July 2010The greathungerlotteryHow banking speculationcausesfood crises
2The great hunger lottery: How banking speculation causes food crisesBy Tim Jones, World Development MovementWith particular thanks to Tom Lines, whose papers on food speculation and regulatingspeculation are available on the World Development Movement website at:www.wdm.org.uk/report/speculation-and-regulation-food-commoditiesWith thanks to Alex Wood for writing section 3.2.With thanks for comments to Julian Oram and Deborah Doane.July 2010About the World Development MovementThe World Development Movement (WDM) campaigns for a world without poverty andinjustice. We work in solidarity with activists around the world to tackle the causes ofpoverty. We research and promote positive alternatives which put the rights of poorcommunities before the interest of big business. WDM is a democratic membershiporganisation of individuals and local groups.Like what we do?Then why not join WDM or make a donation? You can call +44 (0)20 7820 4900or join/donate online at: www.wdm.org.uk/supportRegistered Charity No 1055675Company limited by guarantee number 3201959Designed by RevAngel DesignsThis report is printed on 100 per cent recycled,chlorine-free paper using vegetable-based inks.Cover image: Kindra / IRIN
3The great hunger lottery: How banking speculation causes food crisesContentsExecutive summary 41. Introduction 52. Playing the hunger lottery: The role of financial speculation 72.1 The impact of financial speculation on price increases and volatility 82.2 The murky world of commodity index funds 102.3 Market servant or market master 143. The impact of price swings 153.1 Hunger and poverty 153.2 Cash crops 183.3 Inflation 194. Other causes of the food price spike 204.1 Biofuels 214.2 Low crop yields 214.3 The future outlook for food 215. So what do we do about it? Reregulating speculation 245.1 Worldwide concern 245.2 Transparency 255.3 Position limits 265.4 Action in the US and EU 276. Conclusion 29References 31
great hunger lottery4The great hunger lottery: How banking speculation causes food crisesExecutive summaryTake the highest stakes, riskiest economicbehaviour ever devised, and marry it to themostfundamentalbasicneedofhumankind,and you have the subject of this report.Over the past decade, the world’s most powerfulfinancial institutions have developed evermore elaborate ways to package, re-packageand trade a range of financial contracts knownas derivatives. A derivative is not based on anexchange of tangible assets such as goods ormoney, but rather is a financial contract witha value linked to the expected future pricemovements of the underlying asset. Derivativecontracts are traded on a growing numberof underlying assets, from share prices, tomortgages, bonds, commodity prices, foreignexchange rates, and even index of prices.Derivatives trading has been one of the mostlucrative parts of the financial industry, butit is the increasingly complex, opaque anddisconnected nature of these and similar productsthat ultimately triggered the collapse of the banksand the worst financial crisis in human history.Of course, the financial crisis has been aneconomic disaster of seismic proportions formillions around the world, plunging manycountries into recession causing millions to bethrown out of work, soaring public debts and cutsin vital public services.But while betting on the value of sub-primemortgages or foreign currency valuesundoubtedly leads to disastrous consequences,there is another area where the speculativebehaviour of the world’s largest banks and hedgefunds represents a threat to the very survival ofpeople: food commodities.In The great hunger lottery, World DevelopmentMovement has compiled extensive evidenceestablishing the role of food commodityderivatives in destabilising and driving up foodprices around the world. This in turn, has led tofoodpricesbecomingunaffordableforlow-incomefamilies around the world, particularly indevelopingcountrieshighlyreliantonfoodimports.Nowhere was this more clearly seen than duringthe astonishing surge in staple food prices overthe course of 2007-2008, when millions wenthungry and food riots swept major cities aroundthe world. The great hunger lottery shows how thisalarming episode was fueled by the behaviour offinancial speculators, and describes the terribleimmediate impacts on vulnerable families aroundthe world, as well as the long term damage to thefight against global poverty.Inthereportwedescribehowthecurrentsituationcame to pass, the risks of another speculationinduced food crisis, and what specifically can bedone by policymakers here in the UK as well as inthe US and EU to tackle the problem.But at its heart, The great hunger lottery carries avery straightforward message: allowing gamblingon hunger in financial markets is dangerous,immoral and indefensible. And it needs to bestopped before any more people suffer to satisfythe greed of the banks.
In 2007 and 2008, there was a huge increase inthe price of food and energy. The InternationalMonetary Fund’s (IMF) food price index increasedby more than 80 per cent between the start of2007 and the middle of 2008. Oil prices went toalmost $150 a barrel. The impacts were felt acrossthe world. In rich countries, consumers werepaying more for food and energy. High pricescontributed towards pushing countries intorecession. And high levels of inflation led centralbanks into maintaining strict monetary policywhilst economies went into decline. The storyof commodity prices is a key part of the recentfinancial crisis and economic difficulties.But across the global south, the impacts wereeven more serious. Households in developedcountries tend to spend between 10 and 15per cent of their income on food. While poorhouseholds in developing countries tend to spendbetween 50 and 90 per cent.1High food prices lefthouseholds spending a lot more money on food oreating less. Combined with lower incomes due tothe global economic slowdown, high food pricesled to the number of chronically malnourishedpeople increasing by 75 million in 2007 and afurther 40 million in 2008.2As well as eating less food, households have beenforced to:Eat less fruit, vegetables, dairy and meatin order to afford staple foods.Reduceanysavings,sellassetsortakeoutloans.Reduce spending on ‘luxuries’ such ashealthcare, education or family planning.In this report we argue that part of the reasonfor the spike in food and other commodity priceswas financial speculation. Speculation rides onthe back of underlying changes in supply anddemand, amplifying their impact on price. Thisspeculation continues to impact on price, and aslong as it remains unregulated, there is a danger itwill contribute to a huge spike again.5The great hunger lottery: How banking speculation causes food crises1. Introduction
Section 2 presents the evidence that speculationinderivativesihasinfluencedtherealpriceoffood.It outlines the particular role of commodity indexfunds. It also shows how unlimited speculationhas also caused disruptions in the market, makingit more difficult for farmers to use derivatives tohedgeiitheir risk, and made futures markets lessable to predict future real prices.Section3showstheimpactspriceswingshavehad.It outlines in more detail how poor households indeveloping countries were impacted by the highprices and volatility of staple foods in 2007 and2008. It shows how farmers of cash crops such ascocoa and coffee also suffer from the increasedvolatility in the price of such crops.Section 4 discusses the ways in which real changesin supply and demand have contributed tochanges in food price in recent years.Section 5 outlines proposed ways of regulatingcommodity derivative markets to limitspeculation. Firstly, the extent of worldwideconcern about the impact of speculation oncommodity prices is shown. Two specific proposalsof how to re-regulate commodity derivativemarkets are then presented; clearing andposition limits. The current political situation andproposals in the US and EU are discussed.Section 6 concludes by summarising the reasonswhy governments should re-regulate commodityderivative markets. As well as preventingspeculation from amplifying movement incommodity prices, good regulation could:Make commodity derivatives markets moreable to help producers and purchasers tohedge their risk.Make commodity derivatives more able todiscover future real prices.Free up capital for use in genuinely productiveinvestment.Protect against default on commodity andother derivatives, the direct cause of therecent financial crisis and economic woesacross the world.Regulating commodity derivatives is a key partof the necessary response to the global financialcrisis. High and volatile commodity prices helpedtoprecipitateandexacerbateeconomicdifficulties.Unregulated, opaque derivatives hid major risksin the financial system which directly caused thefinancial crisis. Resources tied-up in unproductivecommodity derivative contracts continue toincreaseeconomicinefficiencyanddenyresourcesfor genuinely useful activities. This report showshow good regulation of commodity derivativescould help to tackle all of these problems.6The great hunger lottery: How banking speculation causes food crisesA derivative is a ﬁnancial contract which does not involve thetrade of any real product. It is ultimately based on the tradein something real, so its value is ‘derived’ from a real trade.A future is one form of a derivative contract.A hedge is when someone reduces their risk to price ﬂuctuations.i.ii.
