COMMODITY AGREEMENTS
COMMODITY AGREEMENTS
Another form of economic cooperation involves commodity agreements. Whereas the first part of the chapter focused on how countries cooperate to reduce barriers to trade, this part focuses on how countries cooperate to stabilize the price and supply of a particular commodity. Most of the developing countries traditionally have relied on the export of one or two commodities to supply the hard currencies needed for economic development. Unhappily, many short-run factors have caused price instability, leading to fluctuations in export earnings. The most important factors are:
1. natural forces such as floods, droughts, and weather;
2. relatively price-insensitive demand;
3. relatively price-insensitive supply (in the short run); and
4. business cycles in advanced industrial countries that can cause sudden changes in quantities demanded.
World commodity prices have fluctuated dramatically in recent years. Nonfuel primary commodity prices fell significantly between 1980 and 1986. By the end of 1986, both demand and supply conditions drove prices to their lowest levels since the 1930s. The major reasons for weak commodity prices were: (1) relatively low rates of economic growth in the industrial countries, leading to weak demand; (2) a reduction in the use of commodities due to structural changes in the world economy, also leading to weak demand; and (3) abundant supplies of commodities.31
However, prices of some commodities, especially for base, nonferrous metals, such as copper, aluminum, tin, nickel, zinc, and lead, increased significantly from 1987—1989. The major reason for the increase in prices was the fact that demand for metals was increasing faster than the growth in GNP in most consuming economies, so there was increased pressure on prices. Even though prices began to fall somewhat in 1990, they were still at higher levels than at the beginning of the 1980s. A commodity agreement is an agreement between producing and
consuming countries designed to stabilize prices. Some commodities, such as copper, operate in a relatively free market. Wild price fluctuations result from
supply and demand as well as speculation. However, consumers and producers alike often would prefer a more stabilized pricing system that allows for predictions of future costs and earnings and thus facilitates planning. The types of commodity agreements most frequently adopted are buffer stocks, price ranges, and export/import quotas. The buffer stock system provides a partially managed system moni-
- tored by a central agency. Free market forces are allowed to determine prices within a certain range, but outside of that range a central agency buys or sells the commodity to support the price. The signatory countries to the commodity agreement (those countries linked to other countries by a signed agreement) provide funds that the buffer stock manager can use to purchase commodities.
The buffer stock manager needs to be concerned on two levels about prices: the net seller range and the net buyer range. The prevailing theory is that once the price enters the "net seller" range, the buffer stock manager is required to sell the commodity in order to force the price to drop. When the price enters the low "net buyer" range, the buffer stock manager is required to buy the commodity in order to increase the price.
At one time, the tin market was managed on a buffer stock system. In the early 1980s, however, the Malaysian government began to buy tin secretly in hopes of increasing the world market price. It then began an aggressive campaign to corner the market. The fund manager was forced to intervene in the market to defend the artificially high floor price of tin, and the fund eventually ran out of money. The result was the disintegration of the tin agreement.32
Price ranges can be handled in different ways. In some of the metal markets, such as zinc, lead, and platinum, prices are fixed at the smelters by producers. Although most purchases are made at the smelters, a free market with prices parallel to the smelter prices but usually at a premium or discount satisfies marginal needs. In a second approach bilateral price agreements can be negotiated between two countries to guarantee maximum and minimum prices.
Quota systems occur when producing and/or consuming countries divide total output and sales in order to keep up prices. Quota systems have been used for such products as coffee, tea, and sugar, and they are often applied in conjunction with a buffer stock system. For the quota system to work, countries must develop close ties to prevent sharp fluctuations in supply. The quota system is most effective when a single country has a large share of world production or consumption. Two of the best examples from a production standpoint are wool, which is controlled by Australians, and diamonds, which are controlled by the DeBeers Company in South Africa.
