Monday, 27 December 2010

Commodities: Stocks-to-flow ratio and Spare Capacity

There has been a lot of focus on rising food prices recently. Commodity prices are very volatile. There are parabolic increases and steep crashes. Investors tend to herd into them getting topped and tailed (buying high and selling low).

Some may find this rather strange, as the demand side of the equation is very predictable. Surely, governments ought to be able to plan for such predictable demand? Consider what my friend MJ recently pointed out about food :

1. The total demand for food rises extremely slowly YoY. No matter how hard I try...bouts of fasts and feasts...the standard deviation of my daily intake of total intake of food would be small. Higher intake of one item would be compensated by lower intake of something else. It gets even smaller over a population.

2. The shift in preference for one food over another in a society happens at glacial speed (barring temporary shortages and bounties...also passing fads). Take the meat preferences in US as an example: i) Despite all the 20th century prosperity in US and the mechanized farming, pork remained the most preferred meat and only near 1950 did beef surpass it in quantity consumed. ii) By 70's, the issue of health (lifestyle diseases) and white meat over red meat had become widely understood. However, that made a very small dent (2%) on relative beef and chicken (of Fish, if you like) consumption by 90's (I don't have comparable data for this decade).

Considering these 2 facts, changes in medium term (3-7 years) demand maybe better explained by specific changes rather than a macro trend.... A Pepsi or Haldiram initiative is more potent than the long-term social change.

My view is that volatile commodity prices can be explained due to the effects of supply shocks. Probably the two most important measures for predicting how volatile a commodity can be are the "spare capacity" and the "stocks-to-flow ratio".

Imagine that wheat has a peak capacity of around 100M kg and a demand of 90M kg . If the "flow" increases (glacially - over a decade) to 95M kg, the spare capacity halves. Due to the way probability and statistics work, the frequency of shortages will increase exponentially(much more than double) resulting in much more volatile prices due to supply shocks.

Existing stock can stabilize prices in the face of supply disruptions. However for food stocks can be low if the cost of stockpiling is high or if it is perishable. Thus, even under a glacial rate of change in demand and unchanged variability of supply, commodities with low spare capacity can tip into severe volatility due to seemingly benign shortages.

If you add high liquidity and easy credit to this scenario, jumpy traders and other economic actors make things worse in the futures market through speculation or in real markets by hoarding.

Interestingly, the stock-to-flow ratio is also a great measure of what makes a good pricing commodity. A commodity with a high stock to flow ratio is useful for pricing because its value is stable and not volatile.

Gold has by far the highest stock-to-flow ratio because very little of it is mined and it is never really "consumed". Thus its flow is tiny. Practically all the gold mined is still in existence. Its desirability underpins its demand. This results in a stable prices when compared to other commodities. It is durable, divisible and has high value per unit weight. Thus, it makes for an excellent store of value compared to other commodities.

A credit system built upon gold has stable interest rates and efficient capital flows. Gold can be transported at relatively modest cost in response to global arbitrage opportunities in interest rates. This is why the British were able to run a huge global trading empire under the Gold Standard using a relatively small amount of Gold as base money in the Bank of England.

Silver is the next best pricing commodity. Although its stocks to flow ratio is much lower than gold, it is still quite high relative to other commodities. Its shares Gold's properties of durability and divisibility. However its relatively lower value per unit weight made it less useful for international capital flows and more useful for local exchange in small denominations, and for coinage. Thus silver was often called a common man's currency. The latter use declined with the general acceptance of self-liquidating Gold-backed Real Bills in industrial societies which replaced silver as the primary currency, even for local exchange.

Oil and other forms of energy have a very low stock relative to their enormous flows. This makes them much more volatile, which is why they are unsuitable as a pricing commodity.

Agricultural products are usually perishable and bulky and make woeful pricing commodities.

Other assets have some good properties (e.g. diamonds, livestock) but not others (not divisible, not durable, etc).

Mish Shedlock notices India's credit-fueled bubble

Mish Shedlock has noticed that like China, India too is in the late stages of a credit-fueled boom. From is blog post Food, Fuel Inflation Hits India; Primary Price Index Up 15%, Credit Expansion Up 23%:

"The sustained growth assumptions of India and China at about 10% each are simply not going to happen. Both countries are overheating and there is a not so little constraint called peak oil that will get in the way. Should India maintain its rate of growth, do not expect to see any containment in price inflation. The same holds true for China."