7The great hunger lottery: How banking speculation causes food crisesFrom early 2007 to the middle of 2008 therewas a huge spike in food prices. Over the periodthere was more than an 80 per cent increase inthe price of wheat on world markets. The priceof maize similarly shot up by almost 90 per cent.Prices then fell rapidly in a matter of weeks in thesecond half of 2008 (See Graph 1 below). Thereare various reasons to explain a general increasein food prices over this time. But only financialspeculation can explain the extent of the wildswings in the price of food2. Playing the hungerlottery:The role offinancial speculation“Deregulation that began in 2000 …encouragedhyper-speculativeactivitiesby market players who had no interestin the underlying physical commoditiesbeing traded. This produced severeprice swings for both oil and food in2008-09 that destabilized businessand household budgets in the US andthroughout the world.” 3Letterfrom 18 US economiststo the US CongressIMFfoodpriceindexGraph 1. Food prices 2001-20094200180160140120100806040200M1 M8 M3 M10 M5 M12 M7 M2 M9 M4 M11 M6 M1 M8 M3 M10Year2001200220032005200620082009200120042007200920082006200520032002
2.1 The impact of financialspeculation on priceincreases and volatilityThe history of modern commodity speculationhas its origins in the mid-19th century, whenso-called ‘futures contracts’ were created foragricultural products traded in the UnitedStates. These contracts allow farmers to agree aguaranteed price for their next harvest well inadvance, giving them greater certainty of incomewhen planting crops. Futures contracts remainvery important for farmers, although in globalterms they tend to only be available to larger,wealthier farmers.However, in the early 20th century futurescontracts started to be bought and sold byfinancial speculators who had nothing to do withthe physical production, processing or retailingof food. This activity began to affect the actualprices of foodstuffs on the daily ‘spot markets’,causing them to become more volatile and to riseand fall more sharply. Following the Wall Streetcrash, the Roosevelt government in the UnitedStates recognised this problem, and introducedregulations such as position limitsito preventexcessive speculation through the Securities Actof 1933, the Securities Exchange Act of 1934 andthe Commodity Exchange Act of 1936.In the 1990s and early 2000s these regulationswere weakened in the face of intense lobbyingby the financial industry. For instance, in 1991lobbying by Goldman Sachs exempted manycommodity speculators from the limits on tradingcreated in the 1930s.6At the same time, new andmore complicated contracts were created basedon the price of food. Derivatives in food, just as inproperty and shares, expanded massively.“In the period before the outbreakof the crisis, inflation spread fromfinancial asset prices to petroleum,food, and other commodities, partlyas a result of their becoming financialasset classes subject to financialinvestment and speculation.” 5Reportofthe UN Commission ofExpertson Reforms ofthe International andMonetarySystem (StiglitzCommission)8The great hunger lottery: How banking speculation causes food crisesPosition limits place a limit on the amount of derivatives whichcan be traded in a particular market. They were created by USregulators in the 1930s to prevent excessive speculation on foodcommodities, whilst still enabling farmers to use derivatives tohedge their risk.i.
Banks such as Goldman Sachs created index fundsto allow institutional investors to ‘invest’ in theprice of food, as if it were an asset like shares.Goldman Sachs’ commodity index fund wascreated in 1991,7the same year it was exemptedfrom position limits. These commodity indexfunds have since become the primary vehiclefor speculative capital involvement in foodcommodity markets.The number of derivative contracts in commoditiesincreased by more than 500 per cent between2002 and mid-2008. Between 2006 and 2008 itis estimated that speculators dominated longpositionsiin food commodities. For instance,speculatorsheld65percentoflongmaizecontracts,68 per cent of soybeans and 80 per cent of wheat.9In a major study on the issue, another UN body,the United Nations Conference on Trade andDevelopment (UNCTAD) concluded that: “partof the commodity price boom between 2002 andmid-2008, as well as the subsequent decline incommodity prices, were due to the financializationof commodity markets. Taken together, thesefindings support the view that financial investorshave accelerated and amplified price movementsdriven by fundamental supply and demand factors,at least in some periods of time.”10This analysis is widely shared within the financialindustry itself. As early as April 2006, MerrillLynch estimated that speculation was causingcommodity prices to trade at 50 per cent higherthan if they were based on fundamental supplyand demand alone.119The great hunger lottery: How banking speculation causes food crisesIs speculation in commodities investment or profiteering?Speculation on commodity markets is sometimes referred to as ‘investment’, but it is nothingof the sort. Buying commodity derivatives is attempting to skim money from a notional value ofoutputs from the ‘real’ economy. It is not investing capital to increase production.Of money spent on commodity derivatives, not £1 is invested in increasing commodityproduction. But there is an opportunity cost of resources being put into commodity derivatives.Instead of being used on speculation, resources could be used on genuine assets and investmentto increase production. This opportunity cost is particularly pertinent following the creditcrunch, as small and medium sized businesses have struggled to secure sufficient capital.Limiting speculation on commodities could divert resources to be invested in genuinelyproductive activities.The author and financial expert, Satyajit Das, who has worked in derivatives and riskmanagement, writes: “Proponents argue that speculators facilitate markets and bring downtrading costs, thereby helping capital formation and reducing cost of capital. There is little directevidence in support of this proposition. Recent experience suggests that in stressful conditionsspeculators are users rather than providers of scarce liquidity. … A reduction in speculativeactivity would also arguable free up capital tied up in trading. This capital could be deployed moreeffectively within the economy.” 8A long position is one where the holder owns the contract, andso proﬁts from its price rising. In contrast, a short position isselling a contract which has been borrowed from a third party,with the intention of buying it back in the future. Short sellersproﬁt from a fall in prices.i.
At the start of the food price boom, one hedgefund manager told the Financial Times: “There isso much investment money coming into commoditymarkets right now that it almost does not matterwhatthefundamentalsaredoing.Thecommonthemefor why all these commodity prices are higher is thesubstantial increase in fund flow into these markets,which are not big enough to withstand the increasein funds without pushing up prices.”12As the foodprice spike reached its height in 2008, anotherhedge fund manager quipped that speculatorsheld contracts in enough wheat to feed every“American citizen with all the bread, pasta andbaked goods they can eat for the next two years”.13Gregory Fleming, President of Merril Lynch, saidin May 2008 that commodity markets lookedsimilar to the dot.com bubble of the late 1990sand the bubble in structured-credit productswhich preceded the credit crunch.14But the situation was probably best summarisedby the famous businessman George Soros, himselfnostrangertofinancialspeculation.Inaninterviewwith Stern Magazine published in the summer of2008, Soros reflected on the nature of the crisis:“every speculation is also rooted in reality…[however] Speculators create the bubble thatlies above everything. Their expectations, theirgambling on futures help drive up prices, andtheir business distorts prices, which is especiallytrue for commodities. It is like hoarding food inthe midst of a famine, only to make profits onrising prices. That should not be possible.”152.2 The murky world of commodityindex fundsMuch of the new money coming into commoditymarkets in recent years has been throughcommodity index funds. These indexes put moneyinto derivatives across a range of commodities.TheyweremainlycreatedbybankssuchasGoldmanSachs and Deutsche Bank. It is estimated themoney in such index funds increased fivefold from$46 billion in 2005 to $250 billion in March 2008.Commodityindexesareopentoanyonetoinvestin,just as the FTSE 100 index is for shares. However,they are rarely marketed at ‘normal’ people andinstead tend to be used by institutional investorssuch as pension funds, insurance companies andmutual funds such as unit trusts.Central to how index funds work are banks.Banks play two, potentially conflicting roles;arranging the buying of derivatives contracts forwhich they charge a fee, and selling the contractthe index fund is buying. This effectively meansbanks are trading against their own clients. Thelargest commodity swap dealers are GoldmanSachs, Bank of America, Citibank, DeutscheBank, HSBC, Morgan Stanley and JP Morgan.16Goldman Sachs on its own made around $5 billionfrom commodities trading in 2009.17Followingconversations with the nationalised British bankRoyal