Columns - The Sunday Times Economic Analysis

Tumbling commodity markets an unexpected bonus?

By the Economist

The sudden fall in commodity prices in international markets could be an unexpected windfall for the Sri Lankan economy. Prices for many commodities have fallen sharply in the last few months. Most significant for Sri Lanka is the fall in oil prices that are less than half the price it peaked to. Many other commodity prices too have fallen to around one half to sixty percent of their prices of about six months ago. Wheat and corn that are considered the two cereals at the base of the human food chain have dropped more than half. Among other price decreases are those of corn and soy beans. The prices of metals like aluminum, copper and nickel have also declined by about forty percent and are expected to fall further.

Among these decreases in prices the most far reaching has been in oil prices that are less than half the peak price of over US $ 150 per barrel about a month ago. The decline in the price of oil has been a dramatic reversal of the trend observed for someime. Last week oil prices dipped to about US$ 66 per barrel. It has increased somewhat since then. The decrease in oil prices will have a significant improvement in the trade balance that has been battered by the huge cost of oil imports. However the issue is whether this decline in prices would continue. Commentators think that the strong demand for oil in developing Asia and the higher costs of extraction of known supplies mean that prices cannot be kept down. They however think that oil prices may not reach the dizzy heights of over US$ 150 for quite sometime.

The other price declines of consequence to the Sri Lankan economy are the prices of wheat and sugar that have also decreased. However the impact on the trade balance by the decrease in these prices would not be as important, as the value of these imports are much less than of petroleum.

On the other hand, the decline in commodity prices is by no means one without its downside as well for us. Tea and rubber prices that benefited from the oil price increases are failing as well. Tea prices at the Colombo auctions fell by 25 percent from about Rs. 400 to Rs. 300 per kilogram. An expectation of lower demand for tea with decreases in incomes; especially from oil exporting Middle Eastern countries is the immediate reason. This expectation results in speculators purposely withholding buying. Further, the decline in oil prices in particular could impact on several of our key exports by decreasing the demand for several of our industrial exports. Therefore the decline in commodity prices has both costs and benefits to the economy.

The commodity price decline was not foretold even a few months ago. The prevailing view was that both oil and food prices would be sustained at a high level mainly due to increased international demand and inability to increase supply. How has this prognosis changed? It is partly due to the expected decrease in demand for food and petrol due to the recession. As much as speculation among traders was an important factor in raising grain and oil prices, traders perceive the global economic crisis as leading to sharp drops in demand. This results in a downward spiralling of prices. The moment the bubble of speculation bursts, price trends could reverse. Will the downward trend in prices continue for long?
Economists and commodity specialists are divided on this. A few months ago, economists predicted that food and oil prices would continue to rise. Last year when prices of oil and food increased, the common saying was that food and oil prices were here to stay. “No Cheap Food”, the London Economist cried out in one of its issues. The rich nations of the world were competing with the emerging Chinese, Indian and Russian income increasing middle classes for a limited supply of goods. And it was believed that the demand from India and China would continue and even gain momentum. This was the driving force for the imbalance between demand and supply. Then the unexpected happened, a crisis in the sub-prime market for housing resulted in a financial crisis and a slowdown in demand, fall in stock prices and a diversion of investment from commodity futures into safer havens like government bonds.

The dramatic turn of economic events illustrates the fragility of the global economy and the difficulty in predicting the future. The question in the minds of people is whether commodity prices will drop further or rise again. The answer may lie mostly in whether Asia’s economic boom could continue and be a significant player in increasing demand for commodities. There is no certainty that the fall in commodity prices would continue for much longer. This is a difficult issue to be definite about as the Chinese and Indian economies are themselves affected by the global meltdown. Many analysts and economists are of the view that prices are likely to remain above long-term norms. According to UN forecasts global food prices will remain high for several years.

As discussed in last week’s column, the recession that is accompanying the downturn in food and commodity prices would have serious repercussions on the country’s industrial sector. Much of the advantages to the trade balance from the reduction in the oil and food import costs could b wiped out by the reduction in exports of industrial goods. What is worse is that such a downturn would seriously affect employment and incomes of a significant number of employees who would not have other employment opportunities. It is therefore important to view the current global developments cautiously and respond to them with countervailing policy measures.

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