Take a smarter bet on commodities: Financial Express: May 21 2009

The new government must take an immediate view on revoking bans on futures trading in a number of commodities. We have had bans imposed on eight commodities at different points in time on grounds of them being responsible for higher inflation. A committee was set up which did show that no such conclusion could be drawn, and a lot of independent studies have shown that futures trading and inflation are not related. Yet, the threat of a ban lingers even as the FMC has taken progressive steps to bring back four products last year, and also wheat just recently. Every time prices move up, there is a loud call for a ban on futures trading. Curiously, if the product is not traded on the futures exchanges, like vegetables, moong, urad and tur today, an increase in price does not provoke any response.
Now, futures prices have actually performed a very useful role to provide early warning signals to the market and the government, provided one is willing to open one’s mind and be free from preconceived notions. In 2005, the wheat futures prices showed that there would be a problem, but were dismissed as being an indicator of speculation. The harvest was sub-optimal and we ended up importing large quantities of wheat at an exorbitant cost. In February 2007, wheat futures actually indicated a fall in prices. Yet, a ban was imposed.
In 2006, the tur and urad futures contracts showed that there were problems with production and stocks. These trends were ignored again on the grounds of being a sign of only speculation. Both were banned in January 2007 but that did not help improve supplies, and prices continued to surge.
Now, the irony here is that when futures prices moved upwards based on fundamentals, the products were banned from the futures trading ambit. However, the government on its own has taken steps to increase the prices of these banned products. Between 2006-07 and 2008-09, the government has actually increased the MSP of wheat by 44% from Rs 750 to Rs 1080/quintal, tur and urad by 60% from Rs 1,520 to Rs 2,420/quintal. Jowar and bajra prices were increased by 40%. When the MSP is increased, the floor is set and the market price settles at a higher level. Therefore, it is odd that when prices are consciously raised by the government, the decision is okay. But, when market prices move up based on fundamentals, futures trading have been blamed consistently.
At present, the debate is on sugar. The government’s own estimates have shown that sugarcane production has declined by 20% this year. Overall sugar production is set to fall by over 50%. Sugar prices have hence increased to match consumption requirements as the existing stocks from higher production in the last two years can provide only limited support. Once again, there is a school of thought which believes that futures trading is the sole reason for higher prices. Coincidentally, the same indications were given by the futures prices in late 2008 and early 2009, which could have been accepted and used for appropriate policy responses. As was the case with wheat in 2006, it was a case of too little too late.
There is serious need for all those who hold a distorted view of futures trading to understand that this market captures both the domestic and global mood relating to the product in one shot when price views are taken. Today global factors influence domestic prices, which we cannot avoid even though we may not like it. A swine flu in Mexico will affect the maize prices in the country while crop failure of urad in Myanmar will affect urad imports and prices in India. Further, the FMC and the commodity exchanges have strong surveillance systems in place to ensure that prices are not out of sync with the fundamentals and trading is orderly. More importantly, as highlighted earlier, futures prices give critical signals, which need to be considered with an open mind. But, certainly, as in a hospital, we do not destroy the diagnostic equipment that tells you there is a problem; the same must not be done to futures trading.