Bank of Scotland, we estimate they madeover$1billionfromcommoditiestradingin2009.18One commentator at the Financial Times notedin 2007 that investors in commodity index fundswere losing large amounts of money and exposedthat the main beneficiary was the trading arm ofGoldman Sachs.19Index funds do not actively follow supply anddemand for a commodity when choosing whetherto put money in or take money out. Instead theyuse commodities as a ‘hedge’ against their risk.For instance, money in commodities is seen toprotect against losing money due to inflation.If institutional investors think inflation is dueto increase, they may put more money intocommodities.Wheninflationisexpectedtobelow,they may take the money back out again. Becausesuch decisions have nothing to do with the supplyand demand of the actual commodity in question,it can play havoc with the commodity price.One important driver for index funds to be usedas a hedge was an influential academic paper in2006 by Gorton and Rouwenhorst which arguedthat commodity prices were negatively correlatedwith shares and bonds, making them excellent fordiversifying investments.20This paper was in turnheavily promoted by Goldman Sachs,21helpingto drum-up business for its commodity derivativetraders. In 2007, Goldman Sachs research wastelling markets that increases in food priceswere due to structural reasons and prices were10The great hunger lottery: How banking speculation causes food crises
likely to continue rising;22ie. putting money intocommodities would be a good idea.UNCTAD say: “a major new element in commoditytrading over the past few years is the greaterpresence on commodity futures exchanges offinancial investors that treat commodities as anasset class. The fact that these market participantsdo not trade on the basis of fundamental supplyand demand relationships, and that they hold,on average, very large positions in commoditymarkets, implies that they can exert considerableinfluence on commodity price developments.”23InMay2008aGoldmanSachsresearchpaperstatedthat “Without question increased fund flow intocommodities has boosted prices.” However, it wenton to argue that commodity prices still reflectedreal supply and demand, saying “The so-calledcommodity speculator should be applauded forspeeding up the message to both oil companies andconsumers that energy markets are tight” and thatthis signalled the need for “greater investment”.24Goldman Sachs’ argument seemed to be thatspeculators, particularly commodity index funds,had spotted what real traders of commoditieshad not; that the fundamentals pointed towardshigher prices. Goldman Sachs accepted that theaction of speculators was pushing up real pricesof commodities, but this was because speculatorswere anticipating changes in supply and demand.In the event, prices crashed just two months later.Speculatorshadnotanticipatedsupplyanddemandchanges so well after all but created a bubble.There is a scarcity of data on the commodityderivatives trade, particularly because hugenumbers are sold ‘over-the-counter’ and so areopaque. There are also limitations in data on hour-by-hour and day-by-day changes. However, oneestimate of contracts purchased by index fundsshows a close correlation with food prices (seeGraph2.below).Whilstonlyusingmonth-to-monthdata,thegraphbelowshowsthenumberofcontractsheld by index traders rising and falling in linewith prices. Interestingly, the number of contractsheld by indexes began to fall before the unusualand extreme drop in food prices in mid-2008.11The great hunger lottery: How banking speculation causes food crisesIndex(January2006=100)Graph 2. Indexofestimated netlong positions ofindextraders and the IMFfood price index(January2006-May2009)25200180160140120100806040200M1 M5 M9 M1 M5 M9 M1 M5 M9 M1 M5YearNetlong positionsofindextradersIMFfood price index20082009200720092008200620062006200720072008
One way in which the movement of money intoand out of index funds is seen is in the correlationbetween commodity index prices and heavilyspeculated exchange rates. The exchange ratesof several currencies affected by carry tradespeculation,26such as the Icelandic krona andHungarian forint, are all highly correlated withthe Reuters Commodity Price Index and Standard& Poors Goldman Sachs Commodity Price Index.There is no real reason why the movements ofheavily speculated against currencies shouldbe correlated with heavily speculated againstcommodities - unless speculators are movingmoney into and out of currencies and commoditieson the same news about the general state of worldmarkets. This speculation then impacts on theprice of currencies and commodities. UNCTADsays the changes in the currency and index price“are clearly driven by factors beyond fundamentalsbecause the fundamentals underlying the differentprices cannot go in the same direction”.27Index funds can also use computer models todecide what to invest in. These models tend to besimilar across funds, leading to herd behaviourinto and out of commodity contracts. UNCTADstates that: “This can result in increased short-termprice volatility, as well as the overshooting of pricepeaks and troughs.”28Jayati Ghosh, professor of economics atJawaharlal Nehru University, New Delhi, says:“From about late 2006, a lot of financial firms– banks and hedge funds and others – realized thatthere was really no more profit to be made in UShousing market, and they were looking for newavenues of investment. Commodities became oneof the big ones – food, minerals, gold, oil. And soyou had more and more of this financial activityentering these activities, and you find that the pricethen starts rising. And once, of course, the pricestarts rising a little bit, then it becomes more andmore profitable for others to enter. So what was atrickleinlate2006becomesafloodfromearly2007.”2912The great hunger lottery: How banking speculation causes food crisesUS$Graph 3. Oil prices 2001-200930160140120100806040200M1 M8 M3 M10 M5 M12 M7 M2 M9 M4 M11 M6 M1 M8 M3 M10Year2001200220032005200620082009200120042007200920082006200520032002
OilThe impact of commodity speculation is not just on food. The commodity traded most byfinanciers is oil. The price of a barrel of oil increased from $60 in 2006 to almost $150 inmid-2008, before falling rapidly to $40 in a matter of weeks. Whilst there are underlyingreasons for a rising oil price, these extreme swings strongly suggest a role for speculation.Writing in mid-2008, Lord Meghnad Desai, emeritus professor of economics at the London SchoolofEconomics,said:“Thereisagrowingfeelingthatthelatestsharpupsurgeinthepriceofoilmaybea speculative bubble rather than an outcome of market fundamentals. The US Commodity FuturesTrading Commission indicated last week that there may be ‘system risk’ and George Soros, theveteraninvestor,intestimonyonCapitolHillonTuesday,warnedthatcommodityindexfunds,whichtreat oil as an asset rather than a commodity to be bought and sold for use, are creating a bubble.”31Goldman Sachs used its position as a financial analyst to talk-up oil markets. Most famously,in March 2008 Goldman Sachs predicted that oil prices would remain high and could reach asmuch as $200 a barrel.32This talking-up of the oil price was repeated in May 2008 when GoldmanSachs energy strategist Argun Murti was reported across the world as saying the oil price couldreach $200 a barrel within six-months.33At the time, Goldman Sachs was heavily investing in oil,through its subsidiary J.Aron.34An April 2010 survey of banks, traders and oil companies found that 70 per cent say speculation iscurrently increasing the price of oil, on average by $10 to $30 a barrel.35A high oil price has many impacts on developing countries. For net oil importers, it increasesthe import bill. As with high food prices, poor people across the world have to use less energyand/or cut their expenditure on other things. Furthermore, as agriculture is an energy intensiveindustry, a high and variable oil price has a knock-on impact on food prices. A research paper forthe World Bank estimates that higher oil and other energy prices caused the prices of US foodexports to increase by 15-20 per cent between 2002 and 2007.3613The great hunger lottery: How banking speculation causes food crises
