Commodities Futures And Inflation

Commodities Futures And Inflation

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ABSTRACT
Indian markets recently thrown open a new avenue for retail investors and traders to participate: commodity derivatives. For those who want to diversify their portfolios beyond shares, bonds and real estate, commodities are the best option. They provide risk management facility. However, India, under pressure to cool inflation running near two-year highs, banned new wheat and rice futures contracts in its fledgling exchanges in February in a bid to check speculation and hopefully tame prices. This report presents a study to find out whether futures trading leads to increase in price of essential commodities like wheat and rice. It also analyses the various factors that are leading to the increase in price of these essential commodities. Some recommendations are given to control the increase in price these essential commodities.
INTRODUCTION
Commodities Futures trading is a class of Derivatives trading, in which futures contracts derive their value from the ruling price of underlying commodities. This is a mechanism by which participants can enter into transactions for purchase and sale of commodities at a price, where the performance of delivery and payment obligation becomes due on a future date.
Futures trading in commodities in India are governed by the provisions of the Forward Contracts (Regulation) Act, 1952. As per provisions of this Act, futures trading in commodities can be conducted only by such Commodity Exchanges, which have got recognition from the Forward Markets Commission (FMC) under Section 6 of the Forward Contracts (Regulation) Act and have got specific permission from FMC to launch futures trading in specified commodities.

HISTORY
Organized commodity derivatives in India commenced nineteenth century when the Bombay Cotton Trade Association started futures trading in 1875, barely about a decade after the commodity derivatives started in Chicago. As time progressed, derivatives market developed in several other commodities in India. Following cotton, derivatives trading started in oilseeds in Bombay (1900), raw jute and jute goods in Calcutta (1912), wheat in Hapur (1913) and in Bullion in Bombay (1920). After the Independence, The Forward Contracts (Regulation) Act was enacted in 1952 and the Forward Markets Commission (FMC) was established in 1953 under the Ministry of Consumer Affairs. FMC acts as a regulatory body, which regulates the commodity markets in India. The mid 1960s witnessed an unprecedented rise in the prices of major oils and oilseeds as a result of sharp fall in the output. Futures trade was banned in most commodities to contain speculation, which the government attributed to rising inflation.

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During liberalisation, the Government set up Kabra Committee in 1993 to examine the role of futures trading. The Committee recommended allowing futures trading in 17 commodity groups. The Government accepted most of these recommendations. Indeed, it was a timely decision too, since internationally the commodity cycle is on the upswing and the next decade is being touted as the decade of commodities.
BENEFITS OF COMMODITIES TRADING
1. Price discovery: Futures markets provide a mechanism for buyers and sellers to interact with one another in an open market. They also have wider access to information and decision making. This results in efficient price discovery.
2. Forecasting and planning tool: Commodity future markets act as a price barometer to farmers. Future prices help the farmers plan their cropping pattern and investment on inputs.
3. Hedging: Futures markets provide the facility of hedging against price risks for the participants in the market. It acts as insurance for the loss.
4. Role of speculators: Speculators are those who does not produce or use a commodity, but risks their own capital in hopes of making a profit on price changes. Speculators do help make futures markets function better by providing liquidity. The participation of speculators willing to take the other side of hedgers' trades adds liquidity and makes it easier for hedgers to hedge.
5. Price stabilization: In times of violent price fluctuations, future’s trading mechanism dampens the peaks and lifts up the valleys i.e. the amplitude of price variation is reduced. It leads to integrated price structure throughout the country and helps in balancing supply and demand position throughout the year.
CURRENT SCENARIO OF COMMODITIES MARKET IN INDIA
The Forward Markets Commission (FMC) is the regulatory body for Commodity Trading in futures/forward trade in India. The Forward Markets Commission is responsible for regulating and promoting futures trade in commodities. The FMC has its headquarters in Mumbai and the regional office is located in Kolkata. There are some 21 commodity exchanges in India. But most of these commodity exchanges are regional, offline and commodity specific. The government has recently allowed three national level multi-commodity exchanges to trade in all permitted commodities. These are National Multi Commodity Exchange (NMCE), Multi Commodity Exchange (MCX) and National Commodities and Futures Exchange (NCDEX). Some of the commodities which are traded are Precious / Bullion Metals, Base Metals, Energy Products, Oil and Oil Seeds, Spices, Pulses, Cereals. The commodities market, has grown to $858 billion in 2007 from $16.9 billion in 2002, and is expected to expand to $1.8 trillion by 2010, according to Assocham. (Source: Business Line, 2007). Also see Annexure attached.
With rising inflation in 2007, Government imposed a temporary ban on futures trading of agricultural commodities in two phases when in January it banned urad and tur (pulses) and then in February trading in wheat and rice was banned. Abhijit Sen was appointed to look into the issue. The report of the committee is still pending.

COMMENTS ON BAN FROM VARIOUS SECTIONS
• “Trading in commodity derivatives has fuelled inflation in India and the government will look at the role of futures in driving up prices”. (Ramesh, Jairam)
• “Once you liberalise the economy, there is no logic in intervening in it. One way to curb the inflation is to cut down money supply," (Alagh)
• “Prices of commodities have gone up due to stagnant productivity and supply shortfalls and to blame commodity exchanges for inflation is misplaced accusation”. (Ravikumar, PH).

