If Commodities Falter, Export Reliant Currencies Could Follow

The commodities bull has been running free for quite some time. Just a few weeks ago, I can recall market punters hyping $200 oil by year’s end and betting on the rising demand for metals in the developing world.  But it seems the euphoria surrounding commodities has changed in a matter of just a few weeks.  If commodities continue to falter, there’s a chance that economies reliant on commodity exports could see their currencies (Brazilian Real, Australian Dollar, et al) slide soon thereafter.

For the better part of this year, it seemed that commodities could only advance. Even in the face of a severe credit crunch and a declining stock market, commodities have rallied.  Using the Deutsche Bank Liquid Commodity Index as a benchmark, commodities have risen by over 40% in the first six months of this year versus a decline of 12% on the S&P (see chart).

click to enlarge

Judging by the steady flow of money piling into commodity index funds, investors have increasingly looked to commodities as an alternative asset class.  Granted, having a portion of your stock portfolio in commodities certainly helped expiate the S&P’s decline, but it now seems that the ‘commodity hedge’ may be losing its prestige.

During the first few weeks of this month, the performance of many commodities has been nothing short of execrable.  Wheat, corn, aluminum, and even ‘haloed’ oil have all stumbled.  This past week, commodities succumbed to another bout of capitulative selling.  Since the beginning of July the Deutsche Bank Liquid Commodity Index has fallen by almost 8%.

Unfortunately, the horizon doesn’t look any brighter. Several market bigwigs, including George Soros (who made a killing by correctly betting on the rise of crude), are now rumored to be short.  If the slump continues, economies reliant on commodity exports will have to cope with painful terms-of-trade shocks.  Brazil is a case in point.

Brazil is a large exporter of commodities.  In fact, a large part of its recent growth can be attributed to the demand for commodities in the developing world.  Take, for example, the period of 2003 – 2007.  During this timeframe global growth rocketed from between 3.4 percent to 5 percent per year.  This robust growth coincided with commodity prices (excluding fuels) increasing by 13.2% annually.  This allowed for the Brazilian GDP to witness an average growth rate of over 4%.

Now, Brazil is exporting at record levels.  Though this has been a multi-year boon for its export economy, should commodity prices continue to decline, Brazil will take in increasingly less revenue from commodity exports.  At the same time, Brazil will be paying the same, if not more, for imports.  As a result, the income of exporters will decline, which will lead to a decline in activity and employment in the export industries.  

In theory, because exporters will then be taking less foreign currency to the forex market, fewer market participants will want to exchange their foreign currency for (in this example) the Brazilian real [BRL].  The result?  The BRL, and similar economies, could face significant downward pressure.

Comments

[EUARTE:]

It will take longer for the Real to weaken because the country has huge reserves. Nonetheless, reserves don't last forever.

One should also keep in mind that Brasil must pay off overly generous interest rates on it's bonds. In addition, one must remember that Brasil, for all it's recent progress, is mostly a third world country with most the population still in this mode. When commodity sales lessen it has little to fall back on.

2008 Jul 28 10:23 AM

[naplsguy:]

He didn't say much, these articles that tell us what happend are things we already know.

2008 Jul 28 11:38 AM

[Macro Monitor:]

EUARTE - interesting points, thanks for the post.

naplsguy - I find it entertaining that you took the effort to make that post.

2008 Jul 28 06:03 PM