...and growth in many countries.

Nonfuel commodities have a higher share in world trade (about 14 percent during 2000-04) than fuel commodities (7 percent). As in the case of oil, many developing countries are highly dependent on nonfuel commodities as a source of export earnings--36 countries have a ratio of nonfuel commodity exports to GDP of over 10 percent, and in 92 countries the ratio is over 5 percent (Figure 5.1). Indeed, in many low-income countries, a large share of export receipts are generated by just a few commodities (see Table 5.1 for selected examples). Moreover, prices of some nonfuel commodities have increased more than oil prices--for example, the IMF metals index has risen by 180 percent in real terms since 2002, while oil prices increased by 157 percent.

[FIGURE 5.1 OMITTED]

Given the significant exposure of many countries to fluctuations in nonfuel commodity prices, the future dynamics of commodity markets have important policy implications. Some observers have suggested that the rise of China and other large emerging markets may have led to a fundamental change in long-term price trends, and that the world has now entered a period of sustained high prices, particularly of metals (see Barclays Capital, 2006a). In contrast, others believe that speculative forces have largely decoupled metals prices from market fundamentals (Societe Generale, 2006), and that prices will inevitably fall back and continue to decline gradually in real terms, as during most of the past century.

This chapter examines these issues by:

* identifying the underlying causes of the recent increases in nonfuel commodity prices and putting them in historical perspective;

* assessing the roles of rising commodity demand from large emerging market countries (especially China) and of financial investors in pushing up prices; and

* evaluating whether the current high price levels are likely to be temporary or lasting.

Long-Term Trends in Commodity Prices and Volatility

Despite recent increases, the prices of most nonfuel commodities remain below their historical peaks in real terms. Over the past five decades, commodity prices have fallen relative to consumer prices at the rate of about 1.6 percent a year (Figure 5.2). (1) This downward trend is usually attributed to large productivity gains in the agricultural and metals sectors relative to other parts of the economy. (2) Compared with the prices of manufactures, however, commodity prices stopped falling in the 1990s as the growing globalization of the manufacturing sector slowed producer price inflation. (3)

[FIGURE 5.2 OMITTED]

On a year-to-year basis, commodity prices can significantly deviate from the long-term downward trend, as price volatility is much higher than the average real price decline (one standard deviation of annual price changes is about 11.5 percent, compared with the long-term price decline of 1.6 percent a year; see Figure 5.3). The current volatility in nonfuel commodity markets is not unusual by historical standards. In fact, the volatility of food and raw agricultural material prices seems to have fallen on average over the past couple of decades, as growing geographical diversification of production and technological advances have reduced the sensitivity of prices to supply shocks, such as bad weather or natural disasters (FAO, 2004b). (4)

[FIGURE 5.3 OMITTED]

Nonfuel commodity prices--especially metals--have a strong business-cycle component (Figure 5.4). The correlation between world growth and annual changes in real metals prices is about 50 percent. Moreover, almost all periods of large upward movements in metals prices have been associated with strong world growth. Prices of agricultural commodities also tend to rise during cyclical upturns, but their response is much more muted than in the case of metals because of more flexible supply and the low income elasticity of demand.

[FIGURE 5.4 OMITTED]

Assessment of Recent Developments

Over the past four years, commodity prices have evolved very differently across various subgroups of the nonfuel index (Figure 5.5). Metals prices have risen sharply since 2002 to the present (by 180 percent in real terms), while food and agricultural raw materials prices have increased much less (by 20 and 4 percent, respectively). As a result, metals contributed almost 90 percent to the cumulative 60 percent real increase in the IMF nonfuel commodity index since 2002 (Table 5.2).

[FIGURE 5.5 OMITTED]

The current price dynamics of food and agricultural raw material prices are similar to earlier cyclical episodes (Figure 5.6). In fact, some of the increase in food prices accumulated since 2001 can be attributed to the depreciation of U.S. dollar--real food prices expressed in the IMF's special drawing rights (SDRs) are now only 9 percent higher than four years ago, and the SDR prices of agricultural raw materials are lower than their 2002 level.

[FIGURE 5.6 OMITTED]

Until recently, metals prices have also tracked historical patterns (5)--but the continued run-up in metals prices this year has made the cumulative price increase significantly larger than usual. A part of the unusually strong run-up in metals prices can be attributed to low investment in the metals sector in the late 1990s and the early 2000s that followed a period of earlier price declines. Some analysts have also suggested that the intensity of the price upswing in this cycle has been amplified by new factors-the increasing weight of rapidly growing emerging markets (especially China) in the world economy and investment activity of financial investors in commodity markets. (6) All these potential explanations are further examined below.