ANALYSIS OF ISSUES INVOLVED
It is claimed that futures trading drives up prices and thus inflation is also shooting up to all time high. But an efficient and well-organised commodities futures market is generally acknowledged to be helpful in price discovery for sellers. It offsets the transaction in commodities without impacting the physical goods until the futures contract expires. Also, Inflation contribution of commodities traded on the exchange was 0.3% while commodities not traded contributed 0.835 to the WPI. The main cause for the Inflation is mismatch of supply and demand. Inflation has declined since July 2007 because of increase in production of food grains. (See Annexure 5).
Thus, a futures market encourages competition by attracting traders who hedge their bets and minimise risks on the basis of their own market information and price judgment. As a result, the commodity market attracts participation of hedgers who have a long-term perspective of the market, and traders, or arbitragers who hold an immediate view of the market.

PROBLEMS CONFRONTING COMMODITIES MARKET
• Commodity Options: Options trading is not allowed in market which is a key part of Derivatives. Both futures and options are necessary for healthy growth of market.
• The Warehousing and Standardization: There is inadequate provision of sophisticated, cost-effective, reliable, and convenient warehousing in the country. Central Warehousing Corporation of India (CWC: www.fieo.com) is operating 500 warehouses across the country with a storage capacity of 10.4 million tonnes.
• Cash versus Physical Settlement: Only about 1% to 5% of the total commodity derivatives trade in the country are settled in physical delivery.
• The Regulator: As the market activity pick-up and the volumes rise, the market will definitely need a strong and independent regular; similar to the Securities and Exchange Board of India (SEBI) that regulates the securities markets.
• Lack of Economy of Scale: There are over 80 commodities are allowed for derivatives trading; in practice derivatives are popular for only a few commodities. All this splits volumes and makes some exchanges unviable. This problem can possibly be addressed by consolidating some exchanges
• Tax and Legal bottlenecks: There are at present restrictions on the movement of certain good from one state to another. These need to be removed so that a truly national market could develop for commodities and derivatives.

CONCLUSION

• Futures Trading is about planning, it is about taking control of the uncertainty. Banning futures trading is about forcing people not to plan. Instead some of the inefficiencies in the market should be taken care of.
• Price risk management and quality consciousness are two important factors to succeed in the global competition. Futures and other derivatives contracts have significant role in price risk management.
• Banning the futures trading, say economists, is like shooting the messenger. Prices in the futures market, they say, are indicators of the shape of things to come and help the government plan its economy well in advance.(Kumar, Birendra)
• Inflation, as any economics book would define, is "the supply of excess money and credit relative to the goods and services produced, resulting in increased prices (money supply grew by 22.8% while RBI’s target was a maximum of 17.5% growth during 2007-08). The possible reasons for Inflation are excess money supply, mismatch of supply and demand.

RECOMMENDATIONS
1. Strengthening the physical market, improving the flow of information, distinguishing hedging and speculating activities, and treating hedgers and speculators differentially.
2. The correct approach lies in addressing the problem and not banning the market. Thus, the futures trading in banned commodities should be allowed. Also allowing Options trading (which is not allowed) because futures trading only allows producers to insure them against downside price movement, and not the opportunity to reap the benefits of an increase in prices.
3. Reduce the margins to be given for futures contact of these essential commodities.
Now the margin on 1 lakh wheat contract is Rs30000, compared to earlier margin of
Rs10000. So futures trading have become more expensive.
4. In order to enhance the agricultural productivity and stabilise the price level, government policy must promote diversification of human resource away from agriculture to non-farm enterprises alongside a technological revolution on the field.
5. Steps such as having a better weekly Consumer Price Index, monitoring the distribution of essential articles through PDS, allowing free flow of goods from rural areas to all parts of the country, a policy on managing the value of the rupee, and so on, will help. But, ultimately, it is agriculture growth that will play the lead role in solving the problem of inflation.
6. To control the money supply by effectively using monetary police because rate of inflation is closely related to growth of money supply. The money supply significantly increased in 2007 which was the major cause of inflation.(See Annexure).
REFERENCES
Alagh. (2007): Business World, March, 2007
Ahuja, Narender L. (2006): Commodity Derivatives Market in India:
Development, Regulation and Future Prospects

Feasibility Study on Wheat Futures Market in India”, Multi Commodity Exchange.

Ghosh, S. et.al, 1987, “Stabilising Speculative Commodity Markets”, New York, Oxford University Press

Nair, C.K.G., “Commodity Futures Markets in India: Ready for ‘Take-off?”, nsenews, July 2004, pp.1-4.

PH, Ravikumar, Business Line, March, 2007

Ramesh, Jairam, Business Line, February, 2007

Singh J.P., On Derivatives Accounting: FAS133 – A Critique, The Business Review, March 2004.

Sahadevan K.G., “Derivatives and Price Risk Management: A Study of Agricultural Commodity Futures in India”, Institute of Management, Lucknow, 2002.

Shah, Jignesh, MD & CEO, MCX India Ltd., Commodities Futures in India, 2004

Should commodity futures be banned? Debate: Deepender Singh Hooda,
Lok Sabha MP, Congress Party, Madan Sabnavis, Chief Economist,
NCDEX: Business Standard: January 31, 2007

Thomas, S., “Agricultural Commodity Markets in India: Policy Issues for Growth”, Indira Gandhi Institute for Development Research, Mumbai, 2003.

http://www.ikisan.com/ban_htm/Future%20Markets.shtml

http://www.mcxindia.com/

http://www.ncdex.com/aboutus/index.aspx

http://sify.com/finance/commodities

http://www.valuenotes.com/asps/Commodities.asp
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