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Financial Markets and the Commodity Price Boom

Causes and Implications for Developing Countries

Cornelia Staritz

Wien, April 2012

The current commodity price boom in combination with high price volatility is historically unprecedented even in the volatile price history of commodities. After two decades of low commodity prices in the 1980s and 1990s, many commodities had registered steep price increases since 2002 reaching a peak in mid 2008. In the second half of 2008 prices fell sharply across commodities but they began to rise again in the first half of 2009 and non-fuel prices reached an all time high during summer 2011. Thus, despite large fluctuations in recent years commodity prices remain well above their historical levels constituting a commodity price boom. While the timing varied for different types of commodities the surge in prices, the sharp correction and the subsequent rebound affected all major commodity categories, including agricultural, metals and energy commodities.

Commodity price dynamics have crucial implications for developing countries, in particular for commodity-dependent low-income countries (LICs). They are affected by high and volatile commodity prices through the import and export side with effects on import costs and export revenues as well as macroeconomic indicators, i.e. the balance of payments, public finances, inflation and exchange rates. As many developing countries are net importers of basic commodities such as fuel and food, commodity price dynamics have direct effects on food and energy security, poverty and economic stability. The impact of the price hikes in agriculture commodities has been most dramatically reflected in food crises with dramatic humanitarian, social and economic consequences in many developing countries in recent years. On the export side, the persistence of commodity dependency remains an important characteristic of many developing countries, in particular in Sub-Saharan Africa (SSA). These countries have benefited from rising revenues from commodity exports but the high price volatility has also highlighted their vulnerability and difficulties in managing their economies.

Given these far-reaching implications, the current commodity price developments call for explanations. Commodity prices are determined by fundamental supply and demand conditions in physical commodity markets. In the last decade these market fundamentals have changed importantly related to increasing demand for commodities from highly growing emerging countries, alternative uses of commodities for energy production (biofuels), and a Research Department 5 reduction in supply due to supply constraints and stagnation in production and productivity related to low investments in the last two decades. Simultaneously to these fundamental supply and demand related changes, trading activities on commodity markets have undergone major changes with the increasing presence of financial investors, including banks, institutional investors and hedge funds. Trading volumes on commodity derivative markets and the share accounted for by financial investors have increased sharply, particularly since 2005.

This paper discusses these changes with regard to fundamental factors and commodity markets and assesses their impact on commodity prices. Further, the paper identifies implications of these developments for developing countries and policy reforms with the objective to stabilize commodity prices and mitigate the negative impacts of the commodity price boom on developing countries.

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