2.3. Market servant or market master?Two main reasons are given for why speculation isneeded in commodity markets; to help producersand buyers of commodities to manage their pricerisk, and to help price discovery. Whilst theseare valid reasons for allowing a limited amountof speculation, there is evidence that excessivespeculation has actually made it more difficult forcommodity markets to fulfil these objectives.a) Price risk managementProducers and purchasers of food who want to usefutures markets to limit their exposure to pricemovements (otherwise known as ‘hedging’) needfinancial traders to take on that risk. Such traderseffectivelyactasinsurersto,forexample,afarmer.Thefarmergetsaguaranteedreturn.Thetradergetsan unknown but potentially higher return. Suchtraders are therefore needed to provide ‘liquidity’to the futures market. Whilst such liquidity isneeded, the current scale of trading by financiersdwarfs that actually needed to provide sufficientliquidity for real buyers and sellers of food.Worryingly, the increased demand for foodderivatives by speculators has actually made itmore difficult for farmers to hedge their risk.With rising futures prices, more margin hasbeen required of farmers in order to hedge. Asubcommittee of the US senate found that thisabnormality in the wheat market impaired theability of farmers to hedge and aggravated theireconomic difficulties in 2007 and 2008.37This finding has been echoed by Gary Gensler,Chairman of the US Commodities Futures TradingCommission, who in a statement to US legislatorsargued that: “record-high volatility has impairedthe ability of many farmers and other businesses tousethefuturesmarketstomanagetheirpricerisks”.38b) Price discoveryFutures contracts are seen as a way to ‘discover’the price of a commodity in the future. Financialtraders are expected to use information they learnabout a particular commodity to influence theirdecisions about what price to buy and sell futurescontracts at. For instance, drought in Australiameans a lower wheat harvest is expected thatyear, and so the price of a future in wheat rises.Policymakers and farmers can then use futureprices to help make decisions.However, in recent years, futures markets have lessaccurately predicted the future spot price39thanjust assuming that the future spot price would bethe same as the current spot price. Ben Bernanke,chairmanoftheUSFederalReserve,sayscommodityfutures markets have a “poor recent record” inforecasting prices,40making it more difficult toforecast inflation and so set interest rates.This failure of futures markets to predictprices can be explained largely because indexspeculators often base their decision to buycontracts on information unrelated to underlyingsupply and demand in that commodity. Theyare driven by factors outside commoditymarkets such as the availability of cheap money,the attractiveness of other markets such ascurrencies, property and shares, and usingcommodity markets as a hedge. Furthermore, thelarger the investments by financial traders themore they determine prices rather than demandand supply, as evidenced by the sub-primemortgage crisis that led to the 2008 crash.41All this suggests that rather than helping todiscover prices, the scale of financial involvementin commodity markets is actually disrupting them,making them less able to set sustainable prices.There is an argument as to how much the increasein futures price is passed on to the spot price. Theless it is passed on, the less speculation affectsthe real price. However, the less it is passed on,the greater the disparity between futures andspot prices, and so the more difficult it is to usederivatives to hedge. Similarly, the greater thedisparity between futures and spot prices, theless well futures markets are doing their job ofdiscovering future prices for a commodity.The less speculation is seen to be impacting onreal prices, the more it will be creating disparitybetween future and real prices. This in turndisrupts the two supposed reasons for futures andderivatives in commodities. Limiting excessivespeculation would help futures markets workproperly, as well as preventing excessive volatilityin commodity markets.14The great hunger lottery: How banking speculation causes food crises
15The great hunger lottery: How banking speculation causes food crises3.1 Hunger and poverty“The price boom between 2002 and mid-2008was the most pronounced in several decades– in magnitude, duration and breadth. Itplaced a heavy burden on many developingcountries that rely on food and energyimports, and contributed to food crises in anumber of countries in 2007-2008.”43UNCTADTheincreaseinthepriceoffoodhasbeendisastrousfor people across the world. There were 75 millionmore hungry people in 2007 and a further 40million in 2008.44The latest estimate by the Foodand Agriculture Organisation (FAO) in June 2009was that over 1 billion people are now chronicallymalnourished due to “global economic slowdowncombined with stubbornly high food prices”.45But the impact of high prices goes well beyondnot getting enough to eat. Poor households indeveloping countries tend to spend between 50and 90 per cent of their income on food, comparedto an average of 10-15 per cent in developedcountries.46It is estimated that the food pricespike increased the number living in poverty bybetween 100 and 200 million.47As well as eatingless food, households have been forced to:Eat less fruit, vegetables, dairy and meatin order to afford staple foods. This canhave drastic impacts on protein and vitaminintake.48Nutritional deficiencies particularlyaffect children, pregnant women and unbornchildren. Ethiopia suffered both from highglobal food prices and widespread droughtin 2008. Ethiopia’s wheat imports increasedfrom threefold from over 300,000 tonnesin 2006 to over 1 million tonnes in 2008.3. The impactofprice swings“The excess price surges caused byspeculation and possible hoardingcould have severe effects on confidencein global grain markets, therebyhampering the market’s performancein responding to fundamentalchanges in supply, demand, andcosts of production. More important,they could result in unreasonableor unwanted price fluctuations thatcan harm the poor and result in long-term, irreversible nutritional damage,especially among children.” 42International Food PolicyResearch Institute
But higher global prices meant its wheatimport bill increased more than fivefold from$84 million in 2006 to $465 million in 2008.49Nuria Mohammed farms vegetables insouthern Ethiopia’s Oromiya region. Droughtin 2008 made Nuria dependent on buyingwheat and maize from the local market.But the price of wheat and maize had morethan doubled. Two of Nuria’s children, FaizaAbdulmalieh and Fatima, both under five, wereamong 30,000 children local health workersestimated were malnourished in the region.Nuria says “When I was nursing Faiza, I wassick, so I could not breastfeed her properly.”50Nigeria is one of the world’s largest importersof wheat. In 2006 Nigeria imported over 13million tonnes of wheat, but by 2008 thishad fallen to less than 3 million.51The priceNigeria was paying for wheat increased fromjust over $100 a tonne in 2006 to almost $300a tonne in 2008. With rising food prices, manypeople have to resort to eating just staplesrather than more ‘luxury’ foods like meat, dairyand vegetables. Shehu Bawa, a consultant forUNICEF, says: “[With lower purchasing power]consumers use the money they would normallyuse for buying eggs and chicken to purchasegrains which is more important to them.”52Forinstance, Joseph Adeleke, a resident of Lagos,said in May 2008 “bread is the only affordablefood for the common man”.53Reduce any savings, sell assets or take outloans. This can include selling-off assetsvital to future income such as land or cattle.Lesotho imports 70 per cent of its food,particularly maize, and was therefore hit hardby high global food prices in 2007 and 2008.Mohemmad Farooq, a UNICEF child protectionspecialist in Lesotho says that many peopleresponded by “selling off assets - if they haveany - or taking loans with high interest rates,for which they could end up in bonded labour,so the situation will get worse.”54OneLesothan, Retselisitsoe Rasetona, said in2008: “We have no food, so we have to borrow;that is how we survive.”55In Ethiopia, Nuria Mohammed says: “I soldthe cattle for 200 Br (Birr) to 300 Br. They hadbecome skinny because of lack of adequatepasture, but still they were our only familyassets. Previously, they would each have beenworth 1,000 Br (US$105).” 56Mauritania imports 70 per cent of its food.In 2004, Mauritania had spent $15 millionimporting 350,000 tonnes of wheat. By2008 it was spending $110 million to import260,000 tonnes.57Many had to borrow to buyfood. “Repaying the debts is more expensivethis year than last,” said Omu Mint Belel, aresident of M’beida, a village in the south,in late 2007. But she says none of this wasenough to prevent hunger: “Already somefamilies are eating only once a day.”58Reduce spending on ‘luxuries’ such ashealthcare, education or family planning.59Solomon Desta, director of a primary school insouthern Ethiopia, said in 2008: “This time lastyear we had already enrolled 2,300 students.Now we have registered 1,800. The turnoutis the lowest of the last three years.”60LemaHarriso, director of another primary schoolin southern Ethiopia says: “Compared to thevastness of our kebele [ward], we expectedmany children [to register for school]. There areabout 400 children of school age in our kebele,but only 260 of them are registered.”61Mohemmad Farooq in Lesotho says that manypeople had to take children out of school in2008 so that they could be sent out to work.62Women tend to manage the food budgetand often bear much of the suffering.Women may also try to increase incomethrough taking on insecure and riskyemployment such as becoming domesticworkers, mail-order brides and sex workers.63High food prices affect poor farmers as wellas the urban poor. A high percentage of ruralhouseholds are net buyers of staple foods. InKenya and Mozambique, around 60 per cent ofrural householders are net buyers of maize.64Veryfew poor farmers produce a significant surplus tosell.65In Zambia, 80 per cent of farm households16The great hunger lottery: How banking speculation causes food crises
