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Remember $150 oil?

The recently concluded G-20 summit in London was a missed opportunity for India in pushing at least one big idea...

Written by David Pais |
April 13, 2009 10:11:47 pm

The recently concluded G-20 summit in London was a missed opportunity for India in pushing at least one big idea: dealing with the problem that is the price of oil and its increasing determination within the fickle global financial system. Stable commodity markets which reflect the fundamentals of the real economy are a global public good and the G-20 summit was the ideal forum to institutionalise this,preventing thereby a recurrence of the food and fuel riots and all their attendant instability.

The summit was historic; the shift in the balance of economic power was unmistakable. For the first time,emerging market economies sat at the same table as equal partners with the developed economies. India’s role was widely interpreted as being suitably constructive,pushing for achievable goals like reforming the governance structure and resourcing at the IMF, while not over-reaching like China did with demands for a new global currency.

However,India dropped the ball on one of the crucial dimensions of the crisis — the need for much tighter regulation of global commodity markets. This would have tapped into the two themes being pushed at the G-20 — fiscal stimulus (US and UK) and greater regulation (France and Germany). Even producer countries like Russia and Saudi Arabia were likely to be in favour of greater regulation; price volatility has brought significant instability to their economies,with the resultant debt overhang in Russia proving to be particularly debilitating.

Only nine months ago oil prices were $147 and inflation in double-digits,prompting a global backlash ranging from hearings in the US Congress to violent protests on the streets of Haiti. While some the market ‘fundamentalists’ tried to justify the surge in commodity prices on the basis of higher demand and tighter supply,subsequent events have belied that analysis.

It is now fairly clear that the surge in commodity prices was by and large the product of two principal dynamics in the financial markets: first,pro-cyclical leverage — banks would take on debt and use the proceeds to buy assets,which pushed up prices and gave the appearance that banks’ balance sheets were healthier than they actually were — thus encouraging banks to take on even more debt. This generated excess liquidity,flowing to every nook and cranny of the hyper-efficient global financial system.

The second dynamic involved commodities increasingly being accorded the status of an ‘asset class’ in their own right. This meant that rather than the traditional participants — suppliers and end-users — commodity markets became the domain of an entirely different investor class,from highly leveraged hedge funds to ‘real money’ pension funds.

It was principally this combination of excess liquidity and external investor interest which resulted in commodity prices reaching the levels they did. Proof: the markets’ highly implausible elasticities over the last 9 months — as also day-to-day price action which bore all the hallmarks of large scale de-leveraging by investors. The fundamentals of the global real economy simply did not justify the price of oil dropping $10 one day,going up $10 the next and falling $10 the day after.

Regrettably,nothing has been done to rectify this. Worse,the Fed’s attempt to kick-start the credit markets will inject trillions of dollars in ‘quantitative easing’ targeting not just Treasury bonds but a wide swathe of assets; a significant proportion of this huge

injection of liquidity risks missing its target and instead finding a home in the commodity markets. And,given the consensus that emerging markets will emerge relatively quickly from the slowdown,it won’t be long before the likes of Goldman Sachs re-emerge from the woodwork and once again start pointing to increased demand as justification for oil at $200.

The policy solution lies in jettisoning free-market orthodoxy and recognising commodity markets should never be treated as an

“asset class”. Regulators should prevent non-commercial interests from participating in these markets. While implementing this won’t be easy,there was a clear political head of steam building ahead of the G-20 towards more regulated financial markets. This political will could dissipate as countries seek to gain competitive advantages and move to implement their individual responses to the crises.

It ’s not too late. India is still uniquely placed to lead the G-20 on this issue. It’s an emerging market and net commodity importer,and has sought to maintain a healthy balance between regulation and functioning markets. Also,the intellectual calibre of the current Indian leadership is held in particularly high esteem around the world. The US will be the key and given the public’s current high levels of resentment towards Wall Street,now would be a particularly propitious time to push for greater regulation of the commodity markets.

The writer,who has worked for Citigroup and Morgan Stanley,is an economist and strategic analyst now based in Delhi

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