The Commodity Futures Conundrum: Economic Times: 7th June 2007

The commodity futures conundrum [ THURSDAY, JUNE 07, 2007 12:02:21 AM]


The story of futures trading in India has been more than an enigma. Members of the committee that recommended the reintroduction of futures trading feel that the markets should not have been opened up. The minister who was instrumental for its resurrection has expressed regret for his action. The Leftists firmly believe that futures trading are responsible for high inflation today. The more moderate opinion leaders are willing to accept the efficacy of futures trading provided farmers have gotten the benefits. And lastly, the more ardent opponents are not willing to accept the market unless ‘only’ genuine users of the commodities participate and that the speculators are shown the door. In this milieu, the government went ahead and banned trading in two pulses and cereals in January and February. It appears that everyone has a different expectation from futures trading. How is one really to view these markets considering that it is not a panacea for some of our deep-rooted agrarian problems? Futures trading are reflective of the prices of commodities which are driven by expectations of demand and supply. While theoretically the futures price is the spot price plus the cost of carry, in practical terms it is a reflection of what the markets expect from the harvest. An expected supply shortfall gets reflected in higher futures prices while the converse holds in case of a surplus. Futures are hence an efficient real time monitoring mechanism of crop expectations. An efficient futures market is intended to discover the right price based on fundamentals while ensuring that there is discipline in the market and that there is no case of either hoarding or price manipulation. If this is taken care of, then it should not matter whether the price is rising or falling. What is important is that the price is the true reflection of fundamentals. The track record in the last three years has been very satisfactory. Rising wheat futures prices in November 2005 correctly predicted that there would be a shortfall in output in 2006. Later in the same year, futures prices indicated that there would be a shortfall in tur production, which was borne out by the ministry of agriculture estimates. Ironically, the ban on urad came when the futures prices were falling as they mirrored the arrivals of the rabi crop as well as imports in February and March. Therefore, there is a lot of merit in the futures markets provided regulatory processes are in place. Large-scale participation of members across various geographies and stringent position limits imposed at the member- and client-level as well as low, overall open interest to availability of the commodity are some of the measures being taken by the exchanges with the regulator FMC to ensure that there is market discipline
Now logically it should not matter whether prices are determined by majority hedgers or speculators or investors or market makers as long as the rules are obeyed. One must realise that even speculators are rational. When a supply shortfall is expected, then prices cannot be driven down, or will not be driven unreasonably high unless there is a counter-party who believes the same. Information symmetry and strong internal regulation, as explained earlier, ensure that there is a self-regulating force in the system. If prices reflect the economic fundamentals, and we are committed to the market mechanism, then it may not be proper to talk about benefits to either the farmer or consumer. The market cannot really play favourites to any part of the value chain. It is akin to interest rates where the market cannot be judged on whether the savers are to be assuaged or borrowers encouraged. Therefore, the issue is not whether the farmer is receiving a higher price or the consumer paying a lower price, but whether the price is the right one and whether farmers have knowledge of this price when taking their selling decisions. It follows that the futures market cannot be held responsible for either crop failures or institutional barriers along the way. If markets are efficient, as was the case in wheat, then as an extension, these prices could be used for cogent policy formulation. The minimum support price (MSP) programme of the government for wheat is a good example where the futures market can play a very important role. The MSP should take into account the prevailing futures prices to be more credible. The futures price is an indicator of the market price and if the MSP reflects the same, then it would be much easier for the Food Corporation of India to procure wheat and avoid the problem we are facing presently. The issue today is that the farmers have become more aware of the situation and are holding back their produce to sell at a later date. Therefore, sans futures and restraints on private procurement, the FCI is still facing problems in procuring. As the futures markets evolve, one can also think of the FCI considering operations on the futures exchanges to ensure that the procurement takes place. If done in advance in smaller quantities (to ensure that there is no distortion in the market), the procurement process is assured. Also, if the FCI can hedge on overseas exchanges then it could do the same on domestic exchanges. If these arguments are acceptable, then it follows that there is a need to permit futures trading in the banned commodities and encourage the same with the regulatory processes in place. Prices in any market send valuable signals: be it forex, money and commodity markets. We must not lose this very important tool as this will take us back several steps, which is acceptable in a closed economy set-up, but sounds anachronistic in a market driven economy.