Some people questioned me about certain points I raised in my article, particularly those relating to market manipulation and farmers not benefitting from futures trading. I even contested the suggestion of the Economic Survey 2007-08 that Aggregators and Cooperatives can help farmers reap the benefits of futures trading.
The Expert Committee on Futures Trading (ECFT) under the chairmanship of Prof Abhijit Sen has recently submitted its report. Prof Abhijit Sen in his Supplementary Note has agreed to my views that farmers have not been benefitted. In Para 10 he said : "It is evident that the active participation of farmers themselves in agricultural commodity futures markets in India is significantly constrained. Most farmers are not in a position to pay high margins directly or even to access sufficient institutional credit to finance margin requirements. Majority of farmers in India also lack the basic enabling capacity in terms of adequate levels of literacy and numeracy. Although the Report has made a number of suggestions on how Exchanges can reach farmers, through Farmers Groups, Aggregators and Co-operatives, the likelihood is that very few farmers will themselves be directly able to access the risk management tools developed in futures markets. Many of the problems that hamper farmers' participation also apply to local traders, so that the indirect route whereby traders avail of the risk management tools and are able to offer farmers some benefit from this is also rather limited at present." (Para 10)
The report could not arrive at a conclusive answer to the question - Did futures trading caused price rise? But Prof Abhijit Sen in his Supplementary Note has said : "Moreover, since inflationary outcomes depend quite critically on the way that inflationary expectations build up, there is considerable, although sometimes exaggerated, concern with steps designed to show that the Government is acting to curb such expectations. Since futures markets can be a source of formation of domestic price expectations, these are not immune to similar treatment. In view of the inconclusive findings of this Report on whether futures' trading has fuelled increase or volatility in the prices of agricultural commodities, it is not possible to rule this out entirely." (Para 18)
SUPPLEMENTARY NOTES
Supplementary Note By Prof Abhijit Sen , Chairman , ECFT
1. The terms of reference of this Committee were to consider whether and how much futures markets impact on wholesale and retail prices and how to make futures markets benefit farmers. These did not cover the broader question of the usefulness and need for commodity futures markets or the specific matter of suspension of futures trading in four commodities that had shortly preceded the setting up of the Committee.
2. The answer to the question whether futures markets affect spot prices is obviously yes. Otherwise, futures markets would serve no role at all. Futures markets allow speculators to take positions in commodities without being involved in physical trade. The argument for this is that the greater liquidity that speculators bring permits more information to be traded compared to what would be possible with only physical trading, without this liquidity in itself necessarily affecting spot prices. Possible benefits from such trading are better price discovery, provision of more reliable risk management tools and, above all, reduced spot price volatility. All these benign effects assume transmission of outcomes from futures to spot market prices.
3. The issue therefore is not whether futures markets affect spot prices; but to what extent are the benign and positive linkages actually observed and, conversely, can there be less benign transmission from futures trading to spot markets? These are also relevant questions in the ongoing debate on whether futures trading in essential commodities should be banned. But since these questions go beyond its terms of reference, the Committee interpreted its remit on impact of futures trading on wholesale and retail prices of agricultural commodities as being limited to the narrow and strict question: did such trading cause spot agricultural prices to increase? However, it was not possible to arrive at any conclusive answer to this question, particularly on the matter of causation, since the period of operation of futures trading was too short to provide statistically meaningful results. The Committee therefore proceeded to note the weaknesses of current futures trading arrangements and, in the light of this, has made recommendations on how to make these more beneficial for farmers. In the process, the Committee ignored its rather curious terms of reference (ii), which appears to suggest that something must be done to minimise any effect that futures markets may have on spot prices. This supplementary note is an opportunity to address this by taking up the broader issues raised in the first line of this paragraph.
4. The advantages of futures trading in agricultural commodities have generally been seen to be threefold:
1) They are perceived to discover and obtain better prices for farmers.
2) They are said to decrease price volatility of agricultural commodities.
3) They offer participants hedging and other tools for price risk management.
