Issues Facing the Japanese Economy in 2012 (January 2012)
Commodities, Financial Instruments, and the Japanese Economy in 2012
Consulting Fellow, RIETI
The November 2011 G20 Cannes Summit Final Declaration (Reference 1) made two requests to the International Organization of Securities Commissions (IOSCO) pertaining to the commodities markets. One was for a report by the end of 2012 on the implementation of appropriate regulations and oversight to increase the transparency of the commodities markets, and the other was for recommendations on improving the functioning and oversight of price reporting agencies for mid-2012. In response, IOSCO has been formulating recommendations on price reporting agencies and preparing to report on the progress made in implementing its "Principles for the Regulation and Supervision of Commodity Derivatives Markets" (Reference 2).
This column will seek to shed light on the commodity market price trends underlying these requests as well as the "commodities" and "financial instruments" relevant to the growing price correlation between commodities and traditional financial instruments, e.g., equities,—the so-called "financialization of commodities"—and will examine the relationship between the "financialization of commodities" and the Japanese economy.
Commodity market price trends and the "financialization of commodities"
Figure 1 shows a plot of well-known international commodity price indices, the S&P GSCI (white line) and the DJ-UBS Commodity Index (orange line), from 2007 to 2011. The S&P GSCI provides high exposure to energy products, while the DJ-UBS is more evenly diversified across energy products, agricultural products, and metals. Prices in commodities markets shot up between 2003 and 2008, particularly for crude oil, causing both commodity indices to soar sharply. With the price rises from 2009 onward coming primarily in precious and industrial metals, however, the DJ-UBS outpaced the S&P GSCI in its climb. The "financialization of commodities" has thus become a topic of particular interest since 2009.
The "financialization of commodities" was even analyzed in the G20 Commodity Study Group Report (Reference 3), which was mentioned in the Cannes Summit Final Declaration, as one dimension—alongside physical demand/supply, biofuel policies, and global monetary expansion—for analyzing commodity market trends. This report examined the evidence for a "financialization of commodities" by defining the term as significant changes in the price levels and volatility of commodities as well as in the price correlations between commodities and traditional financial instruments as a consequence of the expansion of traders of traditional financial instruments into the commodities markets. However, its findings on the existence of a "financialization of commodities" were inconclusive.
The "commodities" and "financial instruments" in question
We will here find out what are the "commodities" and "financial instruments" in the discussions on the "financialization of commodities" from the perspective of price correlation.
Figures 2 through 6 illustrate the respective correlations of the Dow Industrials 30 (United States), the Nikkei 225 (Japan), and the Euro Stoxx50 (Europe) to ICE Brent Crude Oil and COMEX Gold. Figure 2, for instance, shows the correlation between the Dow Industrials 30 (horizontal axis) and ICE Brent Crude Oil (vertical axis). During the period 1990 to 2003 (blue dots), the price of crude oil remained relatively stable despite fluctuations in the Dow Industrials 30, and the two are almost entirely uncorrelated. From 2004 to 2008 (red dots), crude oil prices surged, and overall, a positive correlation can be discerned. This positive correlation becomes more clear-cut during 2009 to 2010 (green dots) and 2011 (yellow dots). This would seem to indicate a strong likelihood of the Dow Industrials 30 ("financial instruments") and ICE Brent Crude Oil ("commodities") manifesting a "financialization of commodities." Figure 3 also shows the possible manifestation of a "financialization of commodities" in the correlation between COMEX Gold and the Dow Industrials 30 from 2009 to 2010.
The "financialization of commodities" and the Japanese economy
Figures 4 and 5 reveal a possible "financialization of commodities" with the Nikkei 225 representing "financial instruments." In contrast to the Dow Industrials 30, however, there is almost no indication of a "financialization of commodities" with respect to either ICE Brent Crude Oil or COMEX Gold. This holds true when looking at TOPIX as well and even when commodity prices are converted into Japanese yen.
In many discussions on the "financialization of commodities," the mechanism underlying the rising correlation between commodity prices and stock prices is described as investors in traditional financial instruments incorporating commodities into their portfolios and, unlike traditional commodity market participants, basing their investment decisions on portfolio selection theory. Should this mechanism be genuine, Figures 4 and 5 suggest the possibility that "financial instruments" representative of the Japanese economy are not often incorporated into portfolios that include "commodities."
As shown in the yellow-dotted portions of Figures 6 and 7, the "financialization of commodities" has collapsed for the Euro Stoxx50 as well, particularly in 2011. Reflecting the European crisis, a negative correlation with COMEX Gold can be discerned in 2011.
Based on these data, it would seem that the "financialization of commodities" is not necessarily a valid argument with respect to the Japanese and European economies. This can be attributed to the fact that Japanese/European stock indices are seldom incorporated into global asset portfolios that include commodities or, conversely, commodities are seldom incorporated into portfolios that include Japanese and European stock indices.
The "commodities" sector in 2012 will see IOSCO's report on the progress made in implementing its "Principles for the Regulation and Supervision of Commodity Derivatives Markets" as well as efforts to improve the transparency of commodity markets. The "financial instruments" sector will be plagued by many uncertainties stemming from the ongoing issues on default, the economic slowdown, and other factors. Given these circumstances, the presence and extent of a "financialization of commodities" will undoubtedly continue to garner interest.
(Sources for figures) Prepared by the author utilizing various data
January 18, 2013
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January 18, 2013［Issues Facing the Japanese Economy in 2012 (January 2012)］