Going Against The Grain On The Post-2005 Commodity Price Boom

Includes: JJA, JJM, OIL, RJA, RJZ
by: Carnegie Endowment

By John Baffes

Over the past decade, metal and energy prices have tripled while food prices have almost doubled. Many observers have responded to those increases by reflexively pointing to rapid growth and industrialization in emerging markets, arguing that a structural shift in the demand for commodities was under way. Given that China and India together account for 37 percent of the world's population, even minor changes in their pattern of demand growth are capable of affecting world commodity prices.

In reality, emerging market demand has driven a structural shift in the demand for refined metals and is a key factor behind soaring energy prices. But it has played a much smaller role in the post-2005 food commodity price boom than is commonly supposed.

Emerging Markets and Extractive Commodities

As commodity prices spiked after 2005, emerging markets experienced unprecedented growth. Between 2003 and 2007, growth in developing countries averaged 6.9 percent-the highest five-year average in recent history. The coincidence of a spike in commodity prices and rapid growth in emerging markets led many observers to link the two phenomena.

Emerging market demand, specifically demand in China, is in fact driving up the prices of metal and energy commodities. Since 1990, China's refined metal consumption (aluminum, copper, lead, nickel, tin, and zinc) has jumped seventeenfold; China now accounts, furthermore, for 41 percent of the world's refined metal consumption, up from just 5 percent two decades ago (see Figure 1).

This enormous share of the world's metal market reflects the role that construction, infrastructure, and manufacturing are playing in driving China's economic growth. In 1990, China's metal intensity (metal use per $1,000 of real GDP) was three times higher than the rest of the world. By 2008, it was almost nine times higher. As early as 2005, there were warnings that China's demand for metal would likely lead to a price supercycle (a price cycle that lasts decades instead of a few years)-this hypothesis is indeed supported by strong econometric evidence.

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Emerging market demand, more generally, has played a critical role in increasing demand for and thus the price of crude oil. In 1965, OECD countries accounted for three-quarters of global crude oil consumption, but by 2010, their share had fallen to a little over half. Over the same period, China's and India's shares grew from less than a percent each to roughly 10 and 4 percent, respectively (see Figure 2). Over just the past fifteen years, moreover, non-OECD countries' share of oil consumption has increased from 35 percent to 47 percent. More important, developing countries accounted for all the growth in global crude oil consumption in the last decade.

While emerging markets are clearly driving the post-2005 commodity price boom for both metal and oil, there are at least three differences in the role they have played in each commodity market. First, China is a much bigger player in the global metal market than it is in the oil market. Second, unlike in the metal market, the pivotal role of emerging market demand is not unprecedented in the oil market. Between 1973 and 1983, non-OECD countries' share of global oil consumption increased from 26 percent to 36 percent. Third, it is unlikely that China's role in the global crude oil market will be as significant in the future as it has been in metals over the past decade, due to its new and efficient car fleet and the substitutability of oil. In short, the post-2005 spike in metal prices is largely a story about China's growth, while the oil price boom is about emerging market growth more generally.

Emerging Markets and Food Commodities

Part of the conventional wisdom, then, that growth and industrialization in the emerging markets are behind the post-2005 rise in commodity prices is certainly true. But the other part of the argument-that rising incomes are translating into much greater demand for food and a subsequent price boom-is likely not, as suggested by at least two lines of research.

The first indicates that per capita cereal consumption (cereals account for most of the world's arable land use) in the largest emerging economies is following a trajectory similar to the trend in now-advanced economies, which suggests that the demand curve was pushed out but will likely fall back somewhat as emerging economies mature. Using annual data for per capita cereal consumption from 1960 to 2009, World Bank staff estimated trends in per capita cereal consumption for China, India, Indonesia, Japan, and South Korea (see Figure 3). The results show that, for Japan and South Korea, consumption initially followed an upward path, peaked in the mid-1980s in Japan and late 1990s in South Korea, and then began to decline in both countries. By 2009, per capita cereal consumption fell to 1970 levels in Japan and 1987 levels in South Korea.

China, India, and Indonesia experienced increases in per capita cereal consumption as well. But over the past decade, China's and Indonesia's consumption curves have plateaued, with Indonesia showing early signs of decline, albeit a very slow one. More interesting, India's path resembles, to some extent, that of Japan and South Korea, reaching a peak during the 1990s and then beginning to decline. India's falling per capita calorie intake is a well-documented phenomenon-and a surprising one in view of the increases in real income and real wages realized over the past decade.