5. With respect to the first and most commonly argued point in favour of futures trading in agricultural commodities, it must be noted that the only way that futures trading can increase prices actually received by farmers who themselves do not trade in futures is if the causality runs from futures to spot prices. This can be through discovery of future spot prices that help farmers make better cropping decisions and by increasing spot prices at harvest: either by providing higher reference prices against which local spot trades settle or enabling traders in the physical market to build more stocks at harvest. Such transmission, by providing informational anchor or enabling access to additional liquidity for spot trading, can benignly serve both producers and consumers by reducing local monopolies and allowing better inventory management. But it also means that the same transmission mechanisms could sometimes less benignly cause speculation in futures markets to spill into spot markets. It is clearly illogical to claim that futures trading will generally tend to improve prices received by farmers and yet maintain that futures trading can never contribute to inflation of spot prices.
6. Some members of the committee felt that transmission mechanisms that can cause futures markets to lead spot markets either do not exist or are unimportant. If so, the higher inflation that was observed in most commodities after introduction of futures markets could not have originated from futures trading. But if that is so, then neither can futures markets be said to have brought benefit of higher prices to farmers, except possibly the miniscule minority who actually trade in futures on their own or through co-operatives. As with all aspects of futures trading in India, research on transmission mechanisms is scanty. However, the IIMB study does find some evidence to suggest that prices from futures markets are acting as reference, contributing more to better integration of geographically separated spot markets than to discovery of future spot prices. Other studies quoted in Section 5 report evidence of unidirectional causation from futures trading to spot prices. Internationally, recent FAO papers on the present situation of high and volatile world commodity prices list speculation in derivative markets among demand side factors.
7. With respect to the second point, i.e. the ability of futures markets to reduce spot price volatility, it is clear from the evidence presented in the Report that the record in India is at best mixed. Although the general presumption is that futures markets reduce spot price volatility because of the greater liquidity that this brings, the academic literature on this is divided both theoretically and empirically. Both in India and internationally, it is not possible to make an unambiguous statement to the effect that futures markets always stabilize markets and reduce price volatility. Indeed, evidence pointing in the opposite direction has increased more recently. For example, there is currently an intense ongoing debate in the United States on the role that the large influx from hedge and index funds into commodity futures might be playing to cause the present situation where both commodity price levels and their volatility have reached unprecedented highs.
8. At the recent Agricultural Forum held by the US Commodities Futures Trading Commission (CFTC) on 22nd April 2008 to discuss these problems, while the official position was to play down speculation and stress fundamentals, such as low physical stocks and increased demand from China and India, all farmers and trade associations blamed the problem mainly on speculative surge from long-only funds. They pointed out that the present situation of high prices which should normally have benefited farmers was actually causing concern. The accompanying high price volatility has led to convergence problems, more basis volatility and a near breakdown of risk management tools that futures markets normally provide. This has increased risk faced by farmers; put farmers, local elevators and other buyers of commodities under pressure of margin requirements and lending limits; and is causing problems in physical marketing. Although a final decision on various demands, including stricter monitoring, regulation and even a moratorium on index and other long-only funds, will only be announced later; CFTC has accepted that problems have emerged in the ability of farmers to avail risk management tools. Therefore, to maintain status quo, it has shelved a proposal to increase speculative position limits and create new hedge exemptions for index and pension funds.
9. These recent problems of the world's richest farmers and commodity traders to avail risk management from the world's largest and most experienced futures exchanges put in perspective the third point above, i.e. ability of futures trading to offer hedging and other risk management tools. Three features underlie current US problems: (i) the entry of speculators with low commodity domain knowledge; (ii) unusually high basis risk and convergence problems associated with recent futures contracts; and (iii) the inability of farmers or even traders to get adequate credit for margin requirements. While these features that have arisen in the background of unusual fundamentals are exceptional in the US, and may turn out to be only temporary, these are all normal and endemic in India.
10. It is evident that the active participation of farmers themselves in agricultural commodity futures markets in India is significantly constrained. Most farmers are not in a position to pay high margins directly or even to access sufficient institutional credit to finance margin requirements. Majority of farmers in India also lack the basic enabling capacity in terms of adequate levels of literacy and numeracy. Although the Report has made a number of suggestions on how Exchanges can reach farmers, through Farmers Groups, Aggregators and Co-operatives, the likelihood is that very few farmers will themselves be directly able to access the risk management tools developed in futures markets. Many of the problems that hamper farmers' participation also apply to local traders, so that the indirect route whereby traders avail of the risk management tools and are able to offer farmers some benefit from this is also rather limited at present. Warehouse Receipts linked to bank credit and OTC products from exchanges have therefore been recommended, but this is just starting. It is vital that the initial experience with this be positive and not beset with problems such that further development is choked off by disappointments from disconnect between promise from futures trading and the actual reality of its delivery in physical markets. A softly-softly approach that builds on the best is preferable to a headlong rush that is bound to fail.
