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What are super cycles?
Early in twentieth century, the Soviet economist Kondratiev proposed that commodity prices moved in cycles, just like overall economic cycles; but in this case longer ones extending to decades. Later, Joseph Schumpeter, the doyen of free market economics, proposed similar long cycles.
"I'm also referring to the long-term swings in prices that are often called "super cycles." What's important to remember is that these long-term swings are driven by the fundamental economic laws of supply and demand, as well as the continuous technological progress that can affect both output and consumption," says Stephen S. Poloz, Governor (Bank of Canada Sept.,21.2015). Yet, over the years this theory has been met with much scepticism from economists. However, the current downturn in commodity prices, 'fits in eerily with the idea', writes Bershidsky in Bloomberg (Aug.7, 2015), pointing to the Bloomberg Commodities Index 46% decline since 2011.
The last century saw four mega cycles according to two economists -- Bilge Erten of the United Nations Department of Economic and Social Affairs and Jose Antonio Ocampo of Columbia University. The first cycle lasted from 1894 to 1932, peaking in 1917. Then from 1932 to 1973, with a peak in 1951;from 1973 peaking soon after and running till 1999, and then from 1999 to 2015 peaking in 2010-2012period(Bloomberg Aug.7, 2015).
For those of you who are academically inclined and want to understand a lot more about their seminal work on commodity super cycles, here is a link to their paper.
How does a commodity super cycle differ from an economic cycle?
We are all familiar with how the law of demand and supply creates economic cycles. Economic cycles in different countries last for differing periods of time, but usually an economic cycle gets completed within 8-10 years. An economic cycle's primary drivers are demand and supply and movements caused by inequilibrium between demand and supply.
A super cycle spans a much larger period of time, and has some secular forces at play that alter the long term demand or supply structure for a commodity or a set of commodities. So, when the world's most populous country and one of the largest in terms of land mass - China, embarked on a huge nation-wide infrastructure building program, it created a huge delta in demand that structurally altered the demand-supply situation for years and years. That fuelled a huge multi-year commodity price boom. Just as the delta fuelled a secular boom, the withdrawal of the same delta - China now going slow on infrastructure building and looking more towards consumption to drive growth - is structurally deflating commodity prices.
Another example: high oil prices which remained above $100 a barrel, spurred technological innovation to find ways to extract oil from places everyone knew it existed, but was deemed too costly to extract when oil was sub $50. These technological innovations led to fracking in the US and oil sands extraction in Canada - which fundamentally altered the supply side of oil. Fears of peak oil are now a distant memory. There's surplus oil around and a lot more that can be pumped out if oil prices climb up again. Technological advancement has therefore created new supply that has fundamentally changed the structural demand-supply situation for oil. The decline in oil prices is not just a part of a usual economic cycle - it appears to be a part of a bigger super cycle.
Another example: Lets look at copper. Twenty years ago copper wire was indispensable for communications systems. Yet now fibre optics, made form silica, has almost entirely replaced copper. That's a structural decline in demand for copper, as an alternate material has substituted it. Copper prices should logically remain weak until a new source of demand comes up to take up supply.
Implications
As can be seen, super cycles reflect very long term trends in prices that are driven by structural changes in either demand or supply for commodities. If you look at the table above, you will see that past super cycles have lasted between 25 to 40 years. Also note that downswing periods last beyond a decade, sometimes stretching to two decades. If you believe in super cycles, you will note that the current downswing is only 5 years old. That's still rather early, if history is any indicator.
That doesn't mean that commodity prices cannot rise at all for the next 10 years. Within the downswing phase of a super cycle, you can have mini booms and busts, but the structural story of soft commodity prices may remain intact for many more years to come - so believe proponents of the super cycle theory.
For a still fragile world economy, the crash in commodity prices is yet another worry. The follow on effects of cuts in capital expenditure and job cuts would be a drag on growth.The current phase of the commodity cycle is good for commodity importers and worrisome for exporters.
Commodity and resource rich countries account for 20% of the world's output. The fall in commodity prices has certainly affected them badly."The oil price drop came as a surprise," said Angolan finance minister Armando Manuel. "It captured my country in a state in which we were not sufficiently diversified."(Wall Street Journal, Oct, 11, 2015).
Oil exporters are showing what may be in store for other major commodity exporters. Nigeria, which got nearly 65% of its government revenue from crude exports before the price plunge, has seen its projected 2015 growth slashed to less than 4% from more than 6% a year ago, according to the IMF. Kazakhstan's growth rate has tumbled to 1.5% this year from 6% before the petroleum collapse. In Venezuela, where the state gets half its revenue from oil sales, the economy declined by 10%. Adding to concerns is the judgement of analysts regarding the price of oil. "We're not at the bottom now," said Ed Morse, global head of commodities research at Citibank.(Wall Street Journal, Oct, 11, 2015).
The oil-price shock isn't expected to dissipate quickly, casting a long shadow for those countries reliant on oil income. Demand has eased, particularly with a slowdown in China, the world's second-largest economy and a voracious energy consumer. (Wall Street Journal, Oct, 11, 2015).With much of its infrastructure already in place and a secular slowing down of its economy, it is unlikely that China will generate the huge demand for metals it has in the last few years.
Commodity exporters already reeling from falling prices now have to face another problem. Many investors are pulling out of those countries. The Institute of International Finance, an industry group, estimates investors will pull a net half-trillion dollars from emerging-market economies this year, marking the first exodus of capital from developing countries in nearly three decades. That accelerates the rise in borrowing costs, exacerbating their problems. And since many of the countries are now in much deeper financial holes, they'll have to borrow at costly levels to cover their expenses. (Wall Street Journal, Oct, 11, 2015).
The oil-price decline is beneficial to energy deficient economies like the U.S., Japan and Europe. India too is in a sweet spot. Lower oil prices have helped to moderate runaway inflation and the government has also seized the opportunity to put its fiscal books in order. India should focus on building infrastructure to take full advantage of low commodity prices.
"Any economy that relies on natural resources will naturally be challenged by large movements in their prices. These shocks are more than just swings in national income; they also force businesses to make decisions about the way resources such as capital and labour are allocated. These decisions often lead to difficult adjustments, but they are necessary for maximizing our economy's potential. While an abundance of raw materials may complicate the management of companies and the conduct of economic policy, it's far better for a country to have resources than not to have them. Even when prices are falling, as they have been recently, our endowment represents a store of value and a source of future riches," says Stephen S. Poloz.
From an Indian standpoint, while deflation in commodity prices certainly gives us a lot of relief, we have to also bear in mind that the huge wealth destruction that's happening in commodity rich countries will impact us as well, in different ways. Soft commodity prices will pin down global growth, as a large set of countries that are commodity exporters will continue to struggle. An environment of low global growth is bad news for our exports - we are already seeing month-on-month declines in our export performance.
From the perspective of FII flows, the sell out from emerging markets on growing realisation that the commodity party is over, means that our market also faces collateral damage since a large portion of emerging market investments by global investors went into EM funds, that allocate across all Ems, including India.
We live in an increasingly interconnected world, and are therefore seeing both sides of impact of the commodity super cycle heading downwards. On balance, it would appear that the positives for India as a consequence of the commodity super cycle turning down will outweigh the negatives in the long run.
We saw in the last two decades that the big delta for commodities happened when China unleashed its infra building program. In the years ahead, will the world's second most populous country - India - provide that delta demand for commodities as it embarks on a nation building spree? Will rapid progress in India over the next decade help cut short the commodity slump and put a smile on the faces of downcast commodity exporting countries? Only time will tell if India will not only progress on her own, but also take many more countries along with it, down the path of prosperity.
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