Financial markets and the commodity price boom: Causes and implications for developing countries

The current commodity price boom in combination with high price volatility is historically unprecedented even in the volatile price history of commodities. Commodity price dynamics have crucial macroeconomic and development implications, in particular for commoditydependent low-income countries. Commodity prices are determined by fundamental supply and demand conditions which have experienced important structural changes in the last decade related to increasing demand from highly growing emerging countries, alternative uses of commodities for energy production, and a reduction in supply due to supply constraints and low productivity. However, these factors alone are not sufficient to explain recent commodity price developments, particularly the large fluctuations between 2008 and 2011. Simultaneously to fundamental changes, trading activities on commodity derivative markets have undergone a major shift related to the increasing presence of financial investors, including banks, institutional investors and hedge funds, that has had effects on the microstructure of these markets and on price dynamics. This paper discusses these changes with regard to fundamental factors and commodity derivative markets and assesses their impact on commodity prices. Further, the paper identifies implications of these developments for developing countries and policy reforms with the objective to stabilize commodity prices and mitigate the negative impacts of the commodity price boom on developing countries.