05 March 2008

FT Insight: Financial system faces commodity-led crisis

The global economy is facing twin shocks. Natural resource markets are delivering a supply shock of 1970s dimensions, while the financial system is delivering a shock comparable to the bank and thrift crises of the 1988-1993 period. The magnitude of each shock is very different. The financial markets require a recapitalisation of the banking system, with estimates ranging from $300bn to $1,000bn.

By contrast, prospective capital requirements in the resource markets dwarf the current needs of the banking system. According to the International Energy Agency, the global energy sector alone needs a real $22,000bn over the next two decades to meet the anticipated rise in primary energy demand. There is also the unavoidable necessity to reduce the CO2 intensity of energy production, a good 80 per cent of which is derived from the dirtiest of fossil fuels. While an accurate quantification of the size of the required green energy investment is not possible, it is likely to be of a similar scale to the expansion of energy supply.

The energy sector is just one example of the more generalised supply problems afflicting the natural resources markets. Scarcity is endemic across most commodity markets, as existing capacity has struggled to meet a demand shock from the rapidly developing middle income economies. Historically low stock-to-consumption ratios show how severely the supply-demand imbalance has eaten into the margins of comfort in many – if not most – commodity markets. Global grain inventories, for example, are at 40-year lows, equivalent to just 15-20 per cent of annual demand. Most industrial metal inventories are at a 30-year trough relative to consumption.

The broad story is of depletion. Most of the easily obtainable resource deposits have already been exploited and most usable agricultural land is already in production. Natural resource discoveries, where they continue to occur, tend to be of a lower quality and are more costly to extract. Meanwhile, the dwindling supply of unutilised land faces competing demands from biodiversity, biofuels and food production.

Predictably, the scale of response to each of these crises is in inverse proportion to their respective magnitude. In the US, the credit crunch has elicited an instantaneous fiscal package to the tune of $168bn, or 1.2 per cent of nominal GDP. In contrast, the latest annual budget appropriation for renewable energy spending is just $1.72bn – 0.01 per cent of GDP.

The US monetary policy response has also focused exclusively on the credit crisis. The more subdued response in Europe shows the European Central Bank and other central banks are opportunistically using the credit crunch to tame incipient inflation. In contrast, the US has chosen to reflate aggressively. The risk that inflation expectations might drag their anchor has been broadly ignored.

The US policy response has reduced the chance of global growth slowing enough to ease the inflation in natural resource prices. A phase of commodity disinflation is what is needed to prevent economic participants from concluding that rising prices are a one way bet. Since the appropriate size of the stimulus cannot be calibrated with any precision, the aggressive reflation runs the risk of providing a monetary accommodation to the inflationary supply shock. Longer term, a more severe contraction in demand is likely to become necessary to re-anchor inflation expectations.

Indeed, in a global economy, where individual central banks’ control over inflation is limited, the costs of re-anchoring straying inflation expectations are likely to be punitive. Even if the stimulus proves insufficient, policymakers will still have sent a strong signal in support of existing price levels. This explicit statement of policy priorities is unlikely to be lost on consumers and businesses.

On cue, since Washington started to ease policy, investor flows into commodities and other real assets have soared. Meanwhile, in spite of the slide into near-recession, forward inflation expectations in the bond market have risen to match the highest levels seen this century. The message is clear enough, but it is unlikely that anyone will pay much attention in an election year.

Tim Bond is head of asset allocation strategy at Barclays Capital.

By Tim Bond

© Financial Times