11. This is important because, as the Report notes, a major conclusion from the IIMB study and other studies reported in Section 5 is that for most commodities, futures contracts in India have so far not been able to serve the purpose of risk management. The levels of basis risk in a majority of contracts for too many commodities are currently so high that it is virtually impossible to hedge. Exchanges are evidently creating contracts that seek to attract speculators rather than serve the hedging need. A large part of the problem is obviously the poor state of infrastructure in spot physical markets and associated difficulties of contract design and delivery. But it is equally true that the main reason why futures exchanges have seen such spectacular growth is because they are serving contracts to meet a demand from speculators that has far outpaced the connection with the physical markets. The exact profile of these speculators is not known and, although many are located in smaller towns, it is unlikely that most of them come with informed knowledge of the commodity domain. Indeed, the required domain knowledge is rather scarce even in the National Exchanges and with the Regulator. A likely consequence of this and replacement of pit trading by screen based trading is that easily available domain material, such as the plethora of news from international exchanges being served on the many commodity portals that have mushroomed, is filtering into prices in futures exchanges more quickly than other information relevant to formation of local spot prices.
12. The upshot of all this is that the spectacular growth of National Exchanges has not been accompanied so far by significant delivery on any of the benign contributions expected from futures markets: price discovery, provision of more reliable risk management tools or reduced spot price volatility. It is necessary therefore to ask whether there are any less benign transmissions that require steps to control growth of these exchanges, or is it just all harmless froth? After all, a liberal attitude would suggest that there be no undue restrictions on the ability of responsible adults to gamble, as long as this does not hurt anyone else. And more seriously, as the Report notes, it is the case that these Exchanges, the trading community and the Regulator are all in a learning phase. Experience is required before there is adequate knowledge about the stable nature of the underlying basis before these markets start delivering positive results. Having found no conclusive evidence that futures' trading always caused inflation, the Report has followed the approach of giving such trading the benefit of doubt on the matter of less benign transmissions and to chart out some requirements that would strengthen positive aspects.
13. However, while this may be the approach that should generally be taken for a range of agricultural commodities, those who have argued for a ban on futures trading in essential commodities have made the case that items of necessary consumption cannot be treated in this manner. Their argument essentially is that in these cases the benefit of doubt should be accorded not to the Exchanges but to those who rely on the existing system of Buffer Stocks, Minimum Price Support and Public Distribution involving the active role of government in physical trade. An important point to note in this context is that when commodity futures trading was opened up in 2003, it was extended to a much wider range of commodities than was justified by reports of previous Committees that had looked into the matter. These had all emphasised that not all commodities are suitable for futures trading. In particular, the Kabra Committee was unanimous against futures trading in wheat, non-basmati rice, pulses, tea coffee, sugar, maize and vanaspati. And both the UNCTAD-World Bank joint Mission and the Guru Committee had noted that commodities such as rice, wheat and sugar, for which there has been substantial government intervention, may not be suitable for futures trading. As it turns out, except for gram and urad and to a lesser extent wheat and sugar, none of these commodities has actually seen any significant futures trading so that a ban would simply legalise market perceptions.
14. Among essential commodities that have seen significant futures trading, critics have focused most on outcomes in wheat, and linked this not only with speculative gains at the 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. It is therefore useful to examine specifically the recent experience with respect to wheat trade.
- Futures trading in wheat became liquid in August 2004 only after public stocks had declined sharply from earlier highs during 1999-2004. But wheat prices, both domestic and international, were still relatively low. These prices remained flat till August 2005, except for the usual seasonal dip in April/June.
- Although futures markets were liquid, the low 2004-05 wheat production was not reflected in harvest prices, either spot or futures. The real WPI of wheat in 2005 marketing season was the lowest since 1996. Also, despite low production and prices, 2005 procurement was 14.8 million tonnes.
- Subsequently, wheat prices rose sharply by 13.3% between September 2005 and March 2006. While some increase in wheat prices in this period is obviously explained by the output decline in 2004-05, the magnitude of subsequent price increase was much larger than in comparable recent periods following even larger output declines (e.g. 2000-01 and 2002-03).