VolatilityAs financial speculation increased from 2000 to 2008, the volatility of commodity prices alsotended to increase. The volatility of the maize price increased by over one-third from 2002-2006to 2007-2008. For the same period, wheat volatility increased by around 50 per cent. UNCTAD findsthat positions taken by financial markets, and particularly those of index funds, were positivelycorrelated with volatility from January 2005 to August 2008. They conclude that “given that indextraders generally follow a passive trading strategy [unrelated to market fundamentals], it is morelikely that it was an increase in their activity that caused greater price volatility”.72The FAO says: “The wider and more unpredictable the price changes in a commodity are, thegreater is the possibility of realizing large gains by speculating on future price movements ofthat commodity. Thus, volatility can attract significant speculative activity, which in turn caninitiate a vicious cycle of destabilizing cash prices.” 73Widely changing prices make it difficult for farmers to make decisions about what crops to growand what to invest precious resources in. For instance, the FAO continues: “At the national level,many developing countries are still highly dependent on primary commodities, either in theirexports or imports. While sharp price spikes can be a temporary boon to an exporter’s economy, theycan also heighten the cost of importing foodstuffs and agricultural inputs. At the same time, largefluctuations in prices can have a destabilizing effect on real exchange rates of countries, putting asevere strain on their economy and hampering their efforts to reduce poverty.” 74French finance minister Christine Legarde has said: “I see the problem on my radar of the volatilityof price” and has called for tighter regulation of commodity derivatives and thecreation of an EU commodities trading regulator, comparable to the US CommoditiesFutures Trading Commission (CFTC).7517The great hunger lottery: How banking speculation causes food crisesgrow maize, but fewer than 30 per cent sell any.The few households which make-up the bulk ofmaize sellers have significantly higher incomes.66In, addition any increase in income was formany producers negated by increasing costs offarm inputs such as oil and fertilizer. The cost offertilizer almost doubled in 2007 and 2008.67Furthermore, in general terms wild price swingsmakeitdifficultforfarmerstomakedecisionsaboutwhat crops to grow and in what they should investprecious resources. As Jayati Ghosh, professorof economics at Jawaharlal Nehru University, NewDelhi, says: “the world trade market in food, hasstarted behaving like any other financial market:it’s full of information asymmetry … So farmersthink, ‘Well, wow, the price of sugarcane is reallyhigh,’ and they go out there and cultivate lots ofsugarcane. By the time their crop is harvested,the price has collapsed. So you get all kinds ofmisleading price signals. Farmers don’t gain.”68High staple food prices have been a problem atan economy-wide level, particularly across sub-Saharan Africa. Africa has gone form being a netexporteroffoodin197069toamassivenetimportertoday. Around 55 per cent of developing countriesare net food importers and almost all countries inAfrica are now net importers of cereals.70Sudden food price surges also frequently resultin political and social unrest, and the crisis of2007-2008 was no different. There were protestsand riots against the rising prices in major citiesacross the developing world. This generated majorheadlines and was top of the international newsagenda in the weeks leading up to onset of thebank collapses. One protestor from Cote d’Ivoireinterviewed at the time, Alimata Camara, said:“We only eat once during the day now. If food pricesincrease more, what will we give our children to eatand how will they go to school?”71
3.2 Cash cropsA simple assumption would be that speculation ondeveloping country cash crop exports would be agood thing, in as much as speculation increasesthe price received for such goods. However,speculation on cash crops such as coffee, cocoa,and cotton is actually a large problem for farmers.Speculation can temporarily push up the prices ofthesecrops,butthisalsocausesthepricetobecomemore volatile with sudden decreases in price too.In the first half of 2008 the price of cocoa hita 28 year high. However, these rises were onlytemporary and in the second half of 2008 cocoaexperienced a sharp decline.76This volatility incash crop prices is a major issue as it makes itharder for farmer’s to make decisions.77Cashcrop farmers in developing countries lack theknowledge and money to adequately respond toconfusing market signals. Changing the cropswhich are grown requires investment in seedsand knowledge, and farmers have few safety netssuch as insurance, futures contracts or other riskreducing instruments to protect them if theyrespond incorrectly.78For example, banks andother lending institutions are reluctant to lend toindividualcocoa-dependentproducersatreasonableinterest rates, since growers ability to repay is tieddirectly to unpredictable future cocoa prices.Cash crop farmers, such as cocoa growers inGhana and Côte d’Ivoire, are especially at risk tocommodity price volatility as a very small quantityof these crops are consumed by farmers. Cashcrops are sold in return for cash to buy food with.The price of both cash crops and food crops arecritical to a cash crop farmer’s wellbeing.79The Fairtrade Foundation states of its producers:“farmers like most smallholders, are net foodbuyers and as such only a minority have gainedfrom increased commodity prices”.80For example,in southern Malawi many cash crop farmersgrow sugar cane. However, the Kasinthula CaneGrowers reported in 2009 that the families of their300 members are spending on average 80 per centof their income on food, compared to around 50per cent a year before, causing many families tonow eat one meal less a day. This is the case eventhough many of these farmers still grow much ofthe food that they eat but even so they still buymore food than they sell.81As farmers cannot respond to the volatile marketthey can be forced out of business altogether,and lose their main source of cash income.82As mentioned in section 3.1 above, one of theinitial responses of cash crop farmers will be tosell any assets they hold, such as land. This cancreate opportunities for corporate land grabbing,18The great hunger lottery: How banking speculation causes food crisesCommodityPrice increase fromstart2006 to mid-2008Maize +180 percentWheat +110 percentOil +110 percentCocoa +90 percentCoffee +70 percentCotton +30 percentSugar +10 percent
19The great hunger lottery: How banking speculation causes food criseswhere companies buy-up land to produce exportcrops. For example, in just five African countries,1.1 million hectares (an area the size of Belgium)has been taken over by companies to growbiofuels.83Furthermore, buying-up land isseen by speculators as an alternative way ofspeculating in food to buying derivatives.84Another problem caused by speculation is thatmore powerful middlemen can use the volatileprice to take advantage of individual farmers bybuying at a low price from the desperate farmersand then selling at the high international price,gaining most of the benefits of high commodityprices for themselves.85This price volatility is alsoa major barrier to increasing cash crop farmer’sefficiency, unstable prices are one of the reasonsfor Africa’s low level of fertilizer use as farmerscan not be sure of their return from investing infertilizers.86Cash crop markets provide the most recentevidence that speculation continues to be aproblem. Chocolate producers have identifiedspeculation as a key reason why cocoa pricesreached an all time high in April 2010.87Meanwhile, in June 2010 the spot price of robustacoffee increased almost 20 per cent in threedays on the London exchange. Hedge fundshad been betting on lower prices, artificiallypushing the price down. However, their positionsunwound when it emerged that one commoditytrading house was holding a large number offuture contracts and actually intended to takephysical delivery of the coffee. Hedge funds wereforced to buy back the contracts they had sold,triggering the sudden correction of a big increasein price.88A commodities analyst, SudakshinaUnnikrishnan, said that the coffee price spikewas not linked to underlying supply and demandissues: “There is no fundamental reason for coffeeprices to have increased so much in recent weeks.”893.3 InflationAs well as increasing food and oil prices for peopleacross the world, speculation also impacts onthe general rate of inflation. Artificially higherinflation leads to higher than necessary interestrates, and so more expensive lending. In the UK,because of high food and oil prices, the Bank ofEngland’s Official Bank Rate stayed as high as 5per cent until October 2008, despite all the signsthat Britain was heading into recession.The fall in commodity prices from mid-2008‘allowed’ the Official Bank Rate to fall to 0.5 percent. Because they make lending cheaper, lowinterest rates are expected to increase demandand thereby inflation in the economy. More moneyis available for investment in economic activity.In the context of speculation on commodityprices, low interest rates can also increaseinflation by increasing speculation. Low interestrates make more money available which can thenbe put into commodity derivatives, increasingcommodity prices. This is another route by whichlow interest rates can increase inflation. But thisdoes nothing to increase demand and economicactivity, it just ties the cheap money up inunproductive derivative contracts.