Interestingly, Credit Expansion this year is up 23% whereas deposits are up only 15%. (The RBI had projected 20% & 18% respectively) . The banking system is using repo lines from the RBI to fill the 8% gap.

The RBI, on its part has raised rates to try and stem inflation. At the same time it is cutting the SLR to ease the strain on banks. Buying up the released government bonds is also issuing more liquidity into the system. Its a classic credit-bubble conundrum as I previously described here - how do you keep the musical chairs playing while keeping inflation in check? An impossible task!

As a nation India is borrowing and spending - on food, goods and services - and on leveraged property. Anecdotal evidence is that property flipping using bank loans is back in vogue in NCR (any views on Mumbai?).

See a detailed article on the RBIs moves here.

Friday, 24 December 2010

Inflation at the bottom of the Pyramid

I think this link sent by Abhishek speaks volumes. It is a clear illustration that the worldwide tsumani of QE type money printing is finding its way to the bottom of the purchasing power pyramid.

Indebted governments (who vest monetary authorities with their power) hate deflation more than anything else. It causes the value of their debts to go up in real terms. It also reduces their power to buy votes through government programs, which enables them to stay in power. QE style government debt monetization suits them just fine ... killing 2 birds with one stone – no deflation and no check on their spending habits.

As long as the monetary authorities do their best to “print their way out of trouble” the worldwide inflation in “things we need” will be unstoppable.

Those looking for a deflationary collapse will have to wait for a complete breakdown of the system. There may be mild deflation in leveraged assets such as housing but basics like food, oil, precious metals cannot be “printed” or “manufactured”. Their demand is constant and unyielding. Their supply is limited.

We live on a spherical planet. There is only one outcome of an exponential growth in the money supply and it is plain to see. Agri-foods may be one of the top investments of the coming decade given this scenario. From :

Sunday, 31 October 2010

The $200-Trillion Debt Which Cannot Be Named

The $200-Trillion Debt Which Cannot Be Named

If the Western monetary system were a person, it would long ago have been declared clinically insane and shipped off to an asylum. What is worse is the conspiracy of silence about the "real" US debt, which we have to assume parallels at least partially the debt of other Western nations. The whole of the West is busted, pretty much – and the "austerity" plans being put in place are just more window-dressing, albeit of a very nasty sort.

Sunday, 17 October 2010

India's conundrum - High Growth and High Inflation

This speech by Dr Subir Gokarn (Deputy Governor, Reserve Bank of India ) is fairly typical. Take for instance the following statement:
I will begin by discussing the current inflationary scenario in India, which, as we have been saying in our recent assessments, is not very reassuring. I will then place this scenario in a broad historical context, with the intention of demonstrating that India has a good record of reining inflation in, regardless of what has driven it.
Anyone who doesn't know that inflation in India has always run rampant is either lying, or deluding himself with false statistics. All he is doing in his speech is to talk on about the components of inflation and a brief history of how it occurred.

To me this speech is the equivalent of a layman standing beside a volcano talking about the what happened during an eruption. He is describing the ash, smoke and fire. However he has no understanding of the geology behind volcanic eruptions or how to predict them.

So, what really explains the unusually high inflation in India? To understand inflation you have to understand the most important thing about inflation. And that is the following statement by Milton Friedman and Anna Schwartz, made in their influential book, A Monetary History of the United States, 1867-1960:

Inflation is always and everywhere a monetary phenomenon
"Friedman advocated a central bank policy aimed at keeping the supply and demand for money at equilibrium, as measured by growth in productivity and demand. The monetarist argument that the demand for money is a stable function gained considerable support during the late 1960s and 1970s from the work of David Laidler. The former head of the United States Federal Reserve, Alan Greenspan, is generally regarded as monetarist in his policy orientation. The European Central Bank officially bases its monetary policy on money supply targets. " - Wikipedia

The above statement provides a clear explanation and a solution to the problem of inflation in India as below:

