Tuesday, October 26, 2010

Last redoubt of the cowboy capitalists

Der Spiegel published a brilliant study of the current pricing dynamics in the copper market this week. It is a fascinating and terrifying glimpse of the evolution of global capital's shiny new bubble: metals. From the piece:
In Manhattan, only one block from Ground Zero, 12 men are sitting at a round table in a windowless room. If it weren't for the countless flashing screens and electronic display panels, they might resemble a group of old men who had gathered to play poker. But these men are copper traders who have gathered at the New York Mercantile Exchange (NYMEX), the world's largest physical commodity futures exchange.

They trade in futures contracts, or agreements that obligate them to sell highly pure copper at a fixed price on a specific date. Each contract represents about 11 tons, with a current market value of roughly $95,000.

Sometimes they go "long," which means betting that prices will rise. Or they take short positions when they expect prices to fall. These traders no longer have any interest whatsoever in the metal itself.

Traders today deal in unimaginable sums worldwide, with securities worth more than $20 billion changing hands every day. Last year, copper futures corresponding to 1.13 billion tons were traded on the world's four largest copper exchanges, in London, New York, Shanghai and Mumbai. It was 71 times as much copper as the industry actually produced in the same period.

For any Australian wishing to understand the world into which we are being swept like a bobbing cork, this is a must read. As the above chart from the article illustrates, copper, like oil before it, is trading on an incredible balloon of virtual demand. The article continues:
Price movements are no longer as dependent on the so-called fundamentals. Nowadays, commodities prices are largely a question of emotion. Of course, this doesn't mean that supply and demand no longer play a role for speculators. On the contrary, speculators eagerly follow every piece of news on residential construction in China, ore production in Chile or inventories in London. The problem is that the market only takes notice of news that reflects its mood. Everything else is glossed over. This can lead to grotesque overreactions and extremely volatile prices, to the detriment of consumers and the economy.

Peter Hollands, a British geologist, recognized early on that a deep-seated change was taking place. Hollands, an authority in the copper business, owns a consulting company called Bloomsbury Minerals Economics, tucked away on a side street near London's West End. "We have been living in a new world for the last six years," says Hollands.

Six years ago, a "wave of liquidity" took hold of the market and moved prices in an unprecedented manner, says Hollands. He points to a chart showing two different copper prices (see graphic). One of the lines on the graph is notional. It rises only moderately after 2004 and doesn't exceed $5,000 per ton. It is the result of the traditional factors that influence the price of copper, such as production costs, inventory levels, industrial orders and the effects of currency movements. This line describes the old world, "when copper was still a simple industrial metal," Hollands says, a touch of melancholy in his voice.

The other line shows the actual changes in the price of copper, how it shot up to over $8,000 and has been hopping nervously up and down since then. This is the new world, the world of finance-driven commodities markets. They are no longer shaped by the market and its forces, but by what the market believes -- or what it is supposed to believe.

This is the real world of markets that confronts our policy-makers. And, as discussed in previous posts, it applies just as readily to the pricing of commodity currencies as it does to the underlying goods.

According to Ilene Grabel and Ha-Joon Chang writing in the FT, there is widespread and growing acknowledgement amongst global policy-makers of the damage these maniacal markets do:
Was it really just over a decade ago that the International Monetary Fund and investors howled when Malaysia imposed capital controls in response to the Asian financial crisis? We ask because suddenly those times seem so distant. Today, the IMF is not just sitting on its hands as country after country resurrects capital controls, but is actually going so far as to promote their use. What about the investors whose freedoms are eclipsed by the new controls? Well, their enthusiasm for foreign lending and investing has not been damped in the least. So what is going on here? In our view, nothing short of the most significant transformation in global financial management of the past 30 years.

Like most transformations, this reform has been gradual. Reform in the IMF view of capital controls actually began soon after the Asian crisis, as countries such as Chile, China and India imposed controls. Most analysts found that these controls were beneficial in key respects. This success led the IMF to soften its hardline stance: it admitted that controls might be tolerable in exceptional cases provided that they were temporary, market friendly and focused strictly on capital inflows. That said, policymakers adopted capital controls at their peril – not least risking condemnation by the Fund and by credit rating agencies, and punishment by international investors.

What was just a trickle of controls before the current crisis is now a flood. Iceland led the way in 2008 as it grappled with its financial implosion. Soon after, a parade of developing countries took action: some strengthened existing controls while others introduced new measures that targeted inflows and outflows. For example, during the crisis China augmented its extensive array of controls, while Indonesia, Taiwan, Peru, Argentina, Ecuador, Ukraine, Russia and Venezuela also introduced controls of one sort or another. In October 2010 alone: Brazil twice raised its tax on foreign investment in fixed-income bonds while leaving foreign direct investment untaxed; Thailand introduced a 15 per cent withholding tax on capital gains and interest payments on foreign holdings of government and state-owned company bonds; and South Korean regulators have begun to audit lenders utilising foreign currency derivatives.

This blog just can't understand why Australia is not having this discussion. Like copper, the Aussie dollar is grossly inflated. Moreover, the real exchange rate, which includes inflation, has been rising even more for years.

Fact is, we've got ourselves into a major pickle. If we undertake currency control initiatives it would mean interest rates would have to be higher to control the boom. That means more pressure on housing just when its entering a correction.

And we've trashed a resource rent tax as an alternative.

So instead, we're gonna sacrifice our non-resource exports to houses and holes.

Inexplicably to this blogger, Chris Richardson joined the unholy consensus today when he uged:
The government to refrain from erecting new trade barriers, subsidising old industries and reaching for regulation without checking if its costs outweighed benefits. And don't chase the chimera of 'supporting jobs' in an economy that is already close to full employment.

Whilst in virtually the same breath agreeing with this bloggers' forecast outcome:
Mining and construction were the main industries set to ''turbocharge'' the economy in years ahead. It said the mining industry's growth rate would top more than 7 per cent this financial year and next, while a recovery in new home building would lift construction's output by as much as 9 per cent this year.

And after that?


The Lorax said...

Markets are infallible. I have a right mind to give you good clip around the ears with my copy of Atlas Shrugged.

A liberal? Give me a break. F*cking communist.

Anonymous said...

Good post. "Trading" seems to dominate just about all commodity pricing now - e.g. http://www.reuters.com/article/idUSWALQLE6QE20101026. So the classic Supply-Demand relationships that are central to self-control of the economy are kaput.
But why say the Aussie $ is grossly inflated?

David Llewellyn-Smith said...

The same speculative dynamics are loose in the currency markets.

The Australian dollar is roughly 1% of the global economy. Yet its currency is 7.6% of global currency trades - almost $200 billion per day, our GDP turned over every six days.

The BIS reckons 17% of global foreign exchange turnover is related to underlying commercial or government activity. If applied to the Australian foreign exchange market that leaves a huge slice for speculators, even allowing a large margin for error.