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p. 29 of 36 BACK | NEXT Foreword 1. Developing Asia and the world II. Economic trends and prospects in developing Asia III. Developing Asia's imprint on global commodity markets Introduction Commodity price drivers Commodity prices: Short and long views Developing Asia’s imprint on global commodity markets The outlook for commodity demand, trade, and prices to 2015 Conclusions Appendix Statistical notes and tables ADO forecasting performance for GDP growth and inflation

Asian Development Outlook 2006 Update : III. Developing Asia's imprint on global commodity markets

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Commodity price drivers

Figure 3.1 shows price indexes of energy and nonenergy commodities from 1983 to 2006. These are World Bank indexes (Box 3.1) for the “real” price of commodities, which deflate nominal commodity prices by an index of manufactured goods’ prices. Throughout this part of ADO 2006, reference is to real prices, unless otherwise indicated. The charts clearly depict a sharp escalation in global commodity prices that began around the fourth quarter of 2001. Although dips have occurred since, these have been shallow and short-lived.

In Figure 3.2, percentage changes in (real) nonenergy prices are shown for the period 1980–2005, together with growth in world GDP over the same interval. Local peaks and troughs in changes in nonenergy prices coincide closely with peaks and troughs in the global business cycle. Typically, as global growth accelerates, the demand for commodities rises, pushing their relative prices up. But when global growth slows, nonenergy commodity prices fall against the manufacturing basket. Periods of falling real prices generally occur when global growth is below trend.

Fixed investment and inventory cycles can aggravate the pro-cyclical behavior of changes in real commodity prices. Short-run price inelasticity of commodity supplies tends to amplify the price response to faster demand growth and depletes inventories. But after investment and supply have expanded in response to rising profits, when demand growth subsequently slows there is greater downward pressure on real commodity prices. Likewise, if inventory demand increases on expectations of rising real prices, and falls when real prices dip, this will amplify cyclicality.

Historically, the global business cycle has been dominated by the performance of industrial countries. But with developing Asia’s growing weight in the global economy, and its expanding appetite for commodities, the region has come to exert greater influence on commodity price movements. One way to look at this is to consider simple correlations between GDP growth and changes in real commodity price. Figure 3.3 displays correlation coefficients between real nonenergy price changes (%) and GDP growth rates for different regions from 1980 to 2005. These computations are made in rolling 10-year windows from 1971 to 2005. This means that at any point in time, the reported correlation coefficient refers to the association between percentage changes in real prices and growth over the preceding decade.

Figure 3.3 illustrates two important stylized facts. First, the link between the ups and downs of growth in the Group of Seven leading industrialized countries (G7) and nonenergy commodity price changes has been reasonably consistent over the past 25 years. The dip in the correlation in the latter period reflects the asymmetric impact of the Asian financial crisis on real commodity prices (they dipped) and on G7 growth (it was barely affected). Second, for developing Asia a strong positive correlation between growth and nonenergy commodity price changes has been present since the early 1990s. In the 1970s through the early 1980s, when growth and (nonenergy) commodity price changes were negatively correlated, developing Asia was mainly a primary commodity producer and exporter. The intercept shift coincides with a period of rapid industrialization during which developing Asia began to import significant quantities of primary commodities.

However, growth is not the only factor that influences the direction of commodity prices. Another important element is global liquidity. Figure 3.4 shows the relationship between real interest rates and an index of real nonenergy, primary commodity prices over the period 1950–2005. This suggests that when global liquidity conditions are easy and real short-term interest rates are low, real commodity prices tend to be higher.

Monetary influences on primary commodity prices work through a number of channels. On the demand side, low real interest rates cut the costs of storage and encourage investment in inventories; on the supply side, they increase the discounted value of future supply (particularly of nonrenewable resources) and provide an incentive to defer extraction. Finally, as recent events attest, low real interest rates and easy liquidity make commodities an attractive asset class for financial investors.

Investing in commodities as part of a hedging strategy against financial risks or as part of a broader portfolio has a long history. However, the past few years have witnessed a flurry of hedge fund and institutional investor activity in commodity futures, though precise numbers about the scale of these investments are hard to come by. In recent times, investment in commodities has been driven by the hunt for yield in a low-interest-rate environment (Box 3.2).

Of course, many other factors influence the behavior of primary commodity prices. Low price elasticities of supply and demand tend to make primary commodity prices volatile. Also, because primary commodity prices are less “sticky” than many other prices—they go down easily as well as up—they have a tendency to overreact to shocks (Frankel 1986). Figure 3.5 illustrates how crude oil prices bounce after supply shocks. While supply conditions are obviously critical, they can be very difficult to predict. There are many sources of genuine uncertainty as well as risk. Future technological, political, and institutional conditions, which do not easily lend themselves to forecasting or precise calculation, can have a critical bearing on the profitability of primary commodity production.