20The great hunger lottery: How banking speculation causes food crisesFinancial speculation is not the only cause ofhigh food prices, and certainly was not the soledriver of the 2007-2008 crisis. Changes such asincreased use of biofuels, changes in crop yieldsand the fall in the value of the dollar have allaffected prices in recent years. Certainly, thesefactors affecting the ‘fundamentals’ of foodprices had a significant bearing on the events of2007-2008. But an examination of the evidenceduring and since the 2007-2008 crisis leads to theinescapable conclusion that speculation rides onthe back of these underlying changes, amplifyingtheir impact on price. The FAO concludes that:At the onset of the price surge in 2007, FAOidentified a number of possible causes contributingto the price rise: low levels of world cereal stocks;crop failures in major exporting countries; rapidlygrowing demand for agricultural commoditiesfor biofuels and rising oil prices. As the pricestrengthening accelerated, several otherfactors emerged to reinforce the upheaval; mostimportantly, government export restrictions, aweakening United States dollar and a growingappetite by speculators and index funds forwider commodity portfolio investments on theback of enormous global excess liquidity.90(emphasis added)In June 2008, at the peak of the crisis, the IMFacknowledged that “Purely financial factors,including market sentiment, can have short-termeffects on the prices of oil and other commodities,but a lasting impact on recent oil price trendsremains difficult to establish.” 91Whilst theyacknowledged a role for speculation in thenhigh commodity prices, the IMF argued thatreal demand and supply factors were primarilyresponsible for the commodity spikes then takingplace. They therefore predicted that “prices areexpectedtoeaseonlygraduallyfromrecenthighs”.92This prediction was shown to be incorrect thefollowing month when prices fell rapidly.4. Othercauses ofthe food price spike
21The great hunger lottery: How banking speculation causes food crisesIt is the scale of the swings in price, and inparticular the sudden fall in prices, which realdemand and supply factors struggle to explain.Clearly there are real demand and supply factorswhich have been behind changes in food price.But financial speculation amplifies thesechanges, pushing prices higher, and makingthem more volatile.4.1 BiofuelsDonald Mitchell at the World Bank argues that themain trigger for the spike in food prices was theincrease in biofuel production from grains andoilseeds in the US and EU. He argues that withoutthe increase in biofuel production “globalwheat and maize stocks would not have declinedappreciably, oilseed prices would not have tripled,and price increases due to other factors, suchas droughts, would have been more moderate.”However, he acknowledges that speculation waspart of the reason for the price spike, but thatwithout increased biofuel use it “would probablynot have occurred” because it was a response“to rising prices.”93Biofuels have certainly increased demand,particularly for maize. The proportion of maizeused for bioethanol increased from 4 per cent in2001/02 to 12 per cent in 2007/08.94Biofuelshave therefore had some impact on the generalrise in food prices. Biofuels would be particularlyexpected to impact on the price of maize, althoughthis would then have knock-on impacts on otherfoods. However, the price of wheat actuallyincreased first in 2007 (see Graph 4 on page 22).Demand for biofuels remained strong andcontinuedtoincreasethroughout2008and2009.95It is therefore difficult to see how biofuels canexplain the sharp fall in food prices in mid-2008,and so the sharp increase in 2007 and 2008.Increased use of biofuels does cause food pricesto rise, as well as having large negative impactson local communities and increasing greenhousegas emissions. But increased demand for biofuelsdoes not explain the huge swings in food prices ofrecent years.4.2 Low crop yieldsGlobal grain production did fall in 2006 by 1.3 percent, though increased by 4.7 per cent in 2007.96Shortfalls in wheat production were higher,with a fall in production of 4.5 per cent in 2006,followed by an increase of just 2 per cent in 2007.Wheat production then increased by 14 per cent in2008.97Such changes, and their knock-on impacton grain stocks, offer some explanation forgradually increasing prices in 2006 and 2007. Butthey offer little explanation for the huge changesingrainpricein2007and2008,comparedto2006.98The UK government argues that low wheat yieldswere a key factor behind the 2007 and 2008 pricespike. They argue that earlier in 2008 food pricescontinued to rise because of uncertainty over the2008 wheat yield. The bubble then burst in mid-2008 once it was clear wheat production was high.However, early in 2008 it was still expected thatthe wheat yield would be 7 per cent higher thanin 2007.99There was no sudden moment whichwould explain the rapid fall in wheat and foodprices in mid-2008. Yields offer an explanation fora general rise in price through 2006 and 2007, anda fall in 2008. But it is unclear how they explainthe large spikes and fluctuations in price.4.3 The future outlook for foodOutlooks for food suggest that fundamentals willcontinuetocausefoodpricestoriseinthemediumterm. The Organisation for Economic Co-operationand Development (OECD) and FAO outlook forfood commodity prices in June 2010 predictedthat from 2010-2019 “Average wheat and coarsegrain prices are projected to be nearly 15-40%higher in real terms relative to 1997-2006”.100Thereport highlights that this is due to factors suchas predicted increased demand from emergingmarkets and increased demand for biofuels.One interesting point about the report is thatwhilst it expects pressure on the food price tocontinue to increase, it predicts that food priceswill not go as high up until 2019 as they did in2007 and 2008. Given that increased demand for
22The great hunger lottery: How banking speculation causes food crisesbiofuels and from emerging markets is continuingto increase, as will the impacts of climate changeon food supply, this prediction begs the questionas to why prices rose so high in 2007/08. Financialspeculation provides the answer.Themorefundamentalsarepushingfoodpricesup,the more likely it is that speculators will once againride on the back of that pressure amplifying prices.Whilst it is entirely possible to prevent food pricesfromrisingashighoverthenextdecadeastheydidin 2007 and 2008 (especially if the rush to biofuelsis stopped and climate change is tackled withurgency), this will only be possible if regulationsare introduced to limit excessive speculation.Indexvalues(2001=100)Graph 4. Prices ofrice, wheatand maize 2001-2009, IMF1016005004003002001000M1 M10 M7 M4 M1 M10 M7 M4 M1 M10 M7 M4 M1YearRice indexWheatindexMaize index2001200220032004200520062007200820092010200120042007
Rice: a victim of speculation by proxyThe knock-on effects of speculation can be seen through a range of commodities. Very little riceis traded on international commodity exchanges or in futures contracts. Yet the price of riceincreased far more than that of wheat in 2007 and 2008. This is given as a key argument by thosewho argue speculation had little impact on the price of food in 2007 and 2008.The international market for rice is very small; about 6-7 per cent of global production.102As therice price rose, key rice exporters such as India, Vietnam and Thailand introduced export bansto protect rice availability for their own people, making the international market even smaller.The rising price also probably prompted households to buy and store more rice, in anticipationof rising prices, but also causing prices to rise further. Intervening to protect the food supply oftheir own people is a necessary and legitimate response from governments to wildly fluctuatingglobal markets.Some commentators point to rice to show that financial speculation was not a problem, butrather blame ‘protectionism’. It is undoubtedly the case that the reason the global rice price wentso high was due to the factors listed above. However, there is strong evidence that the extremeincrease in the price of wheat triggered the increase in the price of rice.In some countries, most importantly India, rice and wheat are substitutes for each other. Indiais a large net importer of wheat. The average cost of India’s net wheat imports rose from $220a tonne in 2006 to $255 a tonne in 2007 and $370 a tonne in 2008. As well as causing the localwheat price to rise, this also led to India importing far less wheat in 2008. Net imports fell from5 million tonnes in 2007 to just over 700,000 tonnes in 2008.103This rise in the price of wheatand fall in wheat imports had knock-on impacts on rice price and demand.The global price of wheat increased particularly in late 2007, whilst the rice price increase beganinearly2008.Statisticaltestsshowthatattimesthepriceofriceis‘caused’bythepriceofwheat.There was a crucial period at the start of 2008 when statistical tests by a researcher for the FAOhave shown that the rise in the price of rice was ‘caused’ by the rise in the price of wheat.104Similarly, a research paper for the World Bank says that there was little change in production orstocks of rice, and the initial increase in world rice price was caused by the increases in wheatprices in 2007.105An FAO food outlook report says: “The shock to demand for rice was largelygenerated by demand to make up shortfalls in wheat available to consumers.” 106Financial speculation can be said to have had an impact on the rice price by amplifying theincrease in the price of wheat, which in turn triggered the dramatic increase in the price of rice.23The great hunger lottery: How banking speculation causes food crises
24The great hunger lottery: How banking speculation causes food crises5. So whatdo we do aboutit?Reregulating speculation“Speculation in basic foodstuffs isa scandal when there are a billionstarving people in the world. Wemust ensure markets contribute tosustainable growth. I am fightingfor a fairer world and I want Europeto take the lead on that.”107Michel Barnier, European commissionerforthe internal market5.1 Worldwide concernWhilst it has been less commented on in the UK,the impact of financial speculation on food andenergy prices has received significant attentionelsewhere in the world; including by governmentssuch as the United States and France, as well as bythe European Commission.Gary Gensler, head of the US governmentcommodity regulator, says: “I believe thatincreased speculation in energy and agriculturalproducts has hurt farmers and consumers.”108In a separate statement before the US HouseAgriculture Commission, Gensler referred to theneed to bring back the checks put in place by theRoosevelt administration, arguing that “Just aswe then brought regulation to the commodities andsecurities markets, we now need to bring regulationto markets for risk management contracts calledover-the-counter derivatives.”109Michel Barnier, European commissioner for theinternal market, told the European parliament:“Speculation in basic foodstuffs is a scandal whenthere are a billion starving people in the world.We must ensure markets contribute to sustainablegrowth. I am fighting for a fairer world and Iwant Europe to take the lead on that.”110MichelBarnier continued: “We have to look at derivatives.Speculation is linked to derivatives which are linkedto raw materials. That is something we want toregulate very carefully in order to tackle speculationin raw materials.” 111These sentiments have been backed by a numberof UN agencies and offices dealing with foodand hunger issues, including the UN’s specialrapporteur on the right to food, Olivier deSchutter, who has called for limits on speculationin foods such as wheat.112
