No. 51, August 2011
Agricultural Commodity FuturesThe Dangers of Providing Speculators a Bigger Playground
by Sunanda Sen and Mahua Paul*
Both ‘hedgers’ and speculators participate in commodity futures markets. ‘Hedgers’ are those who have actual dealings with the underlying commodities, and wish to mitigate the risk of prices declining (if they are producers) or rising (if they are consumers) by the time the actual sale is to take place. Let us say an oilseeds grower anticipates a good crop nationwide and plentiful supply. He may sell three-month oilseeds futures in order to protect himself against a decline in prices by the time he brings his crop to the market. Conversely, a fried foods manufacturer may buy oilseeds futures for fear that prices might rise by the time she/he requires more oil.
Speculators, on the other hand, gamble on the movement of prices: they buy futures if they think spot prices will rise, and sell them if they think spot prices will fall, by the date of the expiry of the contract. They make a profit on the difference between the spot price and the price at which they have bought the futures. In theory, the objective role of speculators is to bring enough liquidity into the market for it to function smoothly, as their operation ensures that there are enough buyers and sellers for the hedgers to be able to pass on their risk. However, it is well known that the overwhelming bulk of trade is carried on by speculators, and is many times the value of the underlying commodities. Unlike in spot purchases, the buyer of a futures contract does not pay its full value at the time of buying it, but rather a small percentage of the value, known as a ‘margin’ payment. The eventual settlement of the contract generally does not take place by means of physical delivery, but by settling in cash the difference between the contract price and the spot price prevailing on the date of expiry of the contract.
Futures trading is not new in India. However, divergent positions on futures trading have of late been a topic of public debate, especially in the context of rising prices of essential foodgrains, farmer-distress, and the failure of State policies to combat the above. A particular target of criticism is the operation of futures markets in agricultural commodities, and especially in cereals, pulses and other essential food items, especially with regard to re-opening futures markets for essential food items which earlier had been de-listed. In India, trade in agricultural commodity futures has taken off since 2003, rising from Rs 0.67 lakh crores (Rs 670 billion) in 2002-03 to Rs 9.02 lakh crore (Rs 9.02 trillion) in 2009-10,1 a more than 13-fold increase.
Arguments that forward and futures trading can be beneficial centre around a process known as ‘price discovery’, whereby the price of a commodity is efficiently determined through interaction of buyers and sellers in the marketplace, subject to competitive markets and full information. Futures trading is supposed to reduce risks for buyers and sellers by minimising uncertainty: Risks are also supposed to get reduced with prices pre-set, thus helping participants in the market to know how much they will need to buy or sell. It is also claimed that the ultimate cost to the retail buyer will be less, because, with less risk, there is a smaller chance that suppliers will jack up prices to make up for losses in the cash market.
Proponents of futures trading further claim it allows risk sharing among various market participants. For example, farmers can ensure remunerative prices by selling their produce with futures contracts. Similarly, the trader can buy futures to hedge against volatile prices, thus hedging the carrying risk to ensure the smoothing of prices for seasonal commodities round the year.
However, those who question the virtues of unbridled trade in commodities in the futures market argue as follows: (a) Futures trading can lead to a rise in spot prices and inflation. Critics point out that when there is bad news about future supply, speculators start hoarding commodities and hence artificially drive up the prices.2 (b) They also point out that futures trading drives up volatility. (c) Thirdly, futures markets are not necessarily either transparent or costless. Opportunities for trading are thus monopolized by large traders/large farmers, leaving little space for others in the market.
Echoing the differences in the current views on futures trading in commodity markets, the official position in India on futures markets has been subject to frequent reversals, with the opening of futures trade in specific items often followed by their de-listing, or vice-versa. However, one can notice a consistent pattern in the official policy to open such markets since the beginning of the major economic reform in the country in the year 1991.
The first of these moves in the post-reform period was in 1993, with the appointment of an official committee on futures trading in commodity markets headed by K.N. Kabra. The report, submitted in 1994, recommended the opening up of futures trading in 17 major commodities. But it did not favour the opening of futures markets in wheat, pulses, non-basmati rice, tea, coffee, maize, vanaspati and sugar (essential food items of daily consumption), unless the market in the respective commodity was found stable in terms of a case by case study.3
In response to the policy changes following the majority recommendations of the Kabra Committee, several Nation-wide Multi-Commodity Exchanges (NMCE) have been set up, especially since 2002, using modern practices such as electronic trading and clearing. The Government has now allowed national commodity exchanges, similar to the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), to come up and deal in commodity futures in an electronic trading environment. These exchanges are regulated by the Forward Markets Commission (FMC). In 1996 a joint mission of UNCTAD and World Bank recommended an opening up of futures trading in India’s commodity market and a minimization of government controls on such trade. And in 2000, the official National Agricultural Policy, pronounced a similar view.