A second way of looking at the effect of emerging market demand on food commodity markets is to examine the relationship between a country's share of global cereal consumption and its share of imports. Between 2003-2005 and 2006-2008-two periods roughly corresponding to low price (pre-boom) and high price (boom) episodes-global cereal consumption increased by about 6 percent. Developing and high-income countries accounted for remarkably similar shares of this surge.

However, their respective contributions to the global cereal supply were quite different. Developing-country imports increased by 14.7 percent, while high-income-country imports increased by 10.5 percent during this period. Developing-country exports, however, increased by more than 27 percent, while those of high-income countries increased by a modest 2.3 percent. Though developing-country imports increased by more than those of high-income countries, net imports to developing countries declined by 4 million tons while net imports to high-income countries increased by 6 million tons.

So developing countries actually helped boost the global food supply to a greater extent than they added to demand. This is in contrast to the 1973 cereal price spike when all of the increase in consumption came from developing countries.

Similar findings have been reported elsewhere. For example, the combined average annual increase in food consumption for China and India (in terms of both growth rates and absolute increases) was lower during the years of the price surge, 2002-2008, than it was between 1995 and 2001. An analysis of consumption patterns of various commodities concluded, in addition, that the demand for beef, poultry, and pork in both China and India exhibited much lower rates of growth from 2003 to 2008 than from 1997 to 2002, and on a few occasions, the growth was actually negative.

Then What Caused the Post-2005 Spike?

Emerging market demand played a key role in the post-2005 increase in metal and energy prices, but there were other factors at work as well. It was not primarily responsible, moreover, for rising food prices. Fiscal expansion in many countries and lax monetary policy created an environment favoring high commodity prices. The depreciation of the U.S. dollar-the currency of choice for most international commodity transactions-strengthened demand (and limited supply) from non-U.S. dollar commodity consumers (and producers). Other important contributing factors include low past investment, especially in extractive commodities; investment fund activity by financial institutions that chose to include commodities in their portfolios; and geopolitical concerns, especially in energy markets.

In the case of agricultural commodities, prices were affected by higher energy prices, more frequent than usual adverse weather conditions, and the diversion of some food commodities to the production of biofuels (notably maize in the United States and edible oils in Europe). These conditions led global stock-to-use ratios for several agricultural commodities down to levels not seen since the early 1970s, further accelerating the price increases. Policy responses including export bans and prohibitive taxes (especially in the rice market) that were introduced in 2008 to offset the impact of increasing world food prices contributed to creating the conditions for the "perfect storm" (see table).

The "Perfect Storm"
2001-2005 2006-2010 Change
Agricultural prices (nominal index, 2005 = 100) 89 147 +66%
Grain/oilseed price volatility (stdev of log differences, monthly) 2.3 3.5 +52%
Crude oil price (US$/barrel, nominal) 34 75 +120%
Fertilizer prices (nominal index 2005 = 100) 77 208 +172%
Exchange rates (US$ against a broad index of currencies) 119 104 -13%
Interest rates (10-year US Treasury bill) 4.7 4.1 -14%
Funds invested in commodities (US$ billions) 30 230 +667%
GDP growth (low and middle income countries, % p.a.) 5.0 5.8 +16%
Industrial production (low and middle income countries, % p.a.) 6.3 7.1 +13%
Stocks (total of maize, wheat, and rice, months of consumption) 3.2 2.5 -21%
Biofuel production (millions of barrels per day equivalent) 0.4 1.3 +203%
Yields (average of wheat, maize, and rice, tons/hectare) 3.8 4.0 +7%
Growth in yields (% change per annum, average) 1.4 1.0 -32%
Natural disasters (droughts, floods, and extreme temperatures) 374 441 +18%
Sources: Barclays Capital, Center for Research on the Epidemiology of Disasters, Federal Reserve Economic Data, International Energy Agency, International Monetary Fund, United States Department of Agriculture, World Bank, and author's calculations.

Looking to the future, the way that technology evolves will play as important a role as emerging market demand, if not more so, in determining the trajectory of commodity prices. This will likely mean the expansion of energy supplies and, therefore, a check on rising energy prices as alternatives to conventional oil, such as shale gas and oil produced from Canadian tar sands, are increasingly exploited. The role of technology with respect to food prices is more complex. On the one hand, innovations will almost certainly increase productivity in agriculture, as they helped, for example, China and India double cotton production over the past ten years. On the other, it may be the case that, in the future, food commodities have a higher oil and ethanol content, making them more sensitive to the price of oil.