25The great hunger lottery: How banking speculation causes food crisesDeveloping countries have also been calling foraction on the issue. In an interview with the WorldDevelopment Movement, Pedro Paez, formerMinister for Economic Policy Coordination ofEcuador, said: “international financial marketsare distorting the markets in food and energy. Thisis increasing vulnerability day-by-day. In one-and-a-half years, the number of people in hunger hasincreased from 900 million to over 1 billion … Thelives of millions of people come to depend on theactivities of a handful of financial speculators.” 113Commodity speculation is therefore a live politicalissue, particularly in the United States and in theEuropean Union, where a package of regulatoryreforms is now under review. Together, action onboth sides of the Atlantic could change the rulesof the game for trading in commodity derivativesand bring markets back into line – as long asgovernments hold firm in their resolve.5.2 TransparencyAll futures contracts need to be cleared throughregulated exchanges. Most contracts are currentlyset in private, meaning it is impossible to knowhow much of what is being traded. Contracts needto be brought out into the open.There is an enormous amount of derivativestrading which takes place ‘over-the-counter’.iThe European Commission says that there were$4.4 trillion of over-the-counter commodityderivatives outstanding in December 2008.114These are private trades for which there is littleinformation. Because such contracts are by theirnature opaque, for those buying the contractthey may have little information of the pricesimilar contracts are being bought and sold at.But because all trading happens through banks,firms such as Goldman Sachs have a very goodidea of what is happening in the market. Theycan use this ‘information asymmetry’ for theirbenefit, over their clients.In contrast, when derivatives are traded throughan exchange it can be seen who is selling whatfor how much. Prices are set in transparentcompetition between buyers and sellers.Exchanges also allow contracts to be ‘cleared’.This is when a clearing entity (the exchange orpotentially a bank) becomes the buyer to eachseller, and the seller to each buyer, of a contract.The clearing entity makes the payments to eachside of the deal, covering them from the risk ofthe other defaulting.115This in turn providesfinancial stability. In contrast, over-the-counterderivatives can be defaulted on. It was non-payment of derivative contracts (not tradedthrough clearing exchanges) which directlycaused the 2007/08 financial crisis. GertrudeTumpel-Gugerell, a member of the ExecutiveBoard at the European Central Bank, says:central clearing of OTC derivatives is an essentialpart of the regulatory reform to make this marketsufficiently transparent and to allow supervisorsand overseers to effectively monitor the build-upof systemic risk.116In return for being protected from default, buyersand sellers make up-front payments to clearingexchanges. Making these upfront paymentsprotects traders from default by the other partybut creates a small cost for each trade whichtakes place. This cost is small for real users ofcommodity derivatives like farmers. In fact, mostfarmers choose to use centralised clearing ratherthan over-the-counter trading, because theirwhole reason for using futures contracts in thefirst place is to protect themselves from risk.Nobel-prize winning economist Joseph Stiglitzsays “Many economists agree that the unregulated,over-the-counter derivatives market played a keyrole in transforming a financial downturn into aglobal economic calamity.”117Economist NourielRoubini, respected for predicting much of therecent financial crisis, argues that trading of allderivatives should be cleared through exchanges.An over-the-counter derivative is a derivative traded privatelybetween two ﬁnancial traders. Banks create a derivative in aspeciﬁc way for its client. Because it is created in private, therest of the market does not clearly see what is being traded atwhat price.i.
26The great hunger lottery: How banking speculation causes food crisesHe says:During the recent financial crisis, things thatwere traded on exchanges - like equities – therewas tumult, there was noise, but there was never afreeze-up of these markets. But in dealer’s markets,we had totally frozen markets for bonds, forderivatives, for credit derivatives, for lots of stuff.So I think market-making and dealing is actuallyonly a source of profit for financial institutions–under the guise of market-making and dealing,they’re doing a lot of proprietary trading. I wouldnot just take that away from them, I would alsomove away from dealers markets altogether toexchanges where there is full transparency.118If all trades had to go through clearing, this wouldimpose a new cost on speculators, which wouldincrease the more excessive speculation takesplace. The small clearing charge if repeated overmany transactions should have a dampeningaffect on speculative trading. For instance, apassive index fund would need to make a clearingpayment every time they role over from onefutures contract to the next. Making all contractsbe cleared through exchanges should limit theamount of excessive speculation whilst providingfinancial stability to real traders in a commodityand the wider economy.5.3 Position limitsPosition limits were first created in the 1930s inthe United States to limit the amount of financialspeculation possible in a particular commoditymarket. Whilst real producers and consumers offood, such as farmers, were allowed to buy andsell unlimited contracts, limits were placed onspeculators so that prices would not be subject tofinancial bubbles, such as the one preceding theWall Street Crash.In 1991, a Goldman Sachs owned commoditiestrading company, J.Aron, wrote to the CFTCarguing that they were using food derivatives tohedge their risk in other markets, just as farmersuse futures to hedge their risk against changingfood price. Therefore they should be treated ashedgers, and the limits on number of contractsshould not apply to them.119This ran counter to the whole purpose of CFTCregulations in the 1930s; to make a distinctionbetween real buyers and sellers of food andthe financial markets. By putting money intocommodity markets, Goldman Sachs wasincreasing its risk to changing food prices, andpotentially contributing to a financial bubble.Under heavy corporate lobbying, this bogusargument was accepted, and the CFTC issued a‘Bona Fide Hedging’ exemption. This allowedGoldman Sachs and many speculators tocompletely bypass the limits on speculation set bythe CFTC, leading eventually to the bubble in foodprices of 2007 and 2008. During 2007 and 2008,far more wheat and maize derivatives were boughtby financial speculators than would have beenallowed if the limits had applied to all of them.PositionlimitsintheUSfailedtopreventtheeventsin food markets of 2007 and 2008 because theywere not applied to speculators, not because theydo not work. However, Europe has never had acommoditiesmarketregulatororsetpositionlimits.As the French government has suggested, theEuropean Union should create a commodityderivatives regulator, equivalent to the CFTC inthe United States. This regulator should thenapply position limits to commodities traded onEuropean markets. Position limits do not need toapply where derivatives are being used to hedgethe buying or selling of real food. But all othertransactions in derivatives should be limited.These limits would still allow financial marketsto provide enough liquidity for real buyers andsellers of food to hedge with. But they wouldprevent the excessive speculation of recent years.One single position limit needs to be set forderivatives in a commodity in all places in whichit is traded. Hedge fund manager Michael Mastersargues that if position limits are not set as anaggregate value covering all exchanges and over-the-counter derivatives “speculators would spreadtheir trading between well regulated and less-regulated venues”.120
27The great hunger lottery: How banking speculation causes food crisesAs shown in section 2.2, commodity index fundspresent a particular problem to commoditymarkets because they move money into and out ofderivatives due to factors unrelated to the supplyand demand for a particular commodity. Positionlimits should fully apply to them. In addition, amore simple measure for commodity index fundswould be to just ban them. Traditional speculatorswho follow commodity markets are best placedto provide the liquidity for hedging. Commodityindex funds decisions are so detached from whatis happening in commodity markets that theybring nothing to them. But they do destabilisemarkets, and waste resources on buyingunproductive derivative contracts from banks.As Michael Masters says:Passive investment provides no benefits to themarkets while it exacts a heavy toll. Investors’desire to turn the commodity derivatives marketsinto something they are not (namely a validinvestment vehicle) must be subjugated to theneeds of bona fide physical hedgers to hedge theirrisks and discover fair prices.1215.4 Action in the US and EUIn the United States a coalition of over 450organisations including civil society, farmers,and businesses such as hauliers and airlines arecampaigningforsuchregulationstobeintroduced.The Obama government and the commodityregulator both support re-regulation. As of June2010, regulation being discussed in Congresscouldforcemuchderivativestradingtogothroughregulated exchanges, and give the CFTC newpowers to set position limits in food and energy.However, regulation is needed in Europe aswell; particularly London and Paris, the twomain commodity exchanges outside the UnitedStates. Whilst derivatives in key staples suchas wheat, maize and soybeans still tend to betraded primarily in the United States, other keycommodities such as cocoa, sugar, oil, metals andcarbon permits are traded in London and Paris.There is also a danger that regulations in the USwill be able to be bypassed by traders operatingthrough London or Paris. Even if this is unlikely tohappen, the threat of it is being used by corporatefinancial lobbies in the US to try to weakenregulations. Joint action by the EU and US is vitalto tackling the commodity speculation problem.Sofar,theUShasbeenaheadoftheEUindoingso.However, Michel Barnier, European Commissionerresponsibleforfinancialmarkets,calledspeculationon food “scandalous” upon his appointment in therole. Barnier told the European Parliament: “Wehave to look at derivatives. Speculation is linked toderivatives which are linked to raw materials. Thatis something we want to regulate very carefully inorder to tackle speculation in raw materials.”122The European Commission is due to bring outproposals on regulating speculation in food laterin 2010. Some EU member states, such as France,are strongly pushing for the EU to take strongaction and set-up a regulator of financial marketsin commodities.123The London Stock Exchangeis preparing to launch its own derivativesexchange in anticipation of regulators forcingmore over-the-counter derivatives to be traded onexchanges.124As of June 2010, the European Commission hadnot published any proposals. Whilst it is likelythere will be moves to increase the number ofderivatives traded through exchanges, it is notclear how strong proposed regulations will be.Furthermore, the European Commission saysit will “assess the possibility of empowering thenational regulators to set position limits”.125However, it would make far more sense forposition limits to be consistent across Europe.They could be set by a European wide regulator,in liaison with the CFTC in the US.Unfortunately the corporate lobby will act tomaintain their ability to make vast profit out ofunregulated trading in commodity derivatives.The financial services lobbyists and banks suchas Goldman Sachs hold huge sway in Brussels.For instance, Corporate Europe Observatory hasrevealed that:When the European Commission set out toreview its strategy on financial services in2004, expert groups were formed on whichGoldman Sachs was represented.
