Hoarders delight

The Forward Contracts (Regulation) Amendment Ordinance, 2008, is said to be the prime reason for the recent price rise.

in New Delhi

IT is unusual for a government to promulgate an ordinance on the eve of a Parliament session. The promulgation of the Forward Contracts (Regulation) Amendment Ordinance on February 12, two weeks before the Budget session of Parliament commenced on February 25, therefore, was curious. Especially so, as the government did not have the courage to lay the ordinance before either House of Parliament before it adjourned for 25 days recess on March 20, probably because the government was apprehensive of the Lefts opposition to it. Parliament re-assembles after the recess on April 15, but the ordinance would have already lapsed by then, on April 7, as the six-week period granted by the Constitution includes the recess period and the holidays.

The government explained the urgency to promulgate the ordinance through a press note thus: The regulatory provisions of the Forward Contracts (Regulation) Act, 1952 (FCRA), have not changed significantly ever since it was enacted in 1952. It was apprehended that any major crisis in this market (commodity futures market) may not only be a setback to further development of commodity futures trading, but would dissuade participants in the real sector, particularly those in the agricultural and agro-based sectors, from availing this price-risk management instrument. As the government is withdrawing from administrative price mechanism and direct market-intervention, the participants in the real sector would be exposed to the price-volatility caused by market forces both domestic and global. Since the issue relates to financial and market integrity, it was not desirable to wait any longer to strengthen the legal and regulatory framework in respect of commodities forward markets.

Trading in commodities can occur in two ways. One is spot trading, where a buyer and a seller of commodities enter into a contract and settle the same by the delivery of the commodities and the corresponding payment within a predefined time period. The FCRA has fixed this as 11 days whereas the Forward Contracts (Regulation) Amendment Bill, 2006, proposes to increase it to 30 days.

Contracts in which the delivery of goods and the payment of the price take place after the predetermined period are called forward contracts. Under the Constitution, spot trading is listed under the State List, while forward trading is under the Union List. Parliament enacted the FCRA, 1952, by virtue of this power. The FCRA permitted forward trading in some commodities and restricted it in others because it assumed there was a correlation between inflation and the speculation involved in forward trading. The Bill and the ordinance proposed to do away with the restriction on forward trading in such commodities. More important, the FCRA prohibited options, which are contracts under which one party has the option or right (but not the obligation) to buy or to sell a commodity at a predetermined price. Options, which are far more speculator-oriented instruments, are proposed to be valid under the Bill and the ordinance.

The present Bill and the ordinance have a brief legislative history, starting from a similar Bill introduced in 1998. It was passed by the Rajya Sabha in December 2003, but could not be passed by the Lok Sabha because of its dissolution in 2004. The National Agricultural Policy, 2000, justified enlarging the coverage of futures markets to agricultural goods to minimise the wide fluctuations in commodity prices, as also for hedging their risks. The National Democratic Alliance government had in April 2003, through a notification under the FCRA, lifted the ban on forward trading in all 54 commodities.

According to the backgrounder prepared by the PRS Legislative Research, New Delhi, forward trading in some specified commodities may take place only through members of recognised commodity exchanges. Currently, the Forward Markets Commission (FMC), a government body sought to be elevated to be an independent regulator as per the Bill/ordinance, recognises 24 commodity exchanges. Three of these are national electronic exchanges (two at Mumbai and one at Ahmedabad) and the rest trade through open outcry (auction by brokers physically present at the exchange). The two largest exchanges (both electronic), Multi Commodity Exchange of India Limited (MCX) and National Commodity and Derivatives Exchange Limited (NCDEX), account for the bulk of trading.

The opposition to the Bill and the ordinance must be understood in the context of the 17th Report of the Standing Committee on Food, Consumer Affairs and Public Distribution (2006-07), presented to both Houses of Parliament in December 2006. The report notes that futures trading in commodities started in India with the first contract introduced in cotton in 1875 by Bombay Cotton Trade Association Ltd. Subsequently, many regional exchanges, one for oilseeds, another for raw jute, and so on, came into existence. By 1939, there were more than 300 commodity exchanges in the country dealing in commodities such as turmeric, sugar, gur, pepper, cotton and oilseeds. Trading was conducted through both options and futures instruments. However, there was no market regulator and hence there was no uniformity in trading practices. The FCRA was enacted to regulate this market with the FMC being set up in 1953 at Mumbai as the regulator. However, in the mid-1960s, the government imposed a ban on the futures trading of most of the commodities on the assumption that this led to inflationary conditions. However, restrictions on forward trading were lifted in April 2003, ostensibly with a view to improving the lot of Indian farmers and to reverse the adverse terms of trade that they have been suffering for their produce. The report notes that at present 103 commodities have been approved for trading, out of which 92 are actively traded.