Notwithstanding this, in 2001, a new committee on the futures market (the Guru Committee) recommended against allowing an unbridled opening of futures in all commodities, many of which, it held, were not fit for futures trading. It suggested a case-by-case approach, a decision on which could be left to individual commodity exchanges, provided the specific case fulfilled all of the five pre-conditions laid down by the committee. These conditions included the availability of a large marketable surplus, storability and standardization of the commodity, volatility of price and absence of controls. More recently, an Estimates Committee of the Parliament in November 2009 also pointed out that futures trade in essential commodities for consumption “may spawn excessive speculation and cause artificial price increase.”4
The surge in food prices, continuing unabated, in spite of the slow rise or almost a stationary level of the Wholesale Price Index (WPI), led the Government to appoint a new committee on commodity futures markets. Contrary to the notion that futures trading helps in managing risks and discovering prices, the committee in its final report of 20085 doubted that futures can provide hedging facilities to all in the market (and especially for the small traders). It suggested that a case for futures trade should rest in providing benefits to farmers who produce the traded commodities.
However,in a supplementary note, the committee drew attention to rising international commodity prices as a factor behind the rising spot market prices for agricultural products in different countries, including India.It may be noticed that this argument weakens the case against future trade as a factor causing price rise in commodities. Stressing the need to insulate the prices of essential food items in the country, the note emphasized the need for revamping the public distribution system (PDS) and hiking the Minimum Support Price (MSP) in order to ensure supply from farmers.
International evidence points to the link between commodity futures and inflation. The international think-tank International Food Policy Research Institute (IFPRI) found that for India “rising expectations, hoarding and hysteria played a role in increasing the level and volatility of food prices, as did the flow of speculative capital from financial investors.”6 A similar view was held by the Washington-based Institute of Agriculture and Trade Policy.7 UNCTAD in its 2009 Trade and Development Report stated that “…a major new element in commodity trading over the past few years is the greater presence on commodity future exchanges of financial investors that treat commodities as an asset class. The fact that these market participants do not trade on the basis of fundamental supply and demand relationships and that they hold, on average, very large positions in commodity markets, implies that they can exert considerable influence on commodity price developments.” The report points at the sharp rise in commodity prices between 2002 and mid-2008, which has been followed by a reversal. Both of those, as pointed out by UNCTAD, were related to the financial market boom, which was recently followed by a crash.8 As pointed out, ‘financialisation’ also increases price volatility and “…hedging becomes more expensive and perhaps unaffordable for developing country users, as they no longer are able to finance margin calls”.9 The same argument probably also holds for intra-country futures trade, where use of high margins can deter small traders.
Official policies in India on futures trading in commodities since 1991
The Economic Survey 2009-10 argues that “if we cannot establish a connection between the existence of futures trading and inflation in spot prices, we should allow futures trade.”10 .” The benefit of the doubt, according to the authors of the Survey, should be given to commodity futures trading. The direction of official policy is clear.
Food items which in recent years have been traded in futures markets include, among others, coffee, barley, ground nuts, desi tur, urad and rice till January 2007; castor< seed, guargum, gur, jeera, maize, masoor gram, mustard seed, pepper, oil cake and soya oil till January 2008; sugar till January 2009; and finally, chilli, castor seed, coriander, dhania and wheat till now.
What do the data tell us?
Agricultural commodities have a low weight in the country’s Wholesale Price Index (WPI). Thus the weight of 87 agricultural goods in the WPI is 25.65 per cent of the total. Of these, 21 goods which control 70 per cent of future trading had a weight as low as 11.7 per cent in the WPI index.12 Therefore, the all-commodities WPI may not reveal much about the impact of futures trade on price rise. When we compare the price movements for potatoes and pulses, which are major staples for the poor, with the all-commodities WPI, we find that prices of the two commodities rose much more steeply than the WPI. Given that essential food items experienced a steeper price rise in this period than the WPI, and that some of these food items have also been open to futures trading, we have done Granger tests13 on the causality between spot and future prices of chana, soya, potato and wheat (for which data was available). From these tests we can check if the causality in terms of rising prices was from future to spot prices or vice versa. For all of these, the Granger test indeed shows a causality, with changes in futures prices leading those in spot prices.14 Moreover, the opening of futures markets has matched the rising spot prices for the majority of goods. Accordingly the uptrend in the latter can be interpreted as a fall-out of trading of these commodities in the futures markets. For futures to provide ‘price discovery’, spot prices should follow movements in futures prices. In this case the spot price rise was obviously the answer to the lead by future prices, which are subject to speculation. Thus the uptrend in futures prices generates an upward spurt in spot prices too.
