What ails the commodity markets????

What ails the commodity markets?
MMTC and India Bulls Financial Services are jointly planning the fourth national commodity exchange. MMTC had sought Commerce Ministry’s approval to hold a minority stake of 26 per cent in the special purpose vehicle to be floated for the new commodity exchange. They have applied to the regulatory body. Forward Markets Commission (FMC) for the same. However with three nationwide exchanges already operational in the country the FMC Chairman, Mr. B.C. Khatua, expressed reservation on allowing a broking firm to promote an exchange. Many might believe that competition among could benefit commodity trading. However this view is grossly misplaced.
The commodity trading in the country has stagnated around 15,000 crores much below the equity segment volumes of over 100,000cr. Globally volumes in equity segment pale in front of commodity volumes. This is anomaly in Indian markets can largely be attributed to excessive intervention from the government and rollback on reforms by the government. It’s a pity that options are yet to be introduced in commodity trading which leaves little room for hedging ones position. Barring a few metals and agricultural commodities most of the contracts have little liquidity. Although contracts covering over 80 commodities have been launched in various exchanges only a handful of commodities attract large volumes. Institutional players FIIs and Mutual funds don’t participate in the market, restricting liquidity to few traded commodities. This leaves them vulnerable to cartelisation and price manipulation making a mockery of the principle of price discovery.
On the other hand government and its netas love to blame the commodity futures market for inflation in food grains. The so-called ‘aam-admi’ government finds an easy scapegoat in commodity futures trading with little acknowledgement of its own policy failure. Poor agricultural infrastructure and lack of investment has taken sheen off food grains cultivation. Minimum Support Price (MSP) declared is very low and private players like ITC are discouraged to buy directly from the farmers, with government fearing a price rise. This Soviet-style curb on prices doesn’t incentivise agriculture and inhibits growth. This is reflected in poor agricultural growth registered in last few years which has dipped below pre-1990 levels. The agricultural growth in FY2006-07 was a meagre 2.7% and pales in front of the 11% growth registered in manufacturing for the same period. The government investment in agriculture fell from 1.8 percent in 1993 to 1.3 percent in 2003. Agriculture’s share of India’s GDP has fallen from 45 percent in 1972-1973 to 21 percent in 2004-2005. However almost 60 percent of India’s 1.1 billion people depend on agriculture for their livelihood.
What is the reason for critical state of agriculture? The answer is regulation , or to be precise ,its over-regulation.Agriculture needs investment and sadly government is not doing so.So why not let the corporate money flow into agriculture.Investment at individual level too can be made if the producers get proper prices which they are denied as layers of middlemen are involved in procurement & distribution process.Sadly that too is discouraged when organised retailers are made to shut shops by the state, pandering to the demands of guilded middlemen. If farmers receive good prices for produces then they are likely to invest in agriculture and will look to improve yields. However this has not happened,making small scale cultivation unsustainable. This also explains the sharp decline in wheat production last year and heavy migration from rural to urban areas in last few years. So the ultimate loser is the largest chunk of the ‘aam-admi’ electorate, the farmer itself. The urban ‘aam-admi’ pays extra for the same commodity for which the rural ‘aam-admi’ has received little and middlemen pocket the lion’s share of the profit. If that was not enough our government loves to import wheat for the countrymen at exorbitant rates. The Government first rejected the tender which offered wheat at $263 per MT in June citing steep price. After 10 days, it changed its mind and ordered import of 5.7 lakh tonnes of wheat at $325 per MT. Indian farmers are paid only Rs 850 per quintal, but through imports, foreign farmers are paid Rs 1,600 per quintal. Similar rates to Indian farmers would have huge impetus to domestic production. To be true the role of the state has remained restricted to free power, subsidized fertilizer and tax-free agricultural income.
All the above-mentioned shortcomings point into one direction; that the government is directionless when it comes to tackling rise in prices of commodities. It protects the middlemen and blames futures trading for price rise. Infact it’s the wrong policies of the government itself which are to be blamed. But then our netas are very apt at blame game and the best way for them to tackle inflation was banning future trading in key four commodities like wheat and pulses in March’07. That argument was more politics and less economics.
This was clear from a study by IIM Bangalore professor Gopal Naik which forms the key input for a panel set up by the Government under Planning Commission member Abhijit Sen to examine the effects of futures trading in agricultural commodities on their consumer prices. Naik’s study establishes that there is no evidence to show that futures trading had any significant influence on their spot market rates. In fact, a comparison of data on futures trading between wheat and Chana suggests that a more reformed agricultural commodities market is likely to be more beneficial to farmers.
The study looked at price volatility in a 30-month period before and after the introduction of futures trading in agriculture commodities. For wheat, price volatility increased from 7.09% between January 2002 and June 2004 — before trading was allowed — to 13.63% between July 2004 and December 2006 after introduction of the exchange markets. This jump is attributed to of lower production, lower stocks, and soaring international prices of wheat by Naik. “The year 2005-06 turned awful for wheat production,” says the report, “the actual production (68.6 million tonnes) turned out 5 % less than forecast which led to prices soar up by 8%.” Also, this year, international production dipped and global prices rose by almost 20 per cent to $158 per tonne. In the case of Chana, price volatility, in fact, marginally decreased from 6.4% between April 2002 and March 2004 before future trading was allowed to 6.16% between April 2004 and March 2006 after introduction of the exchange markets. However, there was high volatility during April 2006-March 2007, which the report says, was the result of “panic” over lower Chana production due to “weather aberration.”
However ignoring all these facts government took the regressive step of banning commodity futures in four commodities and that too at a time when we are projecting Mumbai as an International Financial Centre. This has brought trading volumes in commodities down to a trickle. This sends a wrong signal to domestic as well as overseas investors who want to invest in Indian market as a whole. Already institutional investors are barred from commodity trading. Even the largest stockholder of wheat in the country, the government-owned FCI, doesn’t enter the futures market. “Selective participation of FCI in the futures market would be a welcome step,” said Naik. “It will only deepen the market.”
Madan Sabnavis, Chief Economist at NCDEX Limited, feels that one of the main motivations for reviving these markets was to provide a hedge for farmers, and today, agri-trading volumes have diminished to less than 20 per cent of total traded volumes. This happened just at the time when liquidity was building up and prices were mirroring quite accurately the supply-demand conditions. Instead, it is the non-agri commodities which dominate the trading terminals, even though this is also stagnant at a higher level. However, it must be remembered that price discovery here is strictly not determined in the domestic market as they are images of international contracts and developments. The domestic price of gold or copper or crude is an image of that on, say, the NYMEX or LME. So could this mean that the core business faces the threat of stagnation, if not gradual disappearance?