In a general sense, futures trading and forward trading are interchangeable terms, wherein there is a contract between two parties to buy and sell at a future date based on a predetermined price. Under forward trading, the contract is usually settled by the delivery of goods, while under futures it may also be possible to settle the contract by payment of differences (between the strike price of the contract and the market price on the future date at which the contract is settled).

Under the FCRA, 1952, forward trading can be restricted in certain commodities as determined by the Central government. Using this power, the government, from time to time, makes available commodities for trading in the forward markets. Although the government, in 2003, had made all commodities (including essential ones) available for forward trading, restrictions were imposed in August and September 2006 on forward trading in rice, wheat and pulses to control rising prices and prevent hoarding. This power of the government to include and exclude commodities from the list continues even after the Bill/ordinance seeking to amend the Act. Hence, what the Left seems to be challenging has more to do with the exercise of the power by the Central government under the FCRA (as amended by the ordinance) rather than the amendment itself.

The term commodity derivative connotes a contract that derives its value from the prices of underlying goods or activities, services, rights, interests and events. The permitted underlying items will be notified by the Central government according to the Bill/ordinance. For example, a contract between parties A and B saying that A will pay B the difference in the prices of two varieties of wheat two months from the current date is a commodities derivative. Another example is a monsoon future which specifies that the buyer pays or receives a sum depending upon the actual rainfall in Nagpur in August (as explained by the PRS Legislative Research). The Bill/ordinance permits trading in commodity derivatives.

Derivatives in commodities are healthy if they are used genuinely for hedging and price discovery purposes. But, if these markets are driven by speculators with no real interest in commodity prices, then it may be a ground for restricting forward trading in essential commodities.

In April 2007, Finance Minister P. Chidambaram announced the appointment of a five-member committee headed by Planning Commission Member Prof. Abhijit Sen to examine the impact of futures trading on wholesale and retail prices of agricultural commodities. The committee, which is yet to submit its report, has found a strong correlation between futures trading and prices.

The standing committee has noted in its report that the intended benefit of the commodity market was not realised by farmers, for whose sake the ban in forward trading was lifted. The trading introduced instability and further marginalised small farmers. The committee was of the view that the enlargement of these markets by introducing new contracts such as options and derivatives that had a direct bearing on the actual supplies of the commodities would multiply the speculation-prone character of these markets without any limit. No positive economic purpose is going to be served by these options and derivative contracts, but would be a misallocation of our scarce resources, it suggested.

The committee explained further: With chronic and growing shortages of foodgrain, pulses, edible oils and sugar, subjecting them to the speculative play of the futures derivatives and options is certainly a negative influence as shown by the unjustified rise in prices of these commodities whose futures trade turn out to be many times the actual volume of the trade. Such trading in futures, etc. are certainly distorting the functioning of the real physical and ready markets.

Kamal Nayan Kabra, former Professor of Economics, Indian Institute of Public Administration, and Chairman of the Forward Market Review Committee, 1994, was an expert witness before the standing committee. He expressed his fear that the Bill was a major step towards unlimited space for speculative financial transactions.

Kabra explained that in many of the commodities which had seen sharp increases in their prices, hoarders had taken future positions at high prices to prosper by their hoarding operations. As the time for settlement comes, the prices in the futures market increase quite sharply. He also said that the ready or spot market prices tended to be influenced, at least directionally, by the trend in the futures prices. Said Kabra: A whole range of speculators with no interest in actual physical trade in the commodity in question, either as producers, traders, large-scale consumers/processors or exporters, have started taking position in these complicated markets owing to the lure of easy money by squaring the deals by paying/receiving differences. These people have little understanding either of the actual merchandising, current demand/supply trends or future trends in the domestic or international markets. Such a large number of people are attracted into this gambling, staking a lot of money which in the ultimate analysis is entirely unproductive and turns out to be a zero sum game.

Kabra contested the claim that farmers can get protection against adverse price movements as the futures markets are considered excellent instruments for price-risk management. He said the government had been operating a minimum support price policy for most of the agricultural commodities such as wheat, rice and other cereals, backed by public procurement in considerable quantities. For many other commodities, he told the committee, the Commission on Agricultural Costs and Prices suggested a minimum support price that was announced before every sowing season. Therefore, he suggested, both price discovery and price support were available by means of state policies, though with varying degrees of effectiveness. By contrast, he said, farmers were simply incapable of participating in the futures markets because of their very nature, organisational set-up and modus operandi.