Financial speculation and food crisis

‘The financial markets have evolved into a monster that needs to be put in check.’  This statement, from may 2008, is coming from Horst Köhler, the current German president, christian-democrat and former director of the International Monetary Fund.  It indicates how dominant the financial sector has become in world economy. 
Each moment of the day an enormous moneycloud swishes over the world.  In seconds the manna flashes from one country to another, from one sector to another, searching for the highest profit.  The saying ‘Time is Money’ receives a new dimension: every second you purchase a share, a currency or a raw material too early or too late, can cost you money.

Technology is making the speed possible.  Politics dismissed most limitations on free movement and the storm has only been expanding because mainly the American central bank – the Federal Reserve – created a lot of money.  Since years the Fed is counter-attacking every possibility for an economic recession with “free money”: to keep investment and consumption stable, the American central bank makes borrowing money cheap. 
Paul De Grauwe, professor in international economy at the KU Leuven: ‘For years, Fed-president Alan Greenspan put the interest rate at one procent, lower than the inflation.  Money was too cheap for too long.’  Not only the consumer and the companies but also the enormous financial industry went searching for the higher profits with that money.  The sector used the so-called “innovations”, new financial instruments that became ever more complex. Warren Buffett, one of world’s biggest stock exchange investors, calls these deducted products ‘financial weapons of mass destruction’.

from soap bubble to soap bubble

The search for profit is done in a hectic way and with selective blindness which meanwhile the world has gotten used to.  The world economy is floating from soap bubble to soap bubble for fifteen years now already and the risks for the monetary system are getting bigger every crisis.

First there was a series of regional crises: monetary markets completely focussed on one specific country, then massively redrew and thus created a currency crisis-annex-recession.  This happened in Mexico, Thailand, Malaysia, South-Korea, Indonesia, Brasil, Russia…  Everytime governments had to intervene to prevent the worse.  Afterwards there was the hype of company shares in informatics and communication technology: the rates kept on expanding till one day also the dotcom-soap bubble exploded.  Already then the experienced banker Alexandre Lamfalussy told us that we were talking about a fundamental problem: the problems do not rise because investors have too few information but because they react as a herd everytime and don’t want to see the information.

To limit the consequences of the dotcom-crisis and the assaults of 9/11, Alan Greenspan pushed the money-pedal to the metal.  This only aggravated the problem: even more money went to search for profit, even more consumers purchased on credit.

It was only waiting for the next bubble to come along.  This time it was real estate, especially in the United States and the United Kingdom, that pulled in capital.  First of all cheaper loans pushed up the demand for and the price of houses.  But in the US poor households – of which it could be predicted to have big problems with repaying their mortgage – were trapped with formulas in which the first years almost nothing had to be paid, after which the next years the payment increased with leaps. 
These so-called “ninja-mortgages” - assigned to people with no income, no job, no assets – were subsequently packed in complex investing products which a lot of money was to earned with.  Even the largest banks fell for the siren song but eventually the re-packed rubbish mortgages came true as “financial cluster bombs”, resulting in enormous losses for bank after bank since the housing prices would fall.  ‘The price of greed’, Luc Van der Kelen wrote in Flemish newspaper Het Laatste Nieuws and indeed, it is the craving for high profit margins that leads to crazy risks.  Flipside is now that mainly in the US hundred thousands of households can’t pay their mortgage anymore and are driven out of their houses.

For each of these crises large financial organisations get into trouble because of their risky venture, but the government cannot let them go bankrupt because they would drag the whole system along in their fall.  Socialism for the riches is how some critics call it.  That creates a moral dilemma.  By intervening every time, the state sets at ease the gambler: whatever they do, the government will rescue them.

Raw materials as lifebuoy

The raw materials are well on target to become the next soap bubble.  Certainly there are objective reasons for the excessive rising prices of oil, wheat or soya last springtime.  For oil and natural gas – in fact for almost all raw materials – the booming economies of upcoming giants such as China, India, Brasil and Indonesia forced the demand and thus the prices up. And still, demand and supply of raw oil are almost equal.  According to the International Agency for Energy (IAE), both accounted for 86,8 million barrels a day in april 2008.

The oil price rose the last one and a half year much more than in 2003 and 2006, while the demand rose a lot less.  Demand and supply are equally increasing already for 25 years.  Between 2003 en 2006 the price doubled from thirty to sixty dollar a barrel, while the demand in that period only increased with seven million barrels a day.  The last one and a half year demand “only” rose with two million barrels a day and price increased from sixty to 147 dollar.
Moreover, the coverage of the oil stocks is reaching 53,4 days far, according to the IAE ‘way above the average of the last five years’.  There are also few signs of scarcity such as queues of awaiting cars.  ‘140 dollar a barrel is not justifiable.  It wil collapse’, professor De Grauwe foretells.  That process seems already to be working.