One other aspect of the impact of futures trading is considered to be the volatility it imparts, both in the spot market and in the futures. Of course the impact, if any, implies a causal link between the two set of prices. Comparing the monthly variations in spot prices, we found a distinct rise in volatility for five out of the six sensitive items (rice, wheat, potato, onion, urad and soya) during the period January 2003-December 2006, which also happens to be the period when futures market in these (and other) commodities were operating. This provides an indirect evidence that the opening of futures trade was responsible for wider fluctuations in spot prices of these commodities.
On the whole it can be observed that while futures trading in commodities has led the path for further rise in spot prices, the latter also has been subject to an wider range of volatility with the successive opening of futures markets.
Impact of trading in financial markets on commodity futures
We compared the spurts in the monthly total turnover in stock markets (between the National and Bombay Stock Exchanges) with those for spot and future prices of specific commodities like wheat, rice, potato, urad and soyabean. We tried to find the relation, if any, between movements in the total stock exchange (TSE) turnover and individual spot price indices. Our tests of a regression analysis indicated a strong negative relation between the two for urad, wheat and rice, if we consider the period between May 2008 to May 2009. It may be mentioned here that this also covers the period when global stock markets collapsed, affecting the Indian market as well.
Redoing the exercise over a longer period from May 2003 to May 2009, when the stock market was at its boom till the crash began in mid 2008, we found a positive link between the TSE and individual spot prices of the same five commodities, with TSE regressed on the latter.
The difference can be related to the observations above relating to the ‘financialisation’ of the commodity market. Thus speculation and portfolio adjustments (i.e., when investors adjust the mix of assets they hold to make up for a fall in the price of particular holdings) on the part of agents across markets of financial assets (stocks) and commodities led to a boom in the commodity market as a contagion when the financial market was at its boom. Thereafter the crash in financial asset prices and in the turnover of these assets led the same agents to look for alternative sources of returns on their funds. They turned to investments in commodity futures which, as we observed, also affect the spot prices. The negative relation between the monthly prices of commodities and the monthly values of TSEs over May 2008 to May 2009, reflect the above tendency.15
Stock markets in India, subject to an uptrend as well as volatility, experienced the contagion effects of the recent global financial crisis, as can be witnessed from the dip in stock indices since January 2008. We also notice parallel downslides across countries in commodity futures markets, both for the multi-commodity futures exchange in India and for the international commodity futures exchanges. This confirms the findings of UNCTAD on the financialisation of commodity markets, at a global level. The phenomenon seems to have pervaded the Indian commodity market as well, both by pushing up prices and by linking the commodity market to the market for financial stocks, via the portfolio decision of those who speculate on both.
For India, further opening of the future market in commodities, and especially in food items, needs to be dispensed with, in order not to let speculators have a wider playground to play with at the expense of the common people!
1. Economic Surveys, 2004-05 and 2009-10. (back)
2. However, as opposed to such arguments, it can be argued that with negative news about future, prices may go up irrespective of whether futures market is there or not. (back)
3. It may be mentioned here that both K.N. Kabra and Sunanda Sen, two members of the committee, gave notes of dissent to the Committee, opposing the opening of any essential food item to futures trading.. (back)
4. Estimates Committee Report on Futures Trading. (back)
5. Government of India, Report of the Expert Committee to study impact of future trading on agricultural commodity prices, 2008. (back)
6. IFPRI, “When Speculation Matters”, March 2009 (mimeo). (back)
7. IATP, “Commodities Market Speculation: The Risk to Food Security and Agriculture”, November 2008 (mimeo). (back)
8. Ibid p 54. (back)
9. Ibid p 74. (back)
10 p. 24. (back)
12. Expert Committee Report 2008. (back)
13. A statistical test for determining whether a time-series of data is useful in forecasting another. (back)
14. See Appendix 1, “Trading in India’s Commodity Future Markets”. (back)
15. See op. cit., Appendix 2. (back)
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