  1. Friedman says that inflation is due to money supply growth outstripping economic growth
  2. A free-market economy has a natural DEFLATIONARY tendency due to innovation and efficiency.
  3. Inflation is neither a precondition for, nor a consequence of sustainable growth in an economy.
  4. When growth is accompanied by inflation it is a sure sign of a disproportionate growth in the supply of money
  5. Inevitably this due to a DISPROPORTIONATE GROWTH in BANK CREDIT.
  6. When banks lend short-term deposits over the long-term, it causes a growth in DEMAND DEPOSITS through the money multiplication mechanism.
  7. These new deposits bid up the prices of goods and services because they appear in advance of an increase in production of new goods and services.
  8. This MONETARY GROWTH shows up in the monetary statistics as an increase in the money multiplier.
  9. Traditional central banking policy instruments such as tinkering with reserve requirements and raising repo-rates can not effectively restrict this credit expansion. Credit demand is a function of CONFIDENCE. The central bank can only dampen this confidence to a small extent.
  10. Fast growing liquidity created by this credit growth fuels a high demand for a slow-growth in the quantity goods and services. This creates a feedback loop that increases CONFIDENCE further as businesses seek further bank credit to meet this demand.
  11. This feedback loop increases the money supply further. In due course this process creates a CREDIT FUELED BOOM in the economy.
  12. A CREDIT FUELED BOOM is typically accompanied by high inflation and assets bubbles. Witness the stock markets and property markets, wherein assets are priced above what is economically justifiable.
  13. Eventually this BOOM turns to a BUST as frenzied investment in capacity outstrips real demand and highly leveraged businesses end up with no customers.
  14. MISALLOCATED capital is written off. This BUST causes a disaster on the commercial banking system's balance sheet.
  15. Addicted to easy credit the commercial bankers and industry will cry for bailouts and claim "NO ONE SAW THIS COMING."
  16. Austrian economists will say "We did" and point to many versions of the above explanation that are ignored by the mainstream.
  17. At this point Central Banks panic. They lower interest rates, inject liquidity, purchase distressed assets and print money.
  18. Slowly, confidence will return. Low interest rates will fuel the next asset bubble and/or credit boom.
  19. This time it will be worse because the entire system will expect the bailout even though they know the boom is unsustainable. This is a moral hazard which will lead to a generation of "Fed-watchers" who spout absurd things like "bad new is good because it will result in QE-II".

  1. A sustainable economic system is possible - where virtuous, sustainable growth is driven through capital markets, not bank credit.
  2. Growth is accompanied by low inflation because money supply only increases to finance clearing of goods through self-liquidating credit, and not to finance capital expenditure.
  3. In a sustainable system, investment of SAVINGS (deferred consumption) in capital goods and assets is NOT accompanied by any increase in DEMAND DEPOSITS.
  4. In a sustainable system, BANK CREDIT only expands to satisfy demand for SELF-LIQUIDATING CREDIT. The venerable Letter of Credit system can expand bank credit efficiently to FINANCE the PRODUCTION and DISTRIBUTION of consumer goods in immediate demand. Its shrinks bank credit when this demand is satisfied.
  5. In a sustainable system, CAPITAL INVESTMENT, including asset purchases, factors and facilities of production takes place in CAPITAL MARKETS, away from the commercial banking system.
  6. Therefore, the solution to India's inflation problem is fairly simple:
Restrict COMMERCIAL BANK LENDING to financing the production and distribution of goods via self-liquidating credit.


  1. Open the mint to gold and silver. Issue the Indian Golden Rupee 100% backed by Gold and the Indian Silver Rupee 100% backed by silver. Declare them to be legal tender. There will be no further need for a central bank issued, debt-backed paper currency.
  2. This one act will unlock India's biggest asset - the capital that is currently lying idle in India's enormous private gold hordes amounting to 25,0000 tons. A fraction of this will prove to be more than sufficient to power India's growth.
  3. Dissolve the Reserve Bank of India. The absence of a lender of last resort during financial panics will automatically teach commercial banks to restrict lending to the highly marketable, self-liquidating credit that finances the production of semi-finished goods on their way to satisfy immediate consumer demand.
  4. The only notes in circulation will be those issued by commercial banks, not the RBI. The market will judge the health of a bank by discounting its notes just it does for any other corporation.

Comments welcome. Feel free to distribute this to others.