Goldman Sachs was represented on a groupsetup by then commissioner for the internalmarket Charlie McCreevy to advise on reformsof the derivatives market.Of ten expert groups on financial serviceswith business participation, Goldman Sachsis represented on three.Whenthecommissionformedahighlevelgroupon responding to the financial crisis, one ofsevenmemberswasanadvisortoGoldmanSachs.Three former Commissioners have taken uppositions with Goldman Sachs at the end oftheir term; Peter Sutherland, Karel van Miertand Mario Monti.126The City of London has its Brussels lobbyingheadquarters opposite the European Commissionhead office. The City has already played a leadingrole in campaigning against proposed EUregulations on hedge funds, including arrangingvisits by London mayor Boris Johnson. Yet theCity of London is absent from the Commission’slobby transparency register.127The UK government has been curiously silent onthe role of speculation in influencing commodityprices. Despite the wealth of evidence to thecontrary, the Treasury has been sceptical thatspeculation presents either a systemic risk tothe economy or has been a contributing factor infood price rises. The UK government says “Whilsttheory allows for the possibility of speculationhaving an impact on prices” they are “scepticalthat speculators have played a significant causalrole in the [2007/08] price spikes.”128This runscounter to much of the evidence presented inthis report. But by recognising the theoreticalimpact of speculation, the UK governmentaccepts that in the future speculation could haveimpacts on price. It should therefore recogniseits responsibility to regulate, in order to preventspeculation causing huge price and volatilityproblems in the future.Despiteallthecontroversysurroundingtheworkingsof commodity markets, the UK’s Financial ServicesAuthority has just one reference to commoditiesin the whole of its current business plan:Over the coming year we will continue to review,including within the CESR and IOSCO, whetherthere is sufficient transparency in non-equitymarkets trading. The credit crisis (among otherthings) has prompted regulators to revisitarrangements for fixed income, credit derivatives,structured products and commodities, where asignificant amount of trading takes place OTC. Weare committed to ensuring that any changes to thetransparency regime are justified by market failureanalysisandhavecostsproportionatetobenefits.129Perhaps not coincidentally, London is host to thehighest amount of commodity trading outside theUnited States. Recent opposition to EU regulationof hedge funds by the UK treasury shows thatthe UK government still gives a disproportionatevoice to the financial sector at the expenseof other sectors of the economy, and againstthe interests of citizens. Rather than playingan active role in setting the best regulatorystandards, there is a danger the UK will continueits disastrous no-touch approach to the financialsector. Worse still, it might seek to actively blockprogressive reforms, making it the global pariahof derivative and commodity market reform.Ironically, in doing so the UK government risksnot only jeopardising the food security of millionsaround the world, but also the affordabilityof food and fuel to low-income consumers inthis country, as well as to business end-usershighly dependant on commodities such asfood manufacturers, haulage companies andcommercial airlines.28The great hunger lottery: How banking speculation causes food crises
29The great hunger lottery: How banking speculation causes food crisesReregulating commodity markets is a vital step intackling hunger and reshaping the global economyto work for the benefit of people rather thanprofit for the small elite of bankers. This reporthas outlined five reasons why the UK governmentand European Union should support regulationsto limits excessive speculation in commodities.1) Higher and more volatile food and oil pricesAs outlined throughout the report, speculationin recent years has contributed to the spike infood and oil prices and made prices more volatile.The recent example of hedge funds depressingthe price of coffee also shows the potential forspeculation to reduce prices.High food and oil prices have reduced the realincomes of people across the world. This hasaffected the poorest people the most causinghunger and malnutrition to increase, valuableassets to be sold off, spending on health,education and family planning to fall and morerisky employment to be taken on. Yet the mainreason for speculation is to make large profitsfor multinational banks. This is one of the moststriking examples of the injustice of profit beingput ahead of people.Volatile prices also make it more difficult forfarmers to plan and invest. At a country level,wild swings in commodity prices can destabilisethe economies of commodity exporters andimporters, as the FAO says: “hampering theirefforts to reduce poverty.” 130In richer countries such as the UK, highcommodity prices also reduced the real incomesof consumers, affecting the poorest in society themost. The food and oil price spikes in 2007 and2008 helped to push the UK towards recession,and high inflation led to higher interest rates.Regulating commodity markets would benefitpeople across the world.6. Conclusion
30The great hunger lottery: How banking speculation causes food crisesEven if the UK government remains unconvincedthat financial speculation played much of arole in the 2007 and 2008 price hikes, it doesacknowledge it could play a future role. If thereis any chance of speculation causing price hikesand volatility in the future, regulations must beintroduced now to prevent this from happening.Furthermore, the following are good reasonsto introduce regulations to limit excessivespeculation regardless of any impact on the realprice of food and fuel.2) Help producers and purchasers to hedgetheir riskThe massive influx of speculative money intocommodity markets has made it more difficult forreal buyers and sellers to hedge their risk. Thereis too much liquidity in commodity markets. Thisspeculative money has caused derivatives tofluctuate more wildly in price, increasing ratherthan reducing risk. This fluctuation and higherprices have meant hedgers have had to providemoney margin when buying their hedges. There isevidence that some farmers were not able toaffordtodoso,andsostoppedhedgingaltogether.3) Enable futures markets to betterdiscover pricesThe havoc speculators have brought to commoditymarkets has also made futures markets lessaccurate in predicting future real prices of acommodity. This makes it more difficult forcentral banks to predict inflation and so setinterest rates accordingly.4) Free up capital for use in genuinelyproductive investmentMoney put into commodity derivatives byspeculators is not investment. It does not providecapital for any genuinely useful activities. Sincethe credit crunch, governments and central banksin developed countries have sought to increaseeconomic growth by pumping huge quantitiesof cheap money into financial markets, with thehope this would increase investment. However,money put into commodity derivatives and otherunproductive areas such as property deniescapital for real investment.5) Protect against financial crisesThe credit crunch and financial crisis was causedby a huge boom in private sector debt. This boomwas allowed to take place because risky loanswere hidden in the world of over-the-counterderivatives, hidden from regulators, withoutthe protections of trading through a properclearing exchange. Making the trading of allderivatives, commodity and other derivativessuch as in property, government debt and foreignexchange, is a vital step to prevent such a crisisfrom reoccurring. All derivatives need to bebrought onto properly regulated exchanges, withregulated clearing used to prevent default oncontracts and toxic debt sweeping through thefinancial system.The opposition to regulating commodityderivatives comes from those in the financialindustry with a vested interest in the profits theymake from the unregulated market, particularlythe large banks. The profits banks make allowsthem to throw huge amounts of resourcesinto a behind-the-scenes lobbying effort toprevent regulation. The power of banks in the UKunfortunately makes UK authorities particularlysusceptible to such lobbying.Regulatorsneedtoresistlobbyingandlooktowhatis genuinely in the interests of people rather thantheprofitofasmallelite.Allthosewhohaveconcernfor justice and for less risky economies have topush for such regulations to be implemented.
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