time. The index fund managers keeps accumulating "long positions" since they continue to buy passively, regardless of price. To avoid having to actually make a delivery the trader simultaneously buys a more distant future and sells the expiring future, a double transaction called the calendar spread. Physical delivery becomes irrelevant as the transactions can continually rolled over in this way. A vibrant market for these calendar spreads has emerged. In effect the index funds are hoarding commodity futures and pushing futures prices upwards, independent of any future market.
In fact, index speculators bought more commodities futures than physical traders and traditional speculators put together in the period from 2003 to 2008. In the hybrid futures market index speculators effectively cornered the market through this unrelenting stream of buy orders. This corner has emerged quite independently of any stockpiling of actual commodities or any real physical orders!
The absence of physical hoarding has been one argument raised against those who blame speculation for the steep rise in food prices. The argument is that rising future prices will raise current prices only if suppliers start hoarding food and artificially restricting food supply. The fact of the matter is that speculative pressure can inflate future prices quite independently of physical hoarding. Index speculators, who entered the fray in search of returns, to hedge against inflation or the falling dollar or simply to diversify their portfolio, have added a whole new dimension to demand. Funds invested in commodity index replication strategies grew from $13 billion in 2003 to $317 billion in July 2008 and are still rising. At the same time the prices of the 25 commodities that made up the index rose by an average of over 200 percent.
A paradoxical and perverse impact of the surge into index funds was that commodities, whose prices earlier moved in unrelated ways, began after 2004 (even before the collapse of the housing bubble) to move together and exhibit spillover effects as investors would trade in and out of the entire group of commodities constituting the index at the same time. Energy commodities dominate these indices while food commodities are a much smaller share. Future prices of the non-energy commodities in the index began to display stronger correlations with that of energy commodities after 2004. This suggests that grain and agricultural prices could in a sense be swayed by the tide of energy prices, without regard to the actual situation in their own markets. The illusory alchemy by which a number was turned into profits, it turns out, had far-reaching consequences beyond the calculations of the financial engineers who devised them.
The food bubble
There has been some debate on the mechanisms by which rising future prices pull up spot prices and whether speculation played a role in the food price rise. There is empirical evidence suggesting that spot prices are led by future prices. In grain and energy markets in particular the common practice is to price the spot transaction at the future price plus or minus a spread (to take into account local factors like transportation costs). With futures being promoted for their role in price discovery, it is not surprising that the future prices are regarded as a good signal of market conditions. It does make intuitive sense that as exchanges for agricultural commodities develop and become more globally integrated, dispersed agricultural markets will rely more and more on centralized future markets as benchmarks for spot transactions, more so with the spread of electronic trading and the larger volume of information flows. With the promotion of futures trading exchange trading, a dealer of grain in exchange, say in India, would turn to the global trends in the futures markets as a reference pricing transactions.
The dominance of speculative finance however distorts the relation between future prices and market conditions. This is not to say that the fundamentals of supply and demand are irrelevant to soaring prices. Recurrent and persistent drought conditions in different parts of the globe, dwindling investments in agriculture, the switch of vast swathes of land to bio-fuels, for instance, have all without doubt played a role. But the dominance of speculators in the market has swamped the food market. The commodity futures market has undergone a sea change in the past decade. In 1998, in the US, only 7 percent of all long open interests – outstanding future buy orders that are unfulfilled at a particular date – were held by index speculators and another 16 percent by other speculators. The bulk (77 percent) of these contracts was held by physical hedgers [investors] who were actually involved in buying and selling commodities. By 2008 the share of index speculators had grown to 41 percent, the traditional speculators to 28 percent while physical hedgers had fallen to about 31 percent. About two-thirds of futures positions are held by speculators today. In these ten years the positions of speculators rose by about 1,300 percent while that of commercial hedgers (actually trading in the commodity) rose by only 90 percent. There is thus a huge source of speculative demand that is unrelated to actual demand and supply of these commodities.
The problem is not simply that the futures market is inherently pernicious. It is the logic of finance that has taken hold of the commodity markets that has made the market a hunting ground for finance in its continual search for new prey. The futures markets have become compromised, both as a mechanism of price discovery and means of insurance against price volatility, by the frenetic forays of finance to exploit every speculative opportunity.
Futures trading has been promoted in India as enabling small farmers to benefit from high prices and sidestep the rapacious middlemen-traders, and become a player in a more globally integrated market. With the growing dominance of global investors in these futures markets, the middlemen – who would tend to enter the futures market primarily as hedgers (even while fleecing small farmers who supply the grain) – would get swamped by global investors seeking speculative returns. The spike in prices as a result of this speculation, however, need not translate into higher earnings for small farmers, who could continue to sell to the middlemen at low distress sale prices. Nor do they lead to higher levels of investment in agriculture in the absence of necessary infrastructural and related support to small farmers. While global agro-industrial capital has been engaging in a renewed land grab, in particular in Africa, for global institutional investors it is more profitable and easier to play with commodity index funds rather than in direct investment in agricultural production.
The tragedy is that this gamble on food and commodity prices is depriving more than a billion hungry and impoverished families of access to food and grain.
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