Speculators accumulate as risks rise for world's poor

By Tony Jackson

Published: May 12 2008

In times of famine, Vladimir Ilych Lenin took a robust line on speculation. "We can't expect to get anywhere," he told the Petrograd Soviet in 1918, "unless we resort to terrorism: speculators must be shot on the spot."

Rather strong, perhaps, but the past week brought faint echoes of the sentiment. India's finance minister proposed shutting the country's agricultural futures markets. In Belgium, where the Belgian bank KBC has launched a fund with returns linked to food commodity prices, the Socialist party called for such funds to be banned.

The obvious premise here is that speculation helps push food prices higher. That is not a simple question. But first, a word on speculation itself.

In much of the world, the term still carries Leninist overtones. The speculator is a demon figure - the village rich man who gets wind of a poor harvest, stockpiles grain, holding his starving neighbours to ransom.

In most financial markets, however, the caricature makes no sense. If you cornered the market in General Motors shares, you would simply wind up owning General Motors - and good luck to you. Even most commodities, such as gold, are in the last resort inessential. But food is different. In normal times, speculators have a perfectly sound defence against this. Agricultural futures are a particularly pure form of risk-matching. The farmer fears low grain prices, the baker high ones. If they agree a price for the next harvest, the two worries cancel out. But they may not be worried at quite the same time. So the speculator shoulders the risk in the meantime, thus deepening the market's liquidity and - in theory - reducing the cost of hedging for those who actually need it.

But is it different this time? Is the sheer weight of money going into agricultural derivatives pushing food prices up? No, say those who make money from those instruments, such as the investment banks. Yes, say those who fear being squeezed, such as the farmers.

The first group points to rice, which is scarcely traded on exchanges yet has soared in recent months. The second points to US cotton futures.

These rose so sharply in March that the market was essentially shut to normal traders. This was in spite of cotton stocks being their highest in 40 years. But at just that point, the open interest in cotton futures was substantially bigger than the entire annual cotton crop. Coincidence?

The official line on all this seems to be shifting slightly. In 2006, the International Monetary Fund concluded that in commodities generally, speculative activity responded to price movements rather than the other way round. But by this March the IMF was puzzling over why prices were still rising in spite of the credit crunch and economic slowdown. A large part of the reason, it decided, was financial buying.

The US Commodities Futures Trading Commission still sticks to the former IMF line, producing charts to show speculative trades in agricultural derivatives have not necessarily coincided with market spikes. But it concedes that more research is needed.

Why might that be? First, as the US farming lobby points out, an increasing volume of trade is going over-the-counter, and thus out of sight. More fundamentally, the volume of speculation, as with oil, has been rising steeply. Since 2003, says Morgan Stanley, open interest in corn futures has risen from 500,000 contracts to almost 2.5m.

This should not surprise us. Over those years, pension funds have discovered commodities as a means towards the Holy Grail of diversification - a goal that has certainly been achieved so far, with commodities rising as most other assets have fallen.

And more recently, with the world waking up to the dangers of inflation, commodities have emerged as an explicit inflation hedge - an argument pushed by KBC for its own controversial fund. But as I have pointed out in this column before, the snag is that insofar as such buying pushes the price up, the effect is that of a hamster on a wheel.

This must all be kept in perspective. Of course, the chief reasons for soaring food prices are those usually cited: Chinese demand, low stocks, the high oil price, biofuels and so forth.

But one rather chilling fact should be borne in mind. A chart from Morgan Stanley of agricultural prices over the past century shows that in real terms, prices are nearer the bottom of the range than the top.

It should therefore not surprise us if prices rise a good deal more. In that case, more speculative money will go in, and will play a larger role in the rise itself. And, of course, more people in the poorest countries will starve. It is a potentially grim situation in which the world's wealthy must proceed very carefully