Another example of a quota system is illustrated by the International Coffee Organization (ICO). At one time, the ICO had decided to set up a quota system in which world producers would limit their exports to keep coffee prices between $1.15 and $1.55 per pound, with the quotas to be loosened or tightened as prices neared the upper or lower limit. This plan involved negotiations by producing and consuming nations alike. Two problems emerge with the quota system, however, as illustrated by the ICO: First, the quotas can be perceived as too low by some of the countries, especially those that rely on coffee as their main (and maybe only) major export cash crop. For example, whereas coffee was only 7 percent of Brazil's exports in 1988, it was 29 percent of Colombia's exports, 67 percent of El Salvador's exports, and 97 percent of Uganda's exports.33 Second, a surplus or shortage of coffee might sabotage quantity and price controls. The quota-regulated price range of $1.15-$ 1.5 5 that existed before the breakup of the ICO is a far cry from the $3.40 per pound price that coffee carried in 1977 after the infamous Brazilian frosts.
The global quota for coffee exports was increased in 1984-1985, but the price was maintained at the same level to allow total revenues to rise for exporting countries. However, two problems faced the members of the Coffee Agreement: (1) sales to nonmembers of the Agreement were not covered, and (2) countries continued to complain about their allocations. The first point is important because of the temptation to transship coffee from a non-menber importer to a member importer. The second problem is faced by all producer cartels, as will be seen in the discussion of OPEC later in this chapter. The quota system was temporarily suspended in 1986, largely because of price increases resulting from the Brazilian drought. Some countries, notably nonmember Indonesia, held out for membership in the Organization and a reimposition of the quota system, but at significantly higher levels.34
On July 3, 1989, the ICO finally suspended the price and export-quota provisions, because some of the Central American countries wanted to expand their quotas, but Brazil refused to cut back on its quota in order to allow the expansion for other countries. At that time, the price range had been changed to $1.15 to $1.45, but prices fell through the floor as the agreement expired. Guatemala argued that it could sell only 50 percent of its production and had to stockpile the rest, so being able to sell all of its production at significantly lower prices would still allow it to earn more profits than under the old scheme; volume would rise and storage costs would fall. However, countries such as Uganda, Nicaragua, and El Salvador would be worse off because of the lower quality of their coffee and the lack of excess capacity.35 By the end of 1990, coffee was still trading at below the old price range. Brazil was still not sure if it wanted a quota system, and no one expects prices to change unless there is a frost or a new agreement.
Another form of economic cooperation involves commodity agreements. Whereas the first part of the chapter focused on how countries cooperate to reduce barriers to trade, this part focuses on how countries cooperate to stabilize the price and supply of a particular commodity. Most of the developing countries traditionally have relied on the export of one or two commodities to supply the hard currencies needed for economic development. Unhappily, many short-run factors have caused price instability, leading to fluctuations in export earnings. The most important factors are:
1. natural forces such as floods, droughts, and weather;
2. relatively price-insensitive demand;
3. relatively price-insensitive supply (in the short run); and
4. business cycles in advanced industrial countries that can cause sudden changes in quantities demanded.
World commodity prices have fluctuated dramatically in recent years. Nonfuel primary commodity prices fell significantly between 1980 and 1986. By the end of 1986, both demand and supply conditions drove prices to their lowest levels since the 1930s. The major reasons for weak commodity prices were: (1) relatively low rates of economic growth in the industrial countries, leading to weak demand; (2) a reduction in the use of commodities due to structural changes in the world economy, also leading to weak demand; and (3) abundant supplies of commodities.31
However, prices of some commodities, especially for base, nonferrous metals, such as copper, aluminum, tin, nickel, zinc, and lead, increased significantly from 1987—1989. The major reason for the increase in prices was the fact that demand for metals was increasing faster than the growth in GNP in most consuming economies, so there was increased pressure on prices. Even though prices began to fall somewhat in 1990, they were still at higher levels than at the beginning of the 1980s. A commodity agreement is an agreement between producing and
consuming countries designed to stabilize prices. Some commodities, such as copper, operate in a relatively free market. Wild price fluctuations result from
supply and demand as well as speculation. However, consumers and producers alike often would prefer a more stabilized pricing system that allows for predictions of future costs and earnings and thus facilitates planning. The types of commodity agreements most frequently adopted are buffer stocks, price ranges, and export/import quotas. The buffer stock system provides a partially managed system moni-
- tored by a central agency. Free market forces are allowed to determine prices within a certain range, but outside of that range a central agency buys or sells the commodity to support the price. The signatory countries to the commodity agreement (those countries linked to other countries by a signed agreement) provide funds that the buffer stock manager can use to purchase commodities.
