In the wake of consistent rise of rate of inflation during the first quarter of calendar year 2007 and responding to the concerns expressed at various forums, Parliamentary Standing Committee of the Ministry of Consumer Affairs Food and Public Distribution, appointed an Expert Committee under the Chairmanship of Prof. Abhijit Sen, Member of Planning Commission, to examine whether and to what extent futures trading has contributed to price rise in agricultural commodities. The objectives of the committee were:
1. To study the extent of impact, if any, of futures trading on wholesale and retail prices of agricultural commodities
2. Depending on this impact, to suggest ways to minimize such an impact
3. Make such other recommendations as the Committee may consider appropriate regarding increased association of farmers in the futures market/trading so that farmers are able to get the benefit of price discovery through Commodity Exchanges.
In order to examine whether futures trade could have led to price rise in agricultural commodities, the committee has relied on WPI data as these are a closer proxy of producer prices of agricultural produce than retail prices. Of the 43 agricultural commodities that have futures trading, 24 commodities accounted for 98.7% of total value of futures trading of agricultural commodities in 2006-07. Among the 24 commodities with major share in futures trade, 3 do not feature in the WPI basket at all.
So, these 3 commodities were excluded and mapping was done of 21 commodities with regard to the events of futures trade in these. Annualized Trend Growth Rate and Volatility of WPI of Selected Agricultural Commodities in which Futures are traded were calculated. Both WPI trend growth rate as well as WPI volatility was obtained for pre-futures period as well as post-futures period.
The data showed that the annual trend growth rate in prices was higher in the post-futures period in 14 commodities, viz. Chana, Pepper, Jeera, Urad, Chillies, Wheat, Sugar, Tur, Raw Cotton, Rubber, Cardamom, Maize, Raw Jute and Rice; and lower in 7 commodities, viz. Soya oil, Soya bean, Rape seed / Mustard seed, Potato, Turmeric, Castor seed, and Gur. The first set of commodities account for 48.2% of futures trading volume in agriculture and have a weight of 10.1% in the WPI. Corresponding figures for the second set are 21.3% and 1.7%. Since the number of commodities in which inflation accelerated is double the number in which this decelerated, and their weights are also much higher in both futures trading and in the WPI, there is some support for the claim that opening up of futures markets spurred inflation. Also, significantly, all sensitive commodities (i.e. food grains and sugar) recorded some acceleration in inflation after the start of futures trading.
However, a revealing feature of this data is that of the 14 commodities in which acceleration took place in post-futures period, 10 had suffered negative inflation during the pre-futures period. It is possible in such cases that the acceleration in growth rate of WPI in these commodities is simply rebound and catch-up with the trend, which in turn could have been aided by more efficient price discovery. Similarly, of the 7 commodities in which WPI growth was lower post-futures, 6 had unusually high pre-futures inflation at over 10%. In these cases, too, it is possible that what is being observed is simply reversion to a more normal level of inflation. In both cases, there is the problem that the period during which futures markets have been in operation is much too short to discriminate adequately between the effect of opening up futures markets and what might simply be normal cyclical adjustments.
An analysis was also carried out at macro rather than specific commodity level taking August 2004 as the cut-off point to divide pre-futures and post-futures periods. This is the middle month of the second quarter (July-Sept) of 2004-05 when, taking acceleration in total futures trading volume as the barometer, such trading picked up reasonably. After taking equal observations for both pre and post futures period, trend growth rates for both periods were calculated. This was done for
(i) The weighted average WPI of the 21 selected commodities that have significant futures trading
(ii) All primary agricultural goods (i.e. Food and Non-Food Articles in the WPI Primary Articles Group) and
(iii) The weighted composite index of the 87 processed and unprocessed agricultural commodities. It was observed that not only did inflation accelerate post-futures in every case; price volatility was also generally higher in the post-futures period.
However, although inflation in certain sensitive commodities did accelerate after introduction of futures trading and appear to have benefited traders more than farmers, it does not necessarily follow that introduction of futures trading was the causative factor. The price discovery expected from futures trading should ideally lead to better utilization of available information regarding how supply and demand conditions are likely to evolve; and arbitrage, through speculation and hedging, should ideally affect spot prices only to the extent of bringing these in line with evolving fundamentals and the cost of holding physical stocks.
Inflation and Specific Commodities.
The futures on urad, tur wheat, rice etc were delisted from the Indian exchanges. The committee has studied each of these commodities to analyze the factors behind the inflation and to check whether futures trading has actually resulted in price rise.
The report states that the price of tur was not influenced by the futures trading, but the domestic demand and supply. In the next year after the introduction of futures, the supply of tur was huge, which lead to a steep fall in price. And in 2007, its price again went up as the production was dull. This evidence contradicts the claim that futures trading caused excessive increase in tur prices.
By considering exports and government stock change into account, total rice availability in the domestic market declined by over 5 million tonnes in 2005 but recovered well beyond the 2004 level in 2006 and increased further by more than 1.5 million tonnes in 2007. The price of rise does not increase marginally in any of these years and was increased only after the delisting of rice from futures trading. So, the report states that speculation in futures markets cannot be said to have exerted any strong upward pressure on spot prices of rice.
