What The Monetary Deflation Means to Commodity Producers in Africa and The Americas

When the closely-watched commodities gauge, the CRB futures index fell to 199.03, on Monday, its lowest level since Aug. 30, 1999, and down 8.9% from mid-May, it only provided the most recent signal that the 5-year monetary deflation, created by Alan Greenspan and the Federal Reserve is anything but over.

Since 1996 when the price of gold reached a high of over $400 per ounce to the current $277 per ounce, as of yesterday, the economies of the economically developing world have taken the brunt of mismanagement of U.S. monetary policy courtesy of the man who is chairman of the only organization in New York and Washington D.C. which seems exempt from bipartisan and mainstream media criticism – the Federal Reserve.

Because the economically developing world primarily generates revenue from commodities that it unearths, the dramatic fall in the price of gold and numerous other commodities has not only meant decreased revenues coming to state-owned enterprises and decreased tax revenues coming from mining and manufacturing enterprises, but also insufficient financial resources out of which countries fund badly needed social services for their citizenry.

There are two factors which determine the price of any commodity: 1) the supply and demand of dollar liquidity and 2) the supply and demand for that particular commodity. The first factor influences the price of commodities because it determines the purchasing power of the dollar relative to all goods and services and because the majority of the world's commodities are priced in terms of dollars. That means that every local currency, outside of the U.S. has to first have its value measured in terms of dollars or be converted into dollars before a purchase of the world's major commodities like gold and oil can be made. It also means that exporters in commodity-producing countries earn less for the same amount of work and produce whenever the dollar strengthens relative to gold and the local currency.

This presents a problem for not only the countries of Africa and Central and South America – most dependent upon commodities for revenue – but even for countries like Australia where 70% of all commodity exports are contracted in U.S. dollars; where commodity prices have fallen over the last three months; and where the Australian dollar has hit a 6-month high against the U.S. dollar, making Australian exports more expensive relative to other exporting nations.

While the demand and supply of dollar liquidity is only one of two major factors that determines the price of a commodity, it is the dominant factor because it affects the supply and demand of the commodities almost infinitely more than the supply and demand of commodities affects the supply and demand for dollar liquidity. As an example, the supply and demand for the actual gold specie is a mere drop in the ocean of dollar liquidity. The supply and velocity of money affects the price of gold more than the actual demand for gold.

Even in the case of oil we could see how this works. When the monetary deflation had the price of oil down to $10 a barrel, that extremely low price for oil destroyed the incentive for oil producers to explore and refine oil. Soon, the demand for oil exceeded the supply for oil at such low prices and the price of oil rose to more normal levels. With that rise came increased incentive for oil producers to explore and refine oil. This is a clear example of how the supply and demand of dollars became the dominant influence over the supply and demand for a commodity – oil in this case. Similarly, the lack of dollar liquidity being supplied to the international marketplace by the Federal Reserve resulted in a dramatic fall in the price of gold and other commodities, almost across the board, from 1996 to 1999, ruining the fortunes of farmers, miners and drillers across the globe.

The problem, which began in 1996, came to a head in 1997 around the time the price of gold was down to $315 per ounce. As the dollar grew stronger relative to gold, countries who had pegged their currencies to the dollar began to come under pressure internally and externally to maintain and break their pegs. Generally speaking, the internal pressures came from the monetary authorities' management of domestic policy and the external pressure came from currency speculators. But there were extreme parallel pressures for the pegged nations to go in opposite directions - maintain or break the peg. This is an impossible situation, as no currency can maintain its value when it is being pulled by two extreme perceptions/definitions of its worth. This is especially true with pegged regimes. Why?

Pegged rates require a monetary authority to manage both the exchange rate and monetary policy. With a pegged rate the monetary base contains both domestic and foreign components. And unlike floating and fixed rates, pegged rates invariably result in conflicts between exchange rate and monetary policies. For example, when capital inflows become "excessive" under a pegged system, a monetary authority often attempts to sterilize the ensuing increase in the foreign component of the base with an increase in the domestic component of the monetary base. Balance-of payment crises erupt as a monetary authority begins to offset more and more of the reduction in the foreign component of the monetary base with domestically created base money. When this occurs, it's only a matter of time before currency speculators spot the contradictions between exchange rate and monetary policies and force devaluation.

And that is what happened, first with the peg that existed between the Thailand baht and the U.S. dollar and then between other currencies and the U.S. dollar.

The devaluation causes domestic inflation, possibly hyperinflation, for the citizenry, and it causes exporters to earn less for their goods and pay more for foreign imports necessary to their daily operations. And as speculators continue to place downward pressure on the currency, government comes under increased pressure from the leading exporters of that nation to "competitively devalue" the currency in order to make their goods cheaper on foreign markets; at the same time the general public wants the inflation to stop through a stabilization or revaluing of the currency. Zimbabwe is a perfect example of this scenario as miners and tobacco growers seek competitive devaluations while the public seeks an end to the erosion of the purchasing power of the Zimbabwe dollar.

