By Thanong Khanthong
The Nation
Published on October 16, 2009

Hedge funds and other investors are now investing in physical commodities rather than futures. They are apparently concerned about the sustainability of financial assets, including the health of the US dollar. They would like to get into something tangible rather than holding intangible paper assets.

 Recent events at the G-20 meeting in Pittsburgh and the annual World Bank/IMF meeting in Istanbul have pointed to a downward path for the dollar as world leaders have tried to rectify global imbalances, which are the cause of the current crisis. Opinion is still divided over the eventual fate of the dollar - whether it will collapse to create a global systemic crisis or whether it will go through an adjustment before re-emerging as the reserve currency among other currencies.

The problem is that there is now too much paper wealth chasing fewer commodities. As of September, the total assets of the US hedge funds stood at US$1.95 trillion (Bt65.3 trillion). A year earlier their size reached $3 trillion. The hedge funds have suffered heavily from the market meltdown. But there are also sovereign funds and international reserves, held mostly by countries in Asia and the oil-rich Middle East. They, too, will have incentives to go after hard assets or commodities rather than holding onto the paper assets such as dollar reserves, which are offering zero interest.

Over the past six months, the dollar has fallen by around 14 per cent on a trade-weighted basis. If investors or sovereign funds hold on to the dollar, they will lose money. This is also the dilemma facing the Bank of Thailand, which is also holding a sizeable US dollar portfolio in its international reserves of more than $140 billion (including currency swap obligations). China, which is holding about $2 trillion in reserves, has been aggressively diversifying its wealth into hard assets such as oil, iron ore and other commodities. Not a single day passes without stories about China pouring investment into hard assets worldwide as it prepares for a potential collapse of paper assets.

If the hedge funds and sovereign funds really go after commodities or hard assets, then there is the potential that there would not be enough commodity supply. Martin Hutchinson, author of "Great Conservatives" (Academica Press, 2005; his writings also found at www.greatconservatives.com), warns that a shift of hedge funds and investors into commodities could cause a severe problem. For they could "raise an ominous possibility of a supply shortage in one or more commodities, caused by investor demand that exceeds available mine output and inventory. That could potentially produce a collapse in economic activity similar to that from the 1837-1841 and 1929-1933 liquidity busts, but with the opposite cause".

The problem would be contained if the investments were to be concentrated in the futures markets, where actual physical deliveries of the commodities do not happen, except as paper shuffling. The speculation in the futures markets would not disrupt normal production and distribution. Investors would not want to take delivery of physical commodities because of the cost of shipment, handling and warehousing. Disruption to current economic activity would occur if investors were to demand delivery of commodities. In that case, they would be afraid that the normal arbitrage mechanisms between the futures markets and the commodity markets would be overwhelmed by the volume of demand so that investment in futures would prove less profitable than it should, Hutchinson said.

"When investment moves to physical commodities, as it may now be doing, it potentially disrupts trade flows. A ship laden with copper ore that would normally have sailed from Chile to a smelter on the US West Coast is instead parked in a holding area in order that investors can profit from the rise in value of that copper. That reduces the amount of ore available to smelters."

Hutchinson calls for countries to raise interest rates to counter the tide toward further investment in commodity assets. But he fails to ask a simple question: What if the owners of the commodity assets also think the same - why do they want the fiat currencies in exchange for their commodity assets?

If the situation were to develop to that point, we would have witnessed the end of the fiat-currency era and a move toward a new international monetary system based on barter trade.