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CLIMB a steep flight of stairs down a small side street in Fatehpuri, part of the bustling commercial hub of Old Delhi, and you
will come to a set of rooms overlooking an imposing internal courtyard. In one of them, half a dozen men lounge on mats beneath a
poster of Lakshmi, the Hindu goddess of wealth. Next to them is a clutch of telephone sets, each on a long wire cord. Outside hangs a
blackboard with prices scrawled in chalk. This is the trading floor of the Rajdhani Oils and Oilseeds Exchange, where futures
contracts for soyabean oil, mustard seed and jaggery (sugar) are bought and sold.
It seems a long way from the New York Mercantile Exchange, but the political heat on both places has been much the same of
late. Over the past couple of years India’s government has banned futures trading on commodities that include rice, wheat and lentils
to rein in prices and stop what it sees as dangerous speculation. And in recent months America’s Congress has been mulling a series
of measures to discourage similar speculation in oil markets. On September 18th the House of Representatives passed a bill that
would limit how much speculative traders, such as hedge funds or pension funds, could invest in commodities, and closed the "Enron
loophole", which allows energy traders to escape government regulation when buying and selling over the counter or on electronic
platforms. Japan’s government has tightened controls on futures trading and China has restricted foreign trading in its commodities
markets.
Speculators have long been a popular target for politicians frustrated by volatile commodity prices. In 1947, when wartime
controls ended and food prices soared, Harry Truman raised margin requirements (the share of the value of a futures contract that a
trader must post upfront with an exchange) to 33 %, vowing that food prices should not be a "football to be kicked about by
gamblers". In 1958 America’s Congress banned futures trading in onions for much the same reason.
But this time politicians are not the only ones who blame financiers for distorting prices. George Soros, a veteran investor,
declared earlier this year that commodities were a "bubble". Michael Masters, a hedge-fund manager, caused a storm when he told a
congressional committee in June that the price of oil (then $130 a barrel) might be halved were it not for financial speculation. Even
Shyam Aggarwal, the chief executive of the Rajdhani exchange, says futures trading in food products should be banned, at least
temporarily.
Broadly, these men all make the same argument: that the flood of money from pension funds, hedge funds and the like that has
poured into commodity futures in recent years is distorting spot markets for physical commodities. Rather than helping producers and
consumers to hedge their risks and set commodity prices more transparently and efficiently, futures markets have become dominated
by hedge funds, sovereign-wealth funds and so on seeking to diversify their portfolios. The speculative tail is wagging the spot dog.
If that argument were true, the consequences would be profound. Commodity prices have a more immediate impact on people’s
lives than do stock or bond prices, particularly in poorer countries, where many households spend much of their budgets on food. If
speculators are distorting commodity prices rather than improving price discovery, there may be good reason to shift the balance
between government and market.
Speculating about speculators
At first sight the finger does seem to point to the speculators. Commodities have become a popular alternative asset class for
investors. According to Barclays Capital, institutional investors had around $270 billion in commodity-linked investments at the end
of June, up from only $10 billion six years ago. The number of futures contracts on commodities exchanges has quadrupled since
2001. The notional value of over-the-counter commodity derivatives has risen 15-fold, to $9 trillion (see chart 6).
The timing of this increase coincides neatly with the long commodities boom. Prices since 2002 have soared by any yardstick.
The climb has been most pronounced in dollars, the currency in which most globally traded commodities are priced, because the
dollar itself has weakened. But over the past six years commodity prices have also risen in euros or indeed any other currency.
Speculation might also explain the extraordinary volatility of prices since the financial turmoil struck last August. As large
swathes of debt instruments suddenly became illiquid and risky, investors – so the argument goes – sought safety in commodities. As
America’s Federal Reserve slashed interest rates, so money managers, fearful of inflation, fled to hard assets, particularly oil. That
surge of cash created a new bubble which has recently burst.
On closer inspection, however, the speculation theory stands up less well. First, there is no consistent pattern between the scale
of investors’ purchases of a commodity and the behaviour of spot prices. For example, as investment funds piled into hog futures the
price fell sharply – even as prices of other commodities rose. Second, many of the commodities in which prices have soared over the
past few years, from iron ore to molybdenum, are not traded on exchanges and thus offer less opportunity for investors. Third, much
of the surge of cash that has gone into commodities futures is due to rising prices. As the price of a commodity goes up, so does the
value of a commodity-linked fund, even without any new money.
Lastly, stocks of most commodities have been low compared with their historical averages. This is important, because rising
stocks are the channel through which speculation in futures markets affects the spot price. When speculators push up the futures prices
of oil, for instance, they create an incentive for someone to buy oil in the spot market, sell a futures contract on it and store the oil
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