For agricultural raw materials the situation is different.  The prices for rice, wheat, soya and corn increased strongly – although prices for rice and wheat already decreased by now – byt the wheat stocks are in fact at the lowest level in years.  ‘Seven of the last eight years more wheat has been consumed than has been produced.  The real wheat reserves decreased from 285 million tons in 2000 to 22 million tons now. ‘That is 1,05 percent of world consumption while five percent is needed to be protected against bad harvests’, Jef Vandeputte of Commodity Consultants knows. The shrink of the stocks is not due to bad production  - 2007 and 2008 where record years – but due to increasing demand.  More meat is being eaten in upcoming countries and the production of one kilo meat takes six to eight kilos of grains. 
Vandeputte: ‘This progressed slowly, whereby the market was able to adapt itself.  It was however not the case when the US, the EU, Brasil and Indonesia decided to use food-plants as bio-fuel.  In the US, 4,7 percent of corn production went to ethanol in 2000, and in 2007 it was already 17,2 percent.’  Vandeputte acknowledges this as the most important reason for the high prices.

Nevertheless also on the agricultural markets extraordinary things happened which suggested financial speculation.  The price for cotton increased in february with fifty percent while the stocks were full.

Pension funds massively buying wheat

How can the monetary world influence the price of oil or wheat? That is possible because the financial institutions who are not thinking about really purchasing oil or corn, have become important actors on the futures markets of those raw materials. Futures are contracts by which a buyer commits himself to buy a certain amount of a raw material at a certain time for a predecided price.  The seller accepts to deliver at that price.  Futures permit producers to cover themselves against price fluctuations: the farmer who is seeding, likes to have the certitude about the price he will receive in september.  The useful role of the tradional speculator is that he buys those [futures] at that price because he hopes that in september the price will be higher, which means he can sell with profit.

Now even pension funds, lever funds and banks massively report as purchasers on the futures markets: they awake the demand, push up the future prices in that way, and finally also the actual prices.  After all, when the difference between futures and the dayprice becomes too big, for example oil companies save oil to sell it at the interesting futures price and thus push up the dayprice.
Michael Masters, manager for twelve years already of a lever funds, said it at a lecture for the American senate in may 2008 like this:
‘Why keeps the demand for raw materials increasing while the price is reaching the stars? Because a new category of market actors reports at the market for raw materials futures: institutional investors such as pension funds, lever funds, different investment funds… Together these investors are good for a bigger part of the raw material futures than the traditional actors.’ Masters calls the institutional investors ‘index speculators’ because they gamble at the increase of raw material prices and their corresponding index.

Between 2003 and 2008, investments of index speculators of raw material futures rose from thirteen billion dollar to 260 billion dollar according to Masters. Three of the four Belgian big banks offer their customers such investment instruments (see frame). Masters: ‘This group has now stocked 1,1 billion barrels of raw oil through the futures market, eight times as much as the US has added to their strategic stock in the last five years. With 1,3 billion tons of wheat they can foresee every US-citizen with bread, pasta and pastry  for 2 years. The characteristic of this group is that they invest more as the prices increase.’ Logical since it is about an investment product: the “herd” is attracted by raw material indices growing strongly in value, while shares or houses experience hard times.

Critics doubt about the role of the index speculators.  They point at the fact that wheat such as rice or durum wheat, for which there are no futures markets, also know price increases. ‘That’s right’, says American professor Michael Greenberger of the University of Maryland to MO*. Greenberger is following the subject for years already. ‘If speculation encourages most of the prices, an inkblot comes into being which influences also raw materials without futures markets.’ Also authorities such as Paul De Grauwe or the American investor-philantropist George Soros claim that speculation certainly is not the only responsible cause for the price increases, but is contributing to it for sure. Ergo: the search of the financial magicians for good investments influences the price that you and me are paying for oil, wheat or soya.

through a backdoor

The main question is in how far speculation is increasing the prices. The American Congress is reflecting on speculation on American raw materials for a couple of years already.  That is relevant for the rest of the world because wheat and energy prices are mainly determined by American stock exchange markets.

In june 2006 a report by the senate commission for Homeland Security claimed that ‘only in the regulated market already sixty billion dollar has flown by speculative capital in oil futures. That creates a logical demand for oil which pushes up the price as much as a demand in the physical market…  Although the effect of speculation is hard to calculate, there is enough evidence that the wave of speculation has increased the oil prices. Several analysts estimate that speculation is good for one third of the actual oil price.’ That amounted to seventy dollar then.  In comparison: the first 52 days of 2008 55 billion dollar flowed into the markets for raw material futures.

In the commission of the American senate, cases of direct price manipulation by speculation are also studied. Those are made possible because the Commodity Futures Trading Commission (CFTC), who controls the trade in raw material contracts, cannot or does not want to regulate a part of the market anymore. The CFTC has to keep an eye on market actors and make sure they don’t take such a dominant position by which they can manipulate the market. Nevertheless the commission allowed the creation of several backdoors. Professor Michael Greenberger, once director of the CFTC, tells MO* that the commission tends to scoop out its own authority. ‘It is strongly influenced by those who should be controlled by it.’