Eventually the continual devaluations under a pegged rate regime evolve into the government allowing the value of its currency to float. Once a floating regime replaces a pegged regime, it becomes even more difficult for a commodity-exporting industry or government to plan its activities or to project revenues. This happened in several nations in the economically developing world from 1997 to 2000.

Today the carnage continues, especially in Africa and the Americas where entire government budgets are imbalanced and in deficit because of the shortfall in tax revenues and income due to the fall in commodity prices and instable exchange rates created by the monetary deflation, and the numerous currency depreciations that characterize such an environment of monetary instability.

In the Congo, the low price of gold has contributed to the brutal civil war there as competing rebel groups, which once earned their financial capital from the sale of gold, were forced to turn to the discovery and sale of col-tan, a rare material that is used to make Playstations and cellular phones. The profit margins in gold mining diminished so greatly at the very same time that those in col-tan widened, that the rebels decided to abandon gold for the more lucrative keep to be earned from this new raw material that has captured the fancy of the West. Unfortunately the search and battle for col-tan has only aggravated tensions in the Congo, actually becoming an obstacle to forming a lasting peace in the country of 50 million.

In the Ivory Coast, a new Cocoa and Coffee Bourse (BCC) representing the Ivory Coast's farmers was established last month in order to return the country to a market price stabilization program which would allow most of the country's cocoa crop to be sold forward - ahead of the start of the harvest – in order to lock in minimum prices and revenues for farmers. The farmers want to be able to sell their crops in the forward market in order to protect themselves from falling cocoa prices. The country, which is the world's largest cocoa producer, was made to dismantle that system in August of 1999, when the IMF and World Bank forced the Ivory Coast to liberalize its cocoa market.

But the Ivory Coast is rare among nations in Africa or Latin America that are able to hedge their commodity holdings. Commodity price volatility could possibly be managed through the use of forwards, futures and options contracts, often used by multinational corporations that hedge their commodity market exposures. The only problem is that commodity producers in poor countries lack the cash as well as the lines of credit necessary to participate in the derivatives market. This is especially true of mid to small size producers. Options that ensure against falling prices in return for a one-time premium are not utilized by small enterprises because many simply do not have the necessary funds to purchase the options at the beginning of their planting seasons. In addition, the investment banks that write the options are leery to do so for potential clients in the developing world, fearing losses.

On the flip side, there have been African companies that have been burned in their efforts to hedge currency and commodity price fluctuation. Ashanti Gold based in Ghana is one such entity. In 1999 a dramatic rise in the price of gold caught it unprepared and unable to cover its margin calls. This was especially tragic since, with the price of gold over $300 – at the time – Ashanti's underground reserves were more valuable with each upward tick in the price of gold. Unfortunately, the immediate cash necessary to cover margin calls eluded Ashanti and deprived it of benefiting, in the short-term, from the rise in the gold price.

Today the company continues its hedging efforts and says that it has committed 8.73 million ounces of gold in forward sales and options through 2013, three-fourths of its expected mining, in an attempt to protect itself from a further fall in gold prices. And learning its lesson from 1999, Ashanti says it is now prepared, through better hedging, to immediately profit from any sudden price hikes in gold.

The problem of falling commodity prices, pegs and floating exchange rates makes it almost impossible for a commodities industry and government to plan economic activity. This is the case in Kenya where 200,000 jobs may be created and 2.1 million acres of land has been made available for cotton cultivation in a national effort to jumpstart Kenya's cotton industry. Kenya could have undertaken such an initiative in the past but the falling price of cotton and the lack of incentive to produce the crop in exchange for low to non-existent profit margins that have accompanied it was largely responsible for the country's unwillingness to move aggresively into the sector before this year. In addition, the African Growth and Opportunity Act signed with the U.S. provided another incentive for Kenya to develop its textile industry. But even with such an incentive, Kenya risks placing its national resources behind a plan that would entail it getting active in an industry whose prices are falling (just as Uganda is doing with its recent decision to plant 10 million coffee trees while coffee prices are at all time lows, and like Nigeria is doing with its questionable decision to expand its state-owned cocoa entity, while cocoa prices fall). Not to mention the fact that the cotton industry is an industry where prices are naturally sticky and where the monetary deflation makes them even more so. In Tanzania, disputes have broken out this summer over the price of cotton, as producers in the country have been confused over why the price of cotton has remained the same while the demand for cotton has increased, an apparent violation of the economic law of supply and demand. But the monetary deflation as well as government interference and corruption are combining to produce market distortions the likes of which few have ever seen in Tanzania.

In Latin America, falling coffee prices are tearing into the economies of several countries. During the monetary deflation prices for coffee have fallen below 50 cents a pound and today the most active contract for coffee futures – the December contract - is selling at around 54 cents a pound, a far cry from the price of $3.18 a pound that coffee futures earned in May 1997. Horrifically – to coffee producers –the price is now well below what is considered an average cost of production for a pound of coffee -- 80 cents. It dipped below that level in October of last year and has stayed under that price for 10 months. Mexico, Colombia and Brazil are all feeling the effects of the dramatic fall in coffee prices with Mexico and Colombia deciding how much coffee they should produce at such prices, if at all, and with Brazil now producing as much coffee as it can in order to compensate for the depreciation of the country's currency, the real, against the U.S. dollar.