Role of Emerging Markets

China has become a key driver of price dynamics in the metals markets. During 2002-05, China contributed almost all of the increase in the world consumption of nickel and tin (Table 5.3). In the cases of lead and zinc, China's contribution even exceeded net world consumption growth. For the two most widely traded base metals (aluminum and copper) and for steel, the contribution of China to world consumption growth was about 50 percent. (7) These figures exceed China's 29 percent contribution to world PPP-adjusted GDP growth and are much higher than the current 15 percent share of China in world output. Compared with the last decade, the relative contribution of China to global demand for commodities has increased considerably, as a result of both its rising weight in the world economy and its particularly rapid industrial production growth--including industrial exports--which is closely linked to the demand for metals. (8) Other emerging market countries have also contributed significantly to demand in specific metals markets but, overall, their contribution was not as broad-based as China's (Table 5.3). (9)

Is the strength of Chinese demand for metals temporary or permanent? Historical patterns suggest that consumption of metals typically grows together with income until about $15,000-$20,000 per capita (in purchasing power parity, or PPP, adjusted dollars) as countries go through a period of industrialization and infrastructure building (Figure 5.7). At higher incomes, growth typically becomes more services-driven and, therefore, the use of metals per capita starts to stagnate. (10) So far, China (with its current PPP-adjusted real income of about $6,400 per capita) has generally tracked the patterns of Japan and Korea during their initial development phase. For some metals, China's per capita consumption at a given income level is higher than in the other emerging markets, partly because it has a much greater share of industry in its gross domestic product than is typical for other countries at a similar stage of development (Figure 5.8; see also Chapter 3). This outcome reflects historical antecedents (11) as well as the strong competitiveness of the Chinese economy and relocation of manufacturing production from advanced economies and other emerging markets to China.

[FIGURES 5.7-5.8 OMITTED]

Looking ahead, rapid industrial output growth, construction activity, and infrastructure needs could sustain the growth of demand of emerging markets for metals at high rates in the medium term. That said, some of the current demand strength could be temporary--especially as the Chinese government is aiming at a rebalancing of growth from investment to consumption over the medium term. Moreover, China's size and heavy concentration in industry make it somewhat a special case. India's industrial sector, for example, has a considerably lower share in the economy, and India's continued rapid growth would in the medium term have a less pronounced impact on metals markets than growth in China.

The impact of emerging markets on agricultural prices is less clear-cut. China and other fast-developing countries have often contributed significantly to world demand growth (e.g., in the cases of cotton and beef; see Table 5.4). (12) However, this has not necessarily led to rising prices--the price of cotton, for example, fell by almost 20 percent during 2004-05. Generally, food consumption in developing countries shifts gradually toward high-protein commodities such as meats, dairy products, and oils (FAO, 2004b). But this type of substitution has started at a much lower level of income in China and other countries--for example, meat consumption growth was particularly fast in China when its per capita income was below $3,000 in PPP terms. The contribution of China to consumption growth in some key commodity markets such as bananas, beef, corn, and cotton was higher than its population share during much of the past decade without any noticeable break in the trend of falling real prices (Table 5.4 and Figure 5.5). A similar point can also be made about India and other major emerging market countries.

Will the Recent Run-Up in Metals Prices Be Sustained?

A central question, especially for metal-exporting countries, is whether the recent run-up in prices will prove lasting, or whether the longer-term downward price trend discussed earlier will eventually reassert itself.

Commodities futures markets suggest that the current high prices may not be sustained in the medium term. (13) Over the next five years, the futures prices of metals retain only about one-half of the increase accumulated since 2002 (in real terms, metals prices fall by 45 percent from current levels; see Figure 5.9). This decline contrasts with oil futures prices, which remain very close to the current spot price. There are differences within the group of metals--for example, aluminum futures prices decline less over time (by 31 percent) than copper futures prices (49 percent in real terms). Against this background, Box 5.1 examines the role of financial investors in determining commodity prices. The analysis suggests that while the investors may have played a role in providing liquidity to the markets, there is little evidence that speculative investments have been a significant driver of nonfuel commodity price movements.

[FIGURE 5.9 OMITTED]

Box 5.1. Has Speculation Contributed to Higher Commodity Prices? Investor interest in commodity futures as assets has increased significantly in recent years. For example, participation in the NYMEX oil futures market--as measured by the number of contracts reported by the U.S. Commodity Futures Trading Commission (CFTC)--has risen almost fourfold since 1995 (first figure). Furthermore, the share of noncommercial contracts (long plus short--or total open positions) has steadily increased over this period--from 9 percent to 16 percent of the total. A similar trend can be observed in other commodity markets. The value of noncommercial contracts, however, is not large relative to total transactions in the physical market over a comparable period. (1) [FIGURE OMITTED] The increased investor interest has led some private analysts to suggest that speculative activity has been a major contributor to the recent surge in crude oil and metals prices and may have even caused a bubble (see, for example, Societe Generale, 2006). They argue that speculation has magnified the impact of changes in the fundamental determinants of supply and demand (which have been supportive of higher prices) to an extent that in some cases prices have risen far in excess of levels justified by fundamentals. (2) The Organization of the Petroleum Exporting Countries (OPEC) has also suggested that while geopolitical uncertainties have been a major force behind higher prices, speculation has also been a significant factor, given the organization's accommodative supply policies and the historically high level of inventories in OECD countries. (3) Despite the attractiveness of some of these arguments, however, the supporting evidence has often focused on correlations rather than tests of causality, and has tended to be anecdotal or circumstantial--based on, for example, the increased hedge fund activity accompanying the...

NOTE: All illustrations and photos have been removed from this article.



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