China’s Cards

This article appeared in the June 2009 issue of Globe Asia.

The international economy has been in the grip ofthe steepest decline in industrial production and tradesince World War II. In my March 2009 column ("ACommodity-Price Snapback?"), I outlined an optimisticsnapback scenario.

This was based, in part, on the Zarnowitz Rule (after the lateProf. Victor Zarnowitz, the University of Chicago's pioneer inbusiness cycle research). Prof. Zarnowitz observed that deep recessionstend to be followed by sharp recoveries.

In consequence, anything less than a sharp recovery in theUSA will suggest that the interventionist policies of the Obamaadministration held back what should have been a natural, sharprecovery.

Virtually every economy in the world, including China, hastaken a hit. But China is clearly bouncing back and will come closeto meeting its 8% growth target for 2009.

Instead of engaging in the type of anti-capitalistic populismpracticed by many politicians in western capitals, China's PremierWen Jiabao has been packing Adam Smith's The Theory of MoralSentiments in his luggage. The "party line" has been: free-markets,free-trade and stability. Beijing has matched its rhetoric with largepurchases of commodities.

Commodity prices peaked at alarmingly high levels in midsummer2008. They then fell sharply in the late summer and earlyautumn months, bottoming out in December. Since then, commodityprices have moved up. Indeed, Commodity Research Bureau'sSpot Index, which contains twenty-three commodities, is up by 16.5% since December 2008 (see the accompanying chart).

CRB Spot Index

To obtain a better grasp of the dynamics of commodity markets,let's take a look at the evolution of the oil and copper marketssince June 2008. The accompanying table shows how the spotand 12-month futures prices have moved since last summer. Withthese prices, the term structure of interest rates for oil and coppercan be calculated for specific dates. These commodity (or "own")interest rates are also presented in the table.

Futures as commodity loans

Before interpreting the commodity interest rates, it isimportant to realize that futures markets operate as loan marketsfor commodities. As such, they operate in a manner that is similarto money markets.

When a handler of commodities purchases a commodity andsimultaneously sells a futures contract, he is temporarily borrowing a commodity. This procedure is much like borrowing moneyfrom a bank with the promise to repay the loan in the future.

The sale of a futures contract, in conjunction with the purchaseof a commodity in the spot market, allows a handler to borrow acommodity now and repay it later. These simultaneous buy-selltransactions are, therefore, implicit commodity loans.

If the price of a commodity for future delivery exceeds the spot(or cash) price, the market is in contango, and the commodity interestrate is negative. A lender of a commodity has no incentive tolend to the spot market because he would be in effect selling lowand buying high.

The reverse occurs when the spot price exceeds the futuresprice and the market is in backwardation. Commodity interestrates are positive. In this case, it pays those who hold commoditiesto loan them to the spot market.

Prior to the financial and economic panic in the early autumnof 2008, oil and copper pricelevels were elevated and themarkets were in backwardation.Accordingly, commodityinterest rates were positiveand it paid those who heldinventories to loan them tothe spot market. In short, themarkets were "tight" and inventorieswere "scarce."

With the onset of thepanic, the demand for oiland copper fell sharply andthe commodity interest ratesswitched from positive tonegative. This switch frombackwardation to contangoindicated ample inventoriesrelative to demand in thespot markets. Those whoheld inventories had no incentiveto loan them to thespot market.

While the oil and coppermarkets remain in contango(inventories relative to spotdemands are ample), thecommodity interest rates arebecoming less negative, indicatingthat these markets are"tightening up."

This conclusion is alsoconfirmed by the volatileBaltic Dry Index, which isa freight-rate benchmarkfor shipping dry commodities—like building materials,grains, coal and iron ore.

Since these commodities areraw material inputs used inproduction processes, the cost of moving them in bulk by ship is aprecursor to industrial production.Since reaching dramatic lows in December 2008, the BDI hasmoved up by 240% (see the accompanying chart).

Baltic Dry Index

Oil and Copper: Prices and Interest Rates

Gold a solution

China has played its cards smartly. that lends importantweight to an optimistic recovery scenario. That said, Beijing's commentsabout replacing the world's reserve currency (the US dollar)with an artificial basket "currency" (the International MonetaryFund's Special Drawing Rights) raise more questions than they answer.

Given China's huge dollar-denominated foreign reserve warchest, Beijing has cause to be worried about the value of the dollar. But why jump from one fiat currency into a basket of four fiat currencies(the dollar, yen, euro and British pound)?

If Beijing wants an apolitical, stable international currency thatis "disconnected from economic conditions and sovereign interestsof any single country" - as Zhou Xiaochuan, governor of the People'sBank of China, put it on March 23 - then gold is the answer.

Contrary to the Financial Times editorial "As Good As Gold"(May 8, 2009), the gold standard's recent renaissance is not basedon irrational worries about the international fiat monetary system.Those worries are rational, fact-based worries.