Production of urad declined and was below the average production in the years 2004-05 and 2005-06. But it was recovered in 2006-07. The price of urad was behaving unusually. Thus, Urad inflation did flare up very unusually in the period when futures‘ trading was active (August 2004 to January 2007). But this was a period of below normal production and, although higher imports cushioned supply.
Wheat production was a little bit fluctuating over these years. It went down in 2004-05 and then increased sharply. Exports were declined and as a result of these factors, market availability of wheat increased. But despite that, the inflation persisted. Wheat prices behaved unusually and annualized wheat WPI inflation at 9.8% during the 30 months when futures trading was liquid (August 2004 to February 2007) stands in sharp contrast to inflation in either the previous 30 months (1.5%) or in the year subsequent to de-listing (0.3%, y-on-y February 2008).
The report states that Critics of futures trading have focused most on outcomes in wheat, and linked this not only with speculative gains at cost of both producers and consumers but also with failures in public grain management in the face of uncertainties in both domestic production and world trade.
The possible reasons for the rise in wheat prices are:
1. Price rise in the initial period was as a result of output decline in 2004-05.
2. The world wheat prices have played a significant role in igniting wheat prices in India.
3. The increased demand for wheat during the period.
4. Even though wheat was available in private market, the government stock of wheat was too low to meet the increased demand.
5. In 2006-07, even though the production was increased, the ratio of market arrivals to production was low as a result of private trade.
Steps to minimize the potential risks of Derivatives trading
1. Pace and sequence of market opening.
New and modern technology-driven Exchanges with best international practices have come up. All these developments have taken place in the backdrop of a long history of ban in forward trading when the perception about these markets was not good. That perception has not gone away totally. Even today people express their doubts about the need and efficacy of these markets. Therefore, it becomes all the more important that these markets are set up on a strong foundation. There should not occur any mishap or mischief which may discredit the market as a whole. The Government/Regulator/Exchanges should be able to explain that the markets are beneficial to all groups and if there are any transitional costs, these are the minimum and will be more than compensated with the overall benefit to the economy and the stakeholders.
Before taking any steps to lift the ban on the four delisted commodities, the government should take necessary steps. A cautious approach is to be adopted for revival of futures trade in these commodities rather than have to confront a stop go situation again in the future.
2. Regulatory framework
In order to defend the market against criticism, it is essential to minimize the potential adverse impact of futures trading on prices of agricultural products. This requires properly functioning and regulated markets. There is a need for a clear and unambiguous regulatory framework. The broad parameters of the functioning of the markets have to be clearly laid down. The regulatory authority should have the capacity and the power to discipline the market. Once these pre-requisite are in place they will not only help in controlling aberrations in the market but also help the government and the regulator to explain to various stakeholders at large any abnormal behavior in the market that might occur as a result of some basic fundamental demand and supply factors.
The regulatory framework for the market is provided in the Forward Contract (Regulation) Act, 1952. The FMC (Forward Markets Commission) was set up under this act.
3. Derivatives Markets to be Anchored to Physical Spot-Markets
The derivative market has to be anchored to physical cash market. The physical spot markets have large number of infirmities. Till these infirmities are reformed, it will be difficult for the futures market to progress far ahead of them. Futures markets can act as a catalyst of change for spot markets and nothing more. Whenever futures markets try to grow faster than the under-developed physical markets of underlying commodities, the mismatch between the two gets widened, thereby opening up futures market to the criticism of being driven by speculators, even if benign and closely regulated.
Futures markets efficiency is contingent on the efficiency of spot markets. Efficient spot markets reduce the cost of future- spot arbitrage. Efficient spot markets in commodities would require integration of markets across geographical regions and quality. This reduces the basis risk in the use of futures contracts. Integration of the spot markets requires development of rural communication, transport and storage infrastructure. The committee is of the view that in order to expedite this, a substantial part of the transaction tax which is now being imposed on futures markets should be earmarked for development of the required physical market infrastructure.
4. Speculation an Integral part of Efficient Futures Market
The commodities with a history of high price volatility are prone to excessive speculative interests which open up futures market to the charge of distorting prices having no linkage to the fundamentals of the demand and supply factors. The presence of the speculators on the futures market is often looked upon with suspicion. It must be remembered that if only the farmers and consumers were to operate on the agricultural commodity markets, there is likely to be mismatch in their respective marketing strategies and therefore, they would not be able to transact business at any given point of time since the total volume of business would be very thin. The market would, therefore, become illiquid. Hence, speculators step into to provide the transaction matching through risk transfer and consequential liquidity. In a free market with availability of technology for instantaneous flow of information speculative funds cannot bring secular price rise as supply responses (through inventory unloading, imports and production) are fast. It is opacity or non-availability of efficient markets, like futures markets that gives power to the manipulator-speculator. On the other hand, an efficient and transparent market with sufficient depth of participation will encourage responsible and informed speculation.
5. Consultative Mechanism for Development of the market
The exchanges as well as FMC should have a strong back up of domain knowledge of commodities which are traded on the exchange platforms. The knowledge of fundamental economic characteristics of production, marketing and use of the commodity so as to understand the factors influencing their prices is of utmost importance. Once a proper contract design of a product is in place, the surveillance of the market becomes easy. There should be a consultative group comprising of persons with proven domain knowledge of the commodity sector, both in the FMC as well as in the Exchanges.