One of the puzzles of the current slowdown in global growth has been the sharp rise in the prices of commodities. After all, if growth slows so too should the demand for commodities. Yet precisely the opposite has happened, spawning an immense amount of speculation on the reasons for this disconnect.
Some of the explanations focus on the supply side, such as the Peak Oil theory, which says that crude oil production has reached its limits. Russia’s failure to expand production for the third month running is the latest piece of news providing ammunition for this view. Other supply-side explanations blame the food shortage on the diversion of land to biofuels and on weather-related problems such as droughts.
Another approach has been to point to the weakening dollar. Since commodity prices are internationally denominated in US dollars, any weakening of the currency leaves commodity producers worse off in terms of their home currency. That’s the reason why, says this theory, commodity prices plunged when the dollar recovered a bit last month.
Others believe that commodity prices are high on account of speculation. Now that the equity markets are no longer a one-way street and with the credit markets in disarray, funds have moved into commodities in a big way. Since many resource markets are relatively small, this sudden influx of money has pushed up prices dramatically.
There are elements of truth in all these theories. But perhaps the most interesting of them argues that commodity prices are going up because the structure of the global economy has changed. Although world growth may be slowing, growth in countries such as China and India continues to remain robust and it’s the demand from these countries that’s going to keep commodity prices high.
How plausible is this explanation? The International Monetary Fund’s (IMF) World Economic Outlook has a chart on the “Growing Global Role of Emerging and Developing Economies”. A look at it shows the changing face of the global economy. A decade ago, in 1997, the contribution to global growth, in purchasing power parity terms, was as follows: US 1.05%, the Euro area 0.5%, Japan 0.14%, other advanced economies 0.52%, China 0.56%, India 0.16% and other emerging economies 1.08%. In 2007, the contributions had changed to: US 0.48%, Euro area 0.43%, Japan 0.14%, other advanced economies 0.48%.
Now consider the contribution of the developing countries to growth in 2007: China 1.16%, India 0.41%, and other developing countries 1.76%. In the 10 years between 1997 and 2007, the contribution of the US to global growth has halved, that of China has doubled, while India’s has trebled. This is the main reason for all the talk about developing economies decoupling from the West. It’s the reason why a slowdown in the West today won’t affect global growth as much as it did in the 1990s.
Moreover, the rich nations are predominantly service economies, with manufacturing having a relatively small share. Growth in the more manufacturing-intensive developing countries will therefore have a higher impact on commodity prices than the same growth in the rich countries. Also, the poor in developing countries spend a much higher proportion of their incremental income on food, so growth in these countries leads to more demand for food, pushing up prices.
Consider, for instance, IMF’s numbers on incremental world oil consumption. In 2007, world oil consumption increased by 0.92 million barrels per day (mbpd). Of this amount, the US accounted for an increase of 0.11mbpd, while the other advanced nations saw a fall in oil consumption of 0.438mbpd. In short, the rich countries together saw their consumption of oil decline in 2007. In sharp contrast, China’s oil demand increased by 0.329mbpd, while demand from other emerging economies went up by 0.919mbpd.
Further, with a slowdown in US growth in 2008, IMF is forecasting a negative growth in US oil consumption this year and total rich country demand for oil is predicted to rise by a mere 0.086mbpd. Yet global oil consumption is expected to go up by 1.723mbpd, 1.637mbpd of which will be coming from China and other developing countries. It’s easy to see now why a US slowdown isn’t pushing oil prices down.
Also take a look at world copper and aluminium consumption growth. In 2007, the amount of copper and aluminum consumed declined by 521,200 tonnes. For the other advanced economies the decline was 505,600 tonnes. The divergence is again very clear: in China, the consumption of these metals increased by a huge 479,237 tonnes last year, while it increased by 167,318 tonnes for other developing economies. The numbers show China’s prodigious appetite for metals and the impact that it has on metal prices.
It can be argued that part of this demand is derived demand, the result of China being the workshop of the world. That is undoubtedly true, which is why IMF predicts that, as world output growth slows from 4.9% in 2007 to 3.7% this year and to 3.8% in 2009, oil prices will rise by 34.3% this year before falling 1% in 2009.
Average non-fuel commodity prices (an average based on world commodity exports weights) , according to IMF, are expected to increase 7% in 2008, before falling by 4.9% next year.