Commodity Prices Primary importance

Commodity Prices
Primary importance

At a lunchtime meeting on 26 February, L Alan Winters and Christopher Gilbert discussed the findings of a new book published for CEPR by Cambridge University Press on Primary Commodity Prices: Economic Models and Policy. The volume is based on an international conference held by CEPR in spring 1989, with support from Rio Tinto Zinc, the Centre for Economic Policy Research International Foundation, the European Investment Bank, the Foreign and Commonwealth Office and the Overseas Development Administration. The lunchtime meeting was supported by CUP and by CEPRIF. Winters is Co-Director of the Centre's International Trade programme; Gilbert is a CEPR Research Fellow and a contributor to the book.
Commodity price fluctuations can cause severe disruption to both private and public sectors, Winters noted. Producer governments can misjudge the duration of price booms, over-extending their economies, while for the private sector, rapid changes in cash-flow can disrupt investment and even cause bankruptcy. Such phenomena explain why great efforts are made to predict commodity price movements and to develop models capable of explaining them. Primary Commodity Prices: Economic Models and Policy contains a number of such studies, including some focusing on particular agricultural, metal and energy markets. Whatever our understanding of commodity price fluctuations, however, there will always be a desire to mitigate their effects, in particular on the earnings of commodity-producing countries. Two chapters in the book examine different responses to these problems.
Roland Herrmann, Kees Burger and Hidde Smit focus on how such schemes have operated, starting with two price stabilization agreements often cited as successful. They show that, contrary to its declared objectives, the International Coffee Agreement's principal effect has been a 30% rise in coffee prices for ICA members, not more stable prices. In 1982/3 it redistributed over $2 billion from importing members of the ICA to producing members. As redistributive policies, however, such transfers are necessarily less effective than targeted financial aid. The International Natural Rubber Agreement has been more successful at stabilization, reducing the variance of prices by one-third, but its success is a poor precedent for other commodities because natural rubber is unusual in being a perennial crop with a rather stable level of output which adjusts quickly to price changes.
Herrmann, Burger and Smit also analyse two `compensatory finance' schemes: the IMF's Contingency and Compensatory Financing Facility (CCFF) and the EC's STABEX. They find that neither has been effective: the median effect of the CCFF on foreign exchange inflows has been a 0.6% increase in instability, and of STABEX a reduction of only 0.2%. Among the reasons are delays in making payments and errors in identifying shortfalls in export earnings. In addition subsidized interest rates encourage governments to keep CCFF and STABEX borrowing at the maximum permitted level for as long as possible, so new borrowing is frequently impossible when an earnings shortfall emerges. The policy conclusion, Winters suggested, is that the borrowing limits under the schemes should be increased but their `grant' elements abolished.
In another chapter in the book, Andrew Hughes Hallett and Prathap Ramanujam compare such public sector responses with private hedging on forward markets. In four markets (jute, coffee, cocoa and copper), they found that both hedging and stabilization would significantly reduce earnings fluctuations, and by relatively similar amounts (see table). Doing something is more important than what is done. In so far as they differ, price stabilization offers the greater reduction in variance when demand is inelastic and prices and quantities are negatively correlated; hedging is desirable otherwise. An improved range of instruments should be developed to allow hedging in private markets, Winters argued.

Table: Hedging vs Stabilization

	Reduction in variance of earnings (% of free trade variance)
	Hedging	Stabilization	Preferred Policy
Jute	23.1	16.8	hedging
Coffee	62.0	69.9	stabilization
Cocoa	37.9	37.2	hedging
Copper	81.8	82.4	stabilization

Gilbert began by noting the considerable differences between academic and private sector modellers of commodity markets. Industry analysts use short time series of data with very detailed cost and production information while academics, who generally cannot obtain proprietary data, use long but highly aggregated series. In his chapter on modelling metals markets in Primary Commodity Prices: Economic Models and Policy, industry analyst Tony Bird uses detailed data on aluminium production costs to construct an industry supply curve from which to evaluate the profitability of current capacity and new investment. Private sector analysts typically estimate a simple demand curve and infer a cost-justified price from the intersection of the two. The difference between this and the market price may then be related to stocks and expectations.
Academics turn this procedure on its head. Stocks and expectations move centre-stage, and considerable sophistication is employed to infer either unobserved industry price or quantity expectations (as Gilbert and Theodosios Palaskas do in their chapter in the volume) or to estimate models where expectations play the central role but remain off-stage (see the chapter by Pravin Trivedi). Rational expectations are central to academic explanations of financial asset prices, notably stock prices and exchange rates, which depart for long periods from fundamental values. But academics go too far, according to Gilbert, in viewing primary commodities as just another set of financial assets: they are part financial and part physical assets.
In the long run, he agreed, prices are determined by industry costs, and detailed information about existing capacity is vital in evaluating the profitability of new investment. But supply is often quite inelastic, so year-on-year price changes are dominated by changes in demand and stocks. In the short term, then, the prices of most commodities diverge substantially from those suggested by `fundamentals' such as production costs. Though econometric models of commodity markets are still not very effective at predicting these movements, Gilbert argued, they are looking in the right direction. He concluded that, if the information and long-term perspective of the industry specialist were combined with academics' dynamic and forward-looking models, the forecasts of both could be improved and better explanations of primary commodity prices eventually achieved.