- This suggests that other factors may also have played some role. One possible influence was that of world wheat prices. The IMF reference price for wheat rose 22.9% between June 2005 and March 2006, and by a further 21.6% till October 2006 when it peaked. Interestingly, domestic wheat futures followed world prices fairly closely throughout the period from September 2005 to February 2007, except for a brief period during the 2006 harvest and its immediate aftermath (i.e. April-July).
- In fact, the sharp post-harvest price rise in 2005-06 was followed in April 2006 by the sharpest seasonal decline in Wheat WPI since 1999. The year-on-year change in wheat WPI in April 2006 was almost exactly the same as the percentage increase in wheat MSP, so that farmers did not gain much from the preceding inflationary episode. This was despite the fact that there were nine wheat futures contracts being traded during April 2006, which together indicated an over 20% wheat price increase by the end of the year. There were also reports of large private players entering the market to buy above MSP. However, while actual harvest prices remained near MSP, procurement in 2006 was only 9.2 million tonnes, i.e. 5.6 million tonnes less than in the previous year, even though there was a slightly larger harvest.
- Despite the resulting much larger availability in the private market and despite the government announcing very large imports as early as June, wheat WPI increased 17.8% between April 2006 and January 2007, taking the real WPI of wheat to its highest level since 2000. This magnitude of post-harvest increase, mainly after July, is difficult to explain in terms of the prevailing supply-demand balance in the private market. Rising world prices were clearly influencing expectations as reflected in domestic wheat futures, and government stocks were too low to douse inflationary expectations.
- The rise in world wheat prices was temporarily reversed between October 2006 and May 2007 and this was reflected with a lag in domestic prices: wheat futures began declining in November 2006 and wheat WPI peaked in January 2007. Nonetheless, in view of the high wheat price inflation in the preceding year, government de-listed wheat from futures trading in February 2007 and there have been no new contracts thereafter, although trades offsetting open interest in existing contracts continued till their expiry, i.e. till August 2007.
- But de-listing of wheat futures made little difference to the procurement outcome which, if anything, was even more disappointing in 2007 than in 2006. Although procurement did increase by 2 million tonnes over the previous year, this was from an output 6.5 million tonnes higher and fell well short of target. This was despite an MSP (including bonus) increase of 21.4%, which was more than the increase in wheat WPI over the two marketing seasons. One reason for this was the low ratio of market arrivals to production, suggesting that private trade could undercut public agencies and pay somewhat higher prices to farmers by saving on taxes and market fees.
- Even so, the overall wheat price situation did turn out to be very different from the two previous years. Wheat WPI increased just 5.9% between April 2007 and February 2008, and year-on-year wheat inflation in February 2008 was negative. Of course, the much higher 2006-07 output was the main reason for this. But, in view of the very different experience in the two preceding years, what is remarkable is that domestic wheat inflation was controlled despite world wheat prices shooting up from June 2007 to February 2008 to a level more than double that in February 2007. Moreover, from current indications, wheat procurement will exceed the target in 2008, mainly because 2007-08 harvest is record and MSP was again increased substantially more than increase in wheat WPI but much less than increase in world prices. Although no clear causality can be established, it is evident that the transmission of international price pressures on domestic wheat prices was much lower after wheat futures were de-listed.
This recent experience with respect to wheat trade does provide some evidence, albeit inconclusive, in support of critics who argue that futures trading may be associated with factors that can impede the operation of the public system of grain procurement, storage and distribution.
15. This issue must also be seen in the context of recent global price movements in agricultural commodities. World agricultural prices rose sharply from 1993 to 1996 and then declined even more sharply between 1996 and 2003. With non-tariff barriers coming down after WTO, global price movements now do affect domestic prices much more, and so a close relationship between domestic and global prices has been observed for some agriculture commodities. For example, between July 2004 and January 2007 (which can be taken as the period when futures trading in these commodities really picked up in Indian bourses and continued unhindered) the trend growth rates of domestic prices of maize, soya oil, soya bean and wheat were same as for international prices. Of course, it may only be incidental that futures trading started in India when global prices had just started hardening after a prolonged downturn. As noted in the Report, for many commodities the acceleration of domestic prices post-futures was from a depressed base, and so it cannot be attributed directly or solely to futures trading. However, it is possible that the screen based trading in the National Exchanges does capture international price movements more quickly and that this also gets reflected in domestic prices because of the "reference price" role that futures prices can play.
