People's Democracy

ECONOMIC NOTES

Speculative Surge In Commodity Markets

C P Chandrasekhar

WHILE speculative activity in India’s financial markets has been much noted and commented upon, speculation in commodities has received far less attention. However, in recent years speculation in commodities has grown at a much faster rate than that in stocks, triggered by two developments.
First, the liberalisation of the trade in agricultural commodities within the country, which has increased the presence of large private players including transnationals. Liberalisation has involved the removal of controls on the inter-state movements of agricultural commodities (from surplus to deficit regions); the liberalisation of rules relating to the operation of private traders and agribusiness firms, which has brought in large players into commodity markets; and some weakening of the procurement programme of the government as a prelude to the dismantling of the public distribution system (PDS). One consequence of this combination of trends has been a decline in government stocks from record levels and a rise in stockholding by the private trade for speculative purposes. As a result, these policies have encouraged speculative hoarding at the first sign of an indifferent harvest, resulting in price increases.

FORWARD AND FUTURES TRADING

The second reason for the increase in speculative activity is the liberalisation of forward and futures trading in India’s commodity markets. Forward contracts have historically been a feature of commodity markets, partly because while the demands of actual users of many commodities is continuous across the year, supplies come into the market at specified points in time such as harvest time. Producers of commodities have to make production decisions based on expectations of the price that they would receive when the output arrives, and purchasers of commodities as inputs or final goods must make judgments of the availability and cost of the commodity at different points of time during the year. To guard against price volatility and uncertainty in production and availability, sellers and buyers often entered into forward contracts, specifying the quantity, quality and price of the commodity they would deliver for sale or acquire for purchase at a pre-decided date in the future.

It should be clear that forward contracts are means of hedging against the risk of price volatility or uncertainty of supply. But hedgers cannot function without the presence of speculators. If the market is restricted to hedgers, who are actual producers or users of the commodity, the volume of many contracts could be so low that on some days a trade cannot occur, because a buyer cannot find a seller or vice versa. This is where the speculators step in. They buy or sell in forward trades, not with the intention of actually making or taking delivery, but with the idea of transferring the concerned contract to an actual producer or user at a profit. They can therefore, buy and sell a large number of contracts, enabling the hedger to transfer risk with ease by injecting liquidity into the system. But the moment speculation begins there is the risk that prices could be manipulated to move consistently in one direction for significant periods of time, inflicting losses on some and gains for the others. 

Forward contracts, however, are cumbersome. It requires intending sellers of specific quantities of specific quality at specified times to find the appropriate number of buyers. This entails costs of search and inspection. Further, since there is no centralized market or exchange where the contract is drawn up, prices tend to vary and there is uncertainty about delivery. It is for this reason that futures contracts were evolved.

Futures contracts differ from forward contracts in important respects. Futures contracts are standardized contracts to buy or sell a standard quantity of a standard quality of a commodity. These are traded in exchanges, through brokers, with no need for the buyer and seller to meet and negotiate. An important feature is that a contract need not be settled by actual delivery. It can be matched by an offsetting contract taken by the buyer or seller, and the two can be squared at any point at some gain or loss. The administration of the exchange guarantees that contracts would be settled, and requires traders to pay up margins to cover ongoing losses, if any, to secure the viability of the exchange. To avoid paying margins, traders can buy an option to offer or acquire a contract at some specified future date. If the option is not exercised, because price movements are contrary to expectations, the loss is restricted to the premium paid to hold the option and the transaction costs of acquiring it. 

The existence of futures contracts allows sellers or buyers to hedge against risk by buying offsetting futures contracts that would protect them against losses if the market moves against them. But hedging is not the sole driver of futures markets. The emergence of futures contracts and derivatives such as options in commodity markets, allows the implicit trade in commodities to be many multiples of the explicit trade. The volume of implicit trade is only restricted by the extent of liquidity in the market, whereas the volume of explicit trade is limited by the actual availability of the commodity from different sources. If liquidity in the market fed by speculation is high, prices in futures markets can move in ways that could influence the spot or ready prices at which the commodity is actually sold.
However, if the futures market is predicting a rise in the price of a commodity say, and those holding stocks of the commodity want to benefit, the actual supply and demand for the commodity must be such that spot prices can move in ways that reflect that trend. This depends upon the ability of stockholders to regulate supply in an appropriate manner. Three things are necessary for this: (i) the government should not have large stocks in its hands to dampen spot prices; (ii) the private trade must have stocks to deliver and the capacity to hold on to it till such time prices rise; and (iii) there should be no danger that cheap imports could be resorted to, as and when domestic prices rise.