In that way the “Enron-backdoor” was created at the end of 2000. This allowed trade in energy futures on the market without CFCT supervision from then on. ‘This route was developped when senator Gramm, president of the senate commission Finances, succeeded in having adopted a legislation on the modernisation of trade in raw material futures in a programme legislation of 262 pages just before the parlementarian recess. This new arrangement is called after Enron, because Wendy Gramm, senator Gramm’s wife, was seating in the council of Enron. It is thanks to this legislation that Enron was able to double the price for electricity in 2001 in the west of the US through its own online trade facility.’  Enron was the largest donor of the election campagne for George W. Bush and went broke some years later by massive fraude. The “Enron-backdoor” does not relate to agriculture futures where supervision remains strong, although even there Michael Masters is signalizing black spots in the legislation.

A report of the senate commission for Homeland Security of june 2007 about speculation in natural gasses pointed out how the lever funds Amaranth could manipulate the price for natural gasses through the so-called “London-backdoor”, because it had about fourty percent of all natural gas futures in its pocket through the unregulated market Intercontinental Exchange (ICE).  Supervisory commission CFTC allowed that the ICE, who said to be operating from London, placed its terminals in the US and traded the same products as the regulated markets did.  Spicy detail: the ICE was co-founded by Goldman Sachs, the bank of which current minister of finances Henry Paulson was the president for years.

The ICE also has a very big influence on the oil market. Under influence of the parliamentarian lectures and the corresponding commotion the CFTC has already closed the “London-flight route”.  Greenberger expects that the Congress will take more initiatives for the coming months to counter-attack the financial speculation on raw materials. ‘At the end of may, the CFTC still claimed that there was no proof of excessive speculation. Now they are about to analyse the market of the oil futures more thoroughly.’

A lot of people, also insiders, thus believe that the financial world has increased the prices for raw materials much more than would have been necessary on grounds of the fundamentals (objective grounds that influence the prices, such as demand and supply). That is a technical remark, which however concerns millions of human lifes. Of the high oil prices one could claim that it promotes the environmental aspect of the economy, but the high food prices are killing people in developping countries. This was made clear by the United Nations. Even when index speculators only increase the food prices for a couple of percents, it is already madness. It brings the globalisation in danger: after all, how do you explain that bankers are making impoverished people starve to dead?

rules are needed

For the markets of raw materials, the solutions are clear: the banning of institutional investors from the market of raw material futures, more supervision and transparency, the closing of backdoors.  But the question is more general. More and more damage is done by the money sector: the continuous expanding mortgage crisis is weighing heavily on the real economy. The way to prevent such crises is by putting the banking sector under more rules. Martin Wolf, head economist of the Financial Times: ‘We have no other choice than to regulate the financial sector. A financial sector that is creating enormous gifts for insiders and repeating crises for a hundred millions of innocent bystanders is politically unacceptable. Who wants the market directed globalisation, will have to acknowledge that this is its Achilles tendon. Efficient action is needed now, before an even bigger globale crisis breaks out.’

The problem is that putting the money sector under rules is quite difficult. Firstly because the banking sector is rich and thus has a powerful lobby. The Financial Times calculated that in the US the profit of the financial institutions went from 5 percent of the total company profit in 1982, to 41 percent in 2007.’
Regulation is also hard because in the US and elsewhere, ministers of Finances and central bankers mostly come from the banking world and don’t like to deny opportunities for their former colleagues.
Professor De Grauwe: ‘Alan Greenspan had an unlimited admiration for the financial innovations of his former colleagues and didn’t want to stand in the way of that. As a central banker he is not only responsible for the welfare of the financial sector, but also for the welfare of the total population.’ The financial sector has to serve the world, not the other way around, but if the politics will take the necessary arrangements for that, still has to be fulfilled.

Three out of four Belgian bigbanks are speculating on food

KBC Life MI Security Food Prices is one of the investment funds of which the interest is related to the price evolution of a basket of six agricultural raw materials: cacao, coffee, wheat, sugar, corn and soya. ‘Does the value of an investment increase along the rising prices?’ I asked the KBC-Fund Phone. ‘It is as simple as that’, a lady kindly responds. Meanwhile KBC decided not to start any new food funds anymore.
Dexia Fund Commodities is an investment instrument which is linked to the known Goldman Sachs Commodities Light index, a basket of 25 raw materials (energy, metals, field growing and cattle-breeding). ‘It focusses on investors who want to profit of a policy that aims for surplus values on long term through a exposition in raw materials…  In a difficult climate for most of the other activa classes, the market of raw materials reached a profit of 2 figures in 2007’, is written in the prospectus.
On the investorsphone of Fortis I am told that the bank does not offer funds in raw materials. They send me to the recently by Fortis overtaken ABN Amro. ‘On www.abnamrozertifikate.de you can find a lot of funds under Rohstoffe.’ Indeed, thus there is the Jim Rogers International Agricultural Commodity Index Open End Zertifikat, the Rici Enhanced Agricultural Index Zertifikat or the Brent Crude Oil Zertifikat.
ING claims they don’t offer any investment funds which have their input on the increasing raw material prices.