16. Although not certain, and the Committee having discussed it chose not to pursue the matter further, this raises a prudential issue. In the case of many sensitive commodities, the monthly co-efficient of variation of world prices, both spot and futures averaged more than 3 to 4 times the corresponding co-efficient of variation in the domestic WPI even before the recent unusual rise in world prices. The recent behaviour of food grains prices does not appear to be explained completely by supply fundamentals (production, changes in inventory and international trade). In particular, the contribution of international price movements to domestic price outcomes appears to have increased substantially, except notably the most recent behaviour of rice and wheat prices after delisting. Claims that futures trading have been a cause of the inflation in sensitive commodities needs to be viewed in this context. While strong futures market are argued to reduce price uncertainties in the domestic market, could transmission of world prices through futures markets actually lead to increased volatility of domestic prices?
17. This query is relevant in the present context where international prices of almost all sensitive commodities have suddenly become much higher than domestic prices, which is the reverse of the situation just three years ago. This is posing difficult policy choices for Government. If current world prices are likely to persist, the correct move would be to allow Indian prices also to move in the upward direction. However, quite apart from political considerations that may require adjustments to be fine-tuned to acceptable levels of inflation, it is not entirely clear that world prices will remain at these high levels. There remains the possibility, as has been usually observed in the past, that world agricultural prices may in the near future drop equally sharply. In fact, given the very exaggerated role being attributed to China and India in current world discussion of fundamentals, how India manages its food situation may well be a determining factor.
18. Currently, the policy stance is to attempt insulation of domestic prices from the high world prices by combining a number of different measures including high subsidies, lower tariffs and export restrictions, some of which have been implemented suddenly in almost knee-jerk manner. Moreover, since inflationary outcomes depend quite critically on the way that inflationary expectations build up, there is considerable, although sometimes exaggerated, concern with steps designed to show that the Government is acting to curb such expectations. Since futures markets can be a source of formation of domestic price expectations, these are not immune to similar treatment. In view of the inconclusive findings of this Report on whether futures' trading has fuelled increase or volatility in the prices of agricultural commodities, it is not possible to rule this out entirely. In order to avoid disruptive 'go-stop' responses that neither serve the public purpose nor the growth of markets, it is necessary to take a clear position regarding essential commodities, particularly food grains, where government currently has a large and all embracing involvement in physical trade. Both the literature on futures trading and empirical facts analysed in this report suggest that there are inherent difficulties if futures markets are introduced for commodities where government actively attempts to influence prices and is also a large player in physical trade. Although in the longer run there are possible benefits from combining futures based options with MSP operations as suggested in the Report, it is clearly necessary in the immediate inflationary situation that there be a clear statement of the government's intent to maintain and expand the current system of public procurement and PDS in order to ensure remunerative prices to farmers and affordable prices to consumers.
19. In this context, combining prudence with benefit of doubt, the best course of action would be to identify those commodities where there is possibility of futures trading affecting expectations that may influence inflation in essential commodities and insulate these from futures. Therefore, the suspension of futures trading in the four sensitive commodities should continue and, in the case of sugar and edible oils, discussions with processors held on how much hedging benefits they currently derive from futures markets, and a decision taken accordingly.
20. In the case of other commodities, it may be necessary to reassure the Exchanges of a long term commitment to fostering growth of these markets, subject to necessary corrections of the many weaknesses that have been identified in the Report with respect to contract design and excessive speculation. Even with continued suspension on futures trading in sensitive commodities, the scope for enlarging futures trading is still huge since, despite its recent rapid growth, the existing volume of futures trading for most agricultural commodities is still relatively low compared to international norms on the ratio of volume of futures trading to production. In addition, measures that will allow farmers to have genuine access to futures markets and benefit from them, most importantly the provision of adequate rural infrastructure and other enabling conditions, must be implemented. Therefore, while foodgrains production is increased in Mission mode as per existing policy, the focus, as far as futures trading is concerned, should be on creating conditions for orderly growth and diversification in other segments of the market for agricultural commodities in a manner that will provide benefits to farmers and ensure more stability in crop prices.
(Abhijit Sen)