Speculation moves forward

A FARMER RESTS upon sacks of wheat at a grain market in a Punjab town. - AJAY VERMA/REUTERS

The introduction of futures trading in essential commodities under the reform regime has paved the way for speculative price increases.

FORWARD trading has a long history in the country, but it has never been a matter of much public concern. Until recently, that is. While searching for explanations for the increase in the prices of food that began a few months back, some observers turned their attention to the massive increase in forward and futures trading in commodities. What emerged was revealing.

According to Bloomberg, quoting the Forward Markets Commission, volumes on the National Commodity Exchange, which trades futures contracts in 48 commodities, reached $226 billion in the year ended March 31, 2006. That was more than the $184 billion of shares traded on the Bombay Stock Exchange in the same period. Forward and futures trading had been promoted on the ground that it helped traders deal with market uncertainty by hedging their transactions, and stabilised prices for the final producers. However, the surge in futures trading could not be explained by pure hedging requirements, and obviously reflects an increase in speculative activity.

Leaders of the Left parties saw in this speculation an explanation for the spike in food prices. Their view was endorsed by Congress president Sonia Gandhi, who reportedly told a meeting of the Congress Parliamentary Party in early August: "The Prime Minister and I had a meeting with our Chief Ministers. They were unanimous that forward trading, particularly in wheat, has had an adverse impact and called for a more effective regulatory framework to deal with speculation." As a result of these interventions, the government has now decided to amend the Forward Contracts (Regulation) Act 1952 (FCRA) and strengthen the regulatory powers of the Forward Markets Commission (FMC). What form those amendments will take is yet to be seen.

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 enter 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 contract concerned 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 centralised 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 standardised 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 of traders resorting to cheap imports, as and when domestic prices rise.

It transpires that liberalisation of the trade in agricultural commodities within the country had ensured the realisation of the first two of these conditions. 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.

According to reports private firms such as Cargill India, Adani Exports and ITC and the Australian Wheat Board have together purchased as much as 30 lakh tonnes of wheat this year. While some of this is for conversion into processed goods in their own facilities, a significant part is for resale at a profit. Private firms have also been involved in trading in other commodities. This indicates that large trading firms have cornered supplies of many commodities at prices higher than the minimum support price offered by the government.

One consequence of these trends has been a decline in government stocks from record levels and a rise in stockholding by the private trade for speculative purposes. Thus the government has managed to procure only 92 lakh tonnes of wheat this year as compared with 147 lakh tonnes last year. As a result, 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. Overall food stocks with the government stood at 223 lakh tonnes on June 1, 2006, close to a third of their peak level of 648 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.

These developments on the availability front have provided the basis for speculative trading in commodity futures. Trading on India's commodity exchanges totalled $460 billion in the year ended March 31, a fourfold jump from the year before. There is sufficient ground to believe that the recent surge in the prices of certain essentials, including wheat, seems to be driven by such speculation.

This has been aided by a policy of freely allowing exchange-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 3 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 liberalisation and globalisation. The Kabra Committee, while cautious, recommended allowing futures trading in 17 select commodity groups. It also recommended strengthening of FMC and amendments to the Forward Contracts (Regulation) Act, 1952.

However, this cautious approach was given up 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 would 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. These initiatives have paved the way for the speculative price increases that have forced the government to import as much as 39 lakh tonnes of wheat and ease imports of other commodities, which can have damaging consequences in the long run. It is perhaps time to reverse some of these policies, starting with a ban on forward trading in essential commodities.