The buffer stock manager needs to be concerned on two levels about prices: the net seller range and the net buyer range. The prevailing theory is that once the price enters the "net seller" range, the buffer stock manager is required to sell the commodity in order to force the price to drop. When the price enters the low "net buyer" range, the buffer stock manager is required to buy the commodity in order to increase the price.
At one time, the tin market was managed on a buffer stock system. In the early 1980s, however, the Malaysian government began to buy tin secretly in hopes of increasing the world market price. It then began an aggressive campaign to corner the market. The fund manager was forced to intervene in the market to defend the artificially high floor price of tin, and the fund eventually ran out of money. The result was the disintegration of the tin agreement.32
Price ranges can be handled in different ways. In some of the metal markets, such as zinc, lead, and platinum, prices are fixed at the smelters by producers. Although most purchases are made at the smelters, a free market with prices parallel to the smelter prices but usually at a premium or discount satisfies marginal needs. In a second approach bilateral price agreements can be negotiated between two countries to guarantee maximum and minimum prices.
Quota systems occur when producing and/or consuming countries divide total output and sales in order to keep up prices. Quota systems have been used for such products as coffee, tea, and sugar, and they are often applied in conjunction with a buffer stock system. For the quota system to work, countries must develop close ties to prevent sharp fluctuations in supply. The quota system is most effective when a single country has a large share of world production or consumption. Two of the best examples from a production standpoint are wool, which is controlled by Australians, and diamonds, which are controlled by the DeBeers Company in South Africa.
Another example of a quota system is illustrated by the International Coffee Organization (ICO). At one time, the ICO had decided to set up a quota system in which world producers would limit their exports to keep coffee prices between $1.15 and $1.55 per pound, with the quotas to be loosened or tightened as prices neared the upper or lower limit. This plan involved negotiations by producing and consuming nations alike. Two problems emerge with the quota system, however, as illustrated by the ICO: First, the quotas can be perceived as too low by some of the countries, especially those that rely on coffee as their main (and maybe only) major export cash crop. For example, whereas coffee was only 7 percent of Brazil's exports in 1988, it was 29 percent of Colombia's exports, 67 percent of El Salvador's exports, and 97 percent of Uganda's exports.33 Second, a surplus or shortage of coffee might sabotage quantity and price controls. The quota-regulated price range of $1.15-$ 1.5 5 that existed before the breakup of the ICO is a far cry from the $3.40 per pound price that coffee carried in 1977 after the infamous Brazilian frosts.
The global quota for coffee exports was increased in 1984-1985, but the price was maintained at the same level to allow total revenues to rise for exporting countries. However, two problems faced the members of the Coffee Agreement: (1) sales to nonmembers of the Agreement were not covered, and (2) countries continued to complain about their allocations. The first point is important because of the temptation to transship coffee from a non-menber importer to a member importer. The second problem is faced by all producer cartels, as will be seen in the discussion of OPEC later in this chapter. The quota system was temporarily suspended in 1986, largely because of price increases resulting from the Brazilian drought. Some countries, notably nonmember Indonesia, held out for membership in the Organization and a reimposition of the quota system, but at significantly higher levels.34
On July 3, 1989, the ICO finally suspended the price and export-quota provisions, because some of the Central American countries wanted to expand their quotas, but Brazil refused to cut back on its quota in order to allow the expansion for other countries. At that time, the price range had been changed to $1.15 to $1.45, but prices fell through the floor as the agreement expired. Guatemala argued that it could sell only 50 percent of its production and had to stockpile the rest, so being able to sell all of its production at significantly lower prices would still allow it to earn more profits than under the old scheme; volume would rise and storage costs would fall. However, countries such as Uganda, Nicaragua, and El Salvador would be worse off because of the lower quality of their coffee and the lack of excess capacity.35 By the end of 1990, coffee was still trading at below the old price range. Brazil was still not sure if it wanted a quota system, and no one expects prices to change unless there is a frost or a new agreement.
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