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12 September 2013, Gateway House

G20: The new Bretton Woods?

Global institutions responsible for price discovery and speculation in commodities are suspected of fuelling price hikes. With the world experiencing turmoil in the food and energy markets, fixing the global pricing architecture for commodities should be the priority for the G20

Former Director of Research

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In the last three years, the G20 group of nations has taken up tough geoeconomic issues bedevilling both developed and developing countries. These include matters such as bringing transparency in global energy and commodities markets.

Addressing them is vital as the world faces turmoil in both energy and food markets. The new discoveries of shale oil, turbulence in traditional West Asian energy markets and massive food subsidies being doled out by developing country governments like India have had a disruptive effect globally.

Even though the recently concluded 2013 St. Petersburg G20 summit was dominated by the immediate issue of Syria and the impact of the U.S. Federal Reserve’s quantitative easing programme on emerging markets, it is the right institution that can, and must, address these issues. In fact, the G20 should be the new Bretton Woods that can incorporate the complexities of a diversified global 21st century financial architecture. It is vital that Australia, which will host the next G20 Summit in 2014, restore focus on these longer term issues and act on the recommendations already made by other international institutions and approved by the G20.

Foremost on the agenda is the regulation of global institutions responsible for price discovery and speculation in commodity markets—all suspected of being increasingly de-linked from physical markets and fuelling unqualified price hikes. Oil and gold, the two commodities that have major consequences on India’s (and other emerging markets) external liabilities, inflation and growth continue to suffer from antiquated price reporting mechanisms.

Oil, for example, moved from $45 per barrel in mid-2006 to about $145 in two years, corrected to $40 in a few months and thereafter, again surged to $130 in less than three years. It has been consistently trading at over $100 since. Through this period, oil production and demand fluctuations have hovered in the 10% range, far less than those of its price.

This volatility has affected a number of economies negatively. For example, in India, any large variation in global oil prices has a direct bearing not only on the cost of energy but food and other goods as well. As pricing becomes market-linked, any increase in prices or volatility adversely affects a large number of end consumers.

This can be rectified: the archaic practice of price gathering from price reporting agencies (PRA) needs to make way for a more transparent price discovery process. International agencies such as the International Energy Agency (IEA), International Energy Forum (IEF), Organisation of the Petroleum Exporting Countries (OPEC) and the International Organisation of Securities Commissions (IOSCO) have made practical recommendations to this end which will modify principles followed by PRAs and align them more closely with the international standards on governance and transparency.

The work done by Organisation for Economic Cooperation and Development (OECD), IEA, IOSCO and IEF for promoting price discovery in energy markets is seminal. It was motivated by the evidence that spot market prices had stopped reflecting the physical markets and instead had become tangled with derivative markets, muddling the process of price discovery. These organisations discovered that many price reporting agencies, which assess the price of crude oil, were open to manipulation as their customers—oil producers and traders—could selectively report transactions to suit their interest and because the price assessment process is proprietary and opaque.

The markets did not pay much attention to the G20 report until the European Union’s anti-trust commission began investigating large oil companies earlier this year for manipulating Brent crude oil prices.

The same situation prevailed in food markets. Ten international organisations—chief among them the Food and Agriculture Organisation, the International Monetary Fund, the World Food Programme, the World Bank and the World Trade Organisation—have conducted studies on the volatility of food prices globally. Because investors in the energy markets have also moved into speculation in food markets, these prices and their behaviour are now correlated with oil markets.

A similar practice of data gathering from a small group of banks was followed for setting the London Interbank Offered Rate or Libor. That, too, became a victim of price manipulation. In this case, the IOSCO recommended the separation of the benchmark assessment process from the users, such as banks, to prevent manipulation of the benchmark purely for profit.

The latest fears stem from the surge in gold prices. In April, when the Fed refused to return Germany’s bullion that it had kept under custody, it fuelled speculation that all the gold with the Fed may have been lent out as collateral by the U.S. government for its own borrowings. If this is true, it will prove that there is not enough gold in the world to support the high market prices it is being traded at—a situation already apparent in speculation prevailing in the energy and food markets where the volume of trade has surpassed the physical availability justifying prices.

There is a clear message from the G20 findings: Unless the system can be reformed, these issues, operating within the globally-linked financial architecture, will have systemic impact that no country can address alone. And so far, there is only scattered anecdotal evidence that any country is implementing these recommendations.

A common starting point is the push to share information through a concerted multilateral effort, especially for over-the-counter contracts and voluntary-submission led processes. For the energy markets, it is the JODI (Joint Oil Data Initiative) database. For the agriculture markets, it is AMIS (Agricultural Market Information System).

This can be done for other commodities as well.

Akshay Mathur is Head of Research at Gateway House: Indian Council on Global Relations.

K.N. Vaidyanathan is Senior Geoeconomics Fellow, Gateway House and Chief Risk Officer, Mahindra & Mahindra Ltd.

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