Brazil, the world's largest coffee exporter and producer initially sought to attempt to cause a spike in the price of coffee by stating its intention to hold back 20% of its crop and encouraging other major coffee producers to do the same. However, the plan did not work as intended, and not because other nations did not fully cooperate with Brazil – after all they did not even have to cooperate with Brazil in order to get the coffee price to jump. The mere announcement of a cut in supply, by 20%, from the world's largest exporter, should have been sufficient to cause prices to rise. That the Brazil initiative had no effect on the downward trend in the price of coffee is another indication that the impact of the supply and demand of the commodity itself is negligible, in most cases, in comparison to the effect that supply and demand for dollar liquidity has on commodity prices.

In Chile, falling copper prices are wreaking havoc on the ability of that country's copper industry to forecast its revenues and to plan expansion efforts and capital improvements. Here is a Dow Jones report that reveals the Chilean copper industry's inability to plan ahead with any level of confidence:

SANTIAGO -- Chile's government-linked copper commission Cochilco said Monday it sees the country's total copper output at 4.722 million metric tons in 2001, and 4.763 million metric tons in 2002.

Cochilco, which recently forecast that copper prices will average between $0.74 and $0.78 per pound in 2001, added Monday that copper prices should average between $0.78 and $0.82 per pound next year.

In dollar terms, Chilean copper exports should reach $6.71 billion in 2001 and $7.34 billion in 2002, the agency said. Overall mining exports from Chile - including gold, silver, nitrates, and other products - should bring in $7.79 billion in 2001 and $8.42 billion in 2002.

Cochilco sees investment in the mining sector reaching $1.72 billion in 2001, with about $1 billion of the total coming from outside the country. Investment should total between $1.7 billion and $1.8 billion in 2002, with foreign investors contributing about $1.1 billion of the funds.

Cochilco said Monday that copper prices should bounce up to about $0.80 per pound toward the end of this year, revising downward its previous $0.83 per pound fourth quarter estimate.
Prices could bounce back above $0.90 per pound in 2003 and 2004 on cyclical factors, the agency said.

Good luck to anyone placing their money on Chile's copper sector.

David Gitlitz, Managing Director of Kudlow and Company told BlackElectorate.com, that he believes that the fall in commodity prices can be arrested and may have already begun to bottom out, but that at this point it is difficult to be sure of any reversals in the direction of commodity prices. He still believes that commodities have some rough days ahead of them. But he points to the rise in the price of gold, which is now flirting with breaking the $280 per ounce level, as a reason for his cautious optimism that commodities may soon begin to make a U-turn. "There are a few signs that we may be bottoming out but commodities still have room to fall. An index like the CRB has some more downside risk and even though gold is up in price it takes time for the broader commodities to follow its (gold's) lead. The rest of the commodities have a ways to go. The commodities futures market should be reflecting the dollar's change (in value), at this point, but probably not the recent changes in the price of gold." , he told us from his New York City office.

But Gitlitz does believe that just as the price of gold, in 1996, signaled the onslaught of the monetary deflation and the fall in commodity prices that would accompany it, he believes that the upward direction of commodity prices will also be foreshadowed by a sustained rise in the price of gold. "I am much more comfortable with the rise in the price of gold this week than I was with the rise in gold over the last couple of weeks, because this latest rise has been accompanied by less volatility than the prior increases. Right now, I am looking for some indication of stability in the price level and then a sustained movement upward. I am not in favor of a rapid return to prices above $300 per ounce, but I would be happy to see a gradual upward movement in price somwhere between $280 and $290", he said.

But such an occurrence can only happen with the expressed or indirect consent of Alan Greenspan, who in July, in testimony before the U.S. Congress, rejected the idea that commodity prices were driven by the demand and supply of dollar liquidity. We asked Mr. Gitlitz what he thought about the likelihood that Greenspan would set things right, in light of his most recent pronouncements regarding commodities. Mr. Gitlitz answered," The one thing that you have to hope about Greenspan, right now, is that he knows better. But of course that does not mean that he is going to do better. For those countries that depend upon commodities for revenue this is a time period filled with risk because you just don't know what he (Greenspan) is going to do. If he holds these current price levels for gold, then we are in for a nice recovery down the line. But how nice that recovery would be and whether or not it would be reversed by Greenspan's own actions, we just do not know."

It is unfortunate but the well-being of economies in Africa, Central and South America and the Caribbean may very well depend upon Alan Greenspan's ability to do something he has not done in over 5 years: respond to the concerns of domestic and international commodity producers and maintain a stable price of gold somewhere near the level of $300 an ounce.

Anything short of that, we believe, continues the worst of chain reactions in the economically developing world, particularly in Africa, Central and South America and the Caribbean.

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Cedric Muhammad

Wednesday, August 22, 2001

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