CONSEQUENCES OF LIBERALISATION

The recent surge in the prices of certain essentials, including wheat, seems to be driven by a combination of such factors, led by speculation. Speculation in the futures markets is rife. Trading on India's commodity exchanges totalled 460 billion dollars in the year ended March 31, a fourfold jump from the year before. This has been aided by a policy of freely allowing exchanged based trading in futures and commodity derivatives. Commodity futures trading had been banned for much of the post-Independence period, so that the commodity derivatives market was virtually non-existent. At present, the country has three national level electronic exchanges and 21 regional exchanges for trading commodity derivatives. As many as 80 commodities have been allowed for derivatives trading.
The process of liberalisation began after the government set up a committee under the chairmanship of K N Kabra in 1993 to examine the role of futures trading in the context of liberalization and globalisation. The Kabra committee, while cautious, recommended allowing futures trading in 17 selected commodity groups. It also recommended strengthening of Forward Markets Commission (FMC) and amendments to Forward Contracts (Regulation) Act 1952.

However, major steps forward were taken in 1998, which saw the adoption of a major reform package involving the FMC and the Exchanges, spurred by a World Bank-funded grant. The reform included the introduction of futures trading in edible oils, oilseeds and their cakes, which was a turning point in the development of commodity futures contracts in India. The National Agricultural Policy announced by the government in the year 1999 declared that the government will enlarge the coverage of the futures market to minimise the wide fluctuations in commodity prices, as also for hedging their risk. In the budget for 2002-03, the finance minister announced expansion of futures and forward trading to cover all agricultural commodities.

It has been boom time for speculators since. According to Bloomberg quoting the Forward Markets Commission, volumes on the National Commodity Exchange, which trades futures contracts in 48 commodities, reached 226 billion dollars in the year ended March 31, 2006. That was more than the 184 billion dollars of shares traded on the Mumbai stock exchange in the same period. Activity of this kind could not be driven by pure hedging requirements, and obviously reflects a speculative surge that would have triggered efforts at market manipulation by the big players.

Such manipulation is aided by the fact that large trading firms have cornered supplies of many commodities at prices higher than minimum support price offered by the government. The net result has been that government food stocks on June 1, 2006 were at 223 lakh tonnes, close to a third of their peak level of 648 lakh tonnes on June 1, 2002. Wheat stocks with the government stood at 93 lakh tonnes on June 1, having declined continuously when compared with the level on the same date of the last few years, starting at 413 lakh tonnes on June 1, 2002. These declines are far more than warranted by trends in production, indicating that the private trade has managed to corner a significant volume of stocks.

UNBRIDLED SPECULATION

The collapse of government stockholding, has helped fuel speculation, leading to the recent price increase. In response the government, which is curtailing domestic allocations to maintain its buffer, has been forced to permit imports at high prices to prevent a price spiral. It may be better placed trying to curb the activities of speculators in India.

What is more, there is evidence that private players, including foreign ones are keen to invest in the equity of privately owned commodity exchanges, given the revenues and profits that the speculative surge promises. A few months back Fidelity International, a foreign institutional investor, acquired a nine percent stake in the Multi Commodity Exchange of India (MCX) for Rs 216 crore. Promoted by Financial Technologies (India), MCX has the biggest daily volume in commodity futures. And a few days back, New York-based investment banking firm Goldman Sachs acquired a seven per cent stake in National Commodity and Derivatives Exchange Ltd (NCDEX), from ICICI Bank, an original promoter for around 23.1 million US dollars (Rs 106 crore). This amounts to acquiring 50 per cent of ICICI’s stake at a massive premium. Clearly even owning a commodity exchange has become a major speculative bet.