Current turmoil. threat of speculative swings point to need for better global financial governance, Report says

Trade and Development Report 2008 cautions that gloomy outlook for rich nations could spread, halt recent boom in developing countries if commodity prices plunge

Geneva, 4 September 2008 - Uncertainty and instability in international financial, currency, and commodity markets, coupled with doubts about the direction of monetary policy in some major developed countries, are contributing to a gloomy outlook for the world economy and present considerable risks for the developing world, UNCTAD´s annual Trade and Development Report(1) warns.

The report, known as the TDR 2008, pays particular attention to the situation of developing countries, which remain highly vulnerable to commodity price fluctuations. It also highlights the role of speculation in recent huge swings in commodity prices. The report says such speculation -- which pursues short-term profits at the cost of long-term stability -- and the potential turmoil that could come from abrupt exchange-rate adjustments and shifts in national current-accounts balances point to the need for rational, calming mechanisms to govern international financial flows and monetary balances.

The economist authors of the report say the ongoing global financial crisis and the possibility of tighter monetary policies in a number of countries presage major difficulties for the world economy for the remainder of 2008 and in 2009. The bursting of some speculative bubbles and the volatility of commodity prices pose formidable challenges for policymakers, in particular for monetary policy. A global depression has to be avoided while headline inflation-- inflation that takes into account rises in food and energy prices -- is still very high. The situation could become even more difficult if the currencies of countries with huge current account deficits come under pressure to devalue.

The report, subtitled "Commodity Prices, Capital Flows and the Financing of Investment," was released today.

UNCTAD expects world output to grow by around 3% in 2008, almost one percentage point less than in 2007. In the developed countries GDP growth is likely to be around 1.5%. The short-term outlook is better for the developing world, where growth could exceed 6%, as a result of the relatively stable dynamics of domestic demand in a number of large developing economies. But fallout from the recession in the developed world and overly restrictive monetary policies in countries with high headline inflation could well lead to a further deceleration of growth in developing countries.

For a large number of developing countries, the outlook depends primarily on future trends in the prices of the primary commodities they export. Several structural factors support the expectation that prices will remain at a higher level than over the past 20 years. But cyclical factors, the withdrawal of speculative funds, and delayed supply responses could well bring about a significant downturn. "Just as speculation has amplified the upward movement of prices, it may also amplify any downward movement," says UNCTAD Secretary-General Supachai Panitchpakdi in the Overview to the report.

UNCTAD economists are harsh in their judgement of the system of global financial governance: "The recent crisis has shown once again that market discipline is ineffective in preventing recurrent episodes of ´irrational exuberance,´" because "the current international framework for monetary and exchange-rate policies offers opportunities for speculative activities that are highly profitable for a limited period of time, but ultimately destabilize the entire system." They call in the report for tighter prudential regulation to reduce volatility and the resulting negative income effects, as well as costly public bailouts.

However, recent steps by major central banks to provide liquidity to financial institutions affected by the current turmoil are considered appropriate because of the systemic risks for the global financial system without such action. UNCTAD fears that despite some adjustment of current-account imbalances around the world due to the fall in the US dollar, divergences in monetary policies may invite renewed destabilizing speculation in foreign-exchange markets. The report calls for coordinated intervention of all parties involved in such a case. It also notes that a non-recessionary correction of global imbalances would require stronger stimulation of domestic spending and imports in the major surplus economies, especially in Germany and Japan, as well as a measured appreciation of the Chinese currency. As UNCTAD economists see "a strong likelihood of a sharp and prolonged downturn of the world economy," they deplore that policymakers are unable to tackle this challenge.

On the other hand, they find that the risk of galloping inflation as a result of higher primary commodity prices has been considerably overestimated. The probability of a wage-price spiral occurring is much smaller today than when oil prices rose in the 1970s, the report says. That is because unit labour costs, which are a key determinant of inflation, have increased very little in most countries. "Measures to tighten monetary policy would exacerbate the global slowdown," the report warns.

The TDR 2008 suggests that recent commodity price volatility cannot be explained without taking into account the role of speculation and urges governments to take new measures aimed at achieving greater commodity price stability. It also recommends quick-response instruments to mitigate the impact of sharp commodity price fluctuations: "Stricter regulatory measures that help contain speculation on commodity markets could be one important step, since commodity market speculation typically exacerbates price trends originating from changes in fundamentals."

UNCTAD economists, sounding a recurring theme, advise that greater diversification and industrial development is the best long-term strategy for reducing vulnerability to commodity price shocks. Such a transition requires higher investment in new productive capacities -- the ability to manufacture more varied and sophisticated goods -- and in the infrastructure. Financing such investment is easier in boom phases such as the current one, the report notes. But in several countries, it observes, a large share of the considerable gains from higher prices for fossil fuels and mining products has gone overseas as profits for foreign enterprises. This means that these gains are either lost as potential capital for the countries where they originate or that they are often reinvested by the foreign companies in the same extractive activities, thus perpetuating commodity dependence rather than reducing it, the report says.