Governments should pop commodity bubbles - U.N. report

GENEVA Sun Jun 5, 2011 6:03pm BST

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GENEVA (Reuters) - Direct government intervention may be needed to burst bubbles in commodity markets inflated by a new herd of financial investors, a U.N. study found.

Excessive speculation has added around 20 percent to international oil prices, sending false signals to policy makers, said the report published on Sunday.

"The changing role of commodity markets, which are turning into financial markets, has enormous repercussions for the economy," said one of the report's authors, Heiner Flassbeck, a director at the United Nations Conference on Trade and Development.

"We think you end up with wrong signals for overall macroeconomic policy."

Reforms suggested by the report - Price Formation in Financialised Commodity Markets - included improving transparency on commodity exchanges and over-the-counter physical markets, better inventory data and action through the use of government reserves.

"The possibility of allowing governments' direct intervention in the physical and financial markets needs to be considered," the study concluded.

"In financialised commodity markets, as in currency markets, intervention may even help market participants to better recognise the fundamentals."

Since around 2000, as commodities were perceived to have entered a super-cycle and the equities market bubble burst, oil and other raw materials have lured financial investors, as well as the producers and big consumers historically in these markets.

The report quoted data compiled by Barclays Capital that commodity-related assets under management reached a historic high in March 2011 of around $410 billion, almost double the pre-crisis level of 2007.

Debate has persisted about the impact of investment-class money, with many analysts saying it exaggerates trends, but they also say it provides useful liquidity and that fundamentals of supply and demand ultimately determine market levels.

The authors of the new report, which focussed on six commodities -- oil, barley, cocoa, maize, sugar and wheat, said price distortion is a problem even if it does not last.

"Commodity price inflation endangers a smooth recovery to the extent that it provokes a premature tightening of monetary policy," the report said.

"It has already played an important role in the tightening of Chinese and Indian monetary policy since early 2010."

FINANCIAL MARKET LOGIC SPREADS

Correlation between commodities and other markets strengthened when the world began to emerge from financial crisis in 2009.

As all kinds of traders sought clues on growth and its implications for demand, commodities investors responded to wider economic indicators, not just to figures on inventory levels and supplies.

"Commodity prices risk being subject to speculative bubbles, (they) move far away from fundamental values and display high volatility," the report said.

Oil, the biggest commodity market which has attracted the most financial money, reached above $127 a barrel for Brent in April, its highest since the record 2008 rally, before correcting violently and then recovering to around $115.

The U.N. report's authors cited the risk of a permanent shift, turning markets that used to lag into ones that anticipate just like other asset classes. For those seeking a portfolio diversifier, commodities lose much of their worth.

"Commodity prices and particularly the oil price rose immediately when the recovery began," said Flassbeck.

He dismissed the argument that the new investors and their herd instincts were good for liquidity and said finding the right counterparty to take a position could be harder.

"When everyone coming into the market is going long, then it's exactly the opposite of liquidity," he said.

Various initiatives are under way for tighter regulation of financial markets, including commodities.

The United States' Commodity Futures Trading Commission is seeking a raft of reforms, including limits on the number of speculative contracts traders can hold.

The world's 20 leading economies (G20) are also working towards establishing closer scrutiny.

Flassbeck described the G20 initiative as "a good start."

(Editing by Jane Baird)

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