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Emerging Market Vulnerability: The Commodity Conundrum

A Brief Sketch of Commodity Supercycles

Frequently we are reminded of the fickle nature of markets. This is no exception when it comes to commodities. Take WTI crude oil as an example. In the early 2000s its price was hovering around $40 per barrel. By mid-2008 its price peaked at $140, then abruptly dropped to $40 half a year later (as a result of the financial recession), only to recover again shortly afterwards. This all came to a sudden halt approximately one year ago and a brutal downward pattern emerged ever since. The rest is all too familiar; the price of crude oil now stands at $46. Notwithstanding the idiosyncrasies of the global oil market and the large adverse shock of the recent recession, a clear upward trend emerged over the last 20 years that has only recently been turned on its head. This is not an exception but rather part of a larger phenomenon: the commodity supercycle.

A supercycle consists of two components: a sustained expansion (lasting between 10 to 35 years) and a stagnation phase, which add up to a period ranging anywhere from 20 to 70 years. Joseph Schumpeter’s identification of Kondratieff cycles, as described in his seminal work Business Cycles (1939), is closely linked to the aforementioned phenomenon. Schumpeter explained these cycles using his theory of creative destruction: technological innovation spurs growth in upcoming sectors of production, which then replace outdated methods and reform the status quo from within.

Since commodities are used as productive inputs, their prices soar during times of industrialization and decline as the economy matures. Initially, the prospect of obtaining disproportionately large economic rents animates producers to compete against each other for these productive inputs, ergo demand exceeds supply and prices rise. Then, as new entrants begin to imitate incumbent production methods, prospective payoffs decline and the demand for productive inputs weakens, thus pushing down their prices.

Despite economists’ opinions being divided over the subject, considerable empirical evidence points towards the existence of such medium-term cycles. Two economists, namely Bilge Erten and Jose Antonio, identified four supercycles since 1865 by using band-pass filters, which enabled them to isolate cyclical components of their time series. Their research suggests that commodity prices move with world GDP and are hence determined by global demand. Moreover, their findings indicate that the average commodity price diminishes with each supercycle, thus validating the Prebisch-Singer hypothesis – the price of commodities decreases in relative terms with respect to the price of manufactured goods.

A simple analysis of supply and demand lies at the core of any price mechanism. Consequently, to grasp the intuition behind commodity supercycles, we need to uncover both the driving forces that cause demand to exceed supply during booms, and the elements that reverse this trend during busts.

A famous bet in 1980, between the economist Julian Simon and the biologist Paul Ehrlich, sheds some light on the two prevailing lines of thought that form the foundation for further analysis. Much in line with the predictions of Thomas Malthus, Ehrlich opined that rapidly growing populations will put considerable strain on the earth’s resources, thereby tightening markets and raising prices. Julian Simon provided the counterargument that higher prices are likely to incentivize producers, whose expanded production may more than offset the positive demand shock.

Ten years after the wager was made, the prices of metals were indeed lower, and Simon’s argument was validated. In sum, technological progress leads to more efficient extraction mechanisms and higher output; as a consequence, prices decline in real terms.

The Link between Commodity Prices and Emerging Market Growth

The recent commodity supercycle was the result of the confluence of a set of opportune factors. In the aftermath of the mid 2000s housing bubble, investors sought a new safe haven and found it in the form of commodities. Coincidentally, Chinese growth – fuelled by enormous infrastructure investments that were financed by cheap credit – accelerated at an unprecedented pace.

This was good news for other emerging market economies, who attempted to satiate the seemingly unfathomable appetite of the Chinese economy, while they saw the value of their exports rising. But, China’s transition from resource-heavy investments to a consumer-oriented economy, has now taken a toll on its export-dependent trading partners. Without China to count on, emerging markets have few potential buyers on whom to offload their exports. Sluggish world trade figures bear testimony to the anemic growth currently experienced by most developed economies.

Furthermore, over the past decade, emerging markets have become net buyers of commodities across the board. Clearly, they now face the conundrum of having to mutually sustain themselves. This leads to an interesting conclusion: emerging market growth is, in part, self-perpetuating. More specifically, the demand for commodities is driven by economic growth (particularly China’s), which in turn heavily depends on exports. Hence, demand depends on growth, growth depends on exports, and exports depend on demand. This has turned out to be a double-edged sword since both downturns and upswings are amplified to a great extent.

Significant exposure to world trade (and particularly China) is a risk factor that is endemic to emerging market countries (i.e. risk factors that pertain particularly to developing countries). A second risk factor comes in the form of US monetary policy. Its effects are twofold.

Firstly, the prospect of a FED rate hike causes emerging market currencies to depreciate in relative terms, which raises the value of their dollar-denominated debt. Secondly, higher interest rates encourage capital to leave emerging markets for the US. These two channels (world trade and monetary policy) lead to investor uncertainty and further outflows. As a result, equity indices plummet, currencies devalue, and bond yields spike. This toxic combination is the perfect recipe for emerging market turbulence and closely resembles the scenario witnessed this summer.




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