An issue, which has been raised amid all the controversy, is whether farmers are participating in the market. Sabnavis fells that the answer is an honest ‘no’, because there are several hindrances in terms of accessibility and minimum lot size as farmers may not be in a position to bring an economic size lot to the exchange for delivery. Farmers can trade if there are convenient lot sizes and they cannot be offered unless there is enough liquidity — the classic chicken and egg problem. While the exchanges can offer 1 tonne contracts and 10 tonne contracts, from a buyer’s perspective, the 1 tonne contract is not economical as it would entail higher costs. So, the willing seller may not find a buyer. Therefore, liquidity would be missing and the price discovery process would be retarded.
Sabnavis feels that there is need for two entities to step in quickly. The first is the consolidator who can represent the farmers on the exchanges who consolidates the produce of, say, 10 farmers and puts in the contract. The other is to have market makers who would actually offer buy and sell quotes so that liquidity is generated and the two processes buttress one another. The regulatory processes need to be addressed with urgency to put the market back on track. He feels that institutional players like mutual funds and FIIs must be allowed to participate with well defined frontiers to add liquidity. Awareness amongst end users such as corporates must run alongside to add weight to these efforts. Or else, interest would dwindle further given that the capital market is spiralling upwards quite relentlessly.

He also demands suitable amendments in regulatory structures in four areas. Firstly, FCRA (Foreign Contribution Regulation Act, 1976) needs to be amended to bring in options. Secondly, the concept of consolidator needs to be implemented so as to bring in the farmers.
More autonomy should be granted to FMC. With a surge in trading volumes, the responsibilities of the regulator will considerably increase(in case they rise). In addition to appropriate financial and operational freedom has become absolutely necessary. FMC should be given more teeth so that it is able to take independent decisions for benefit of investors. It should not remain a mere reflection of the fancies political masters, who sadly are driven more by short-term political gains rather than long-term economic benefits.