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Commodities ban: Will it help?

Commodities ban: Will it help?

The government has banned futures trading in eight commodities and is planning to extend this to some more items. However, the available data on futures trading does not show any evidence that it has either reduced or increased volatility of spot prices. Is it a wrong move? BT's Rohit Viswanath finds out.

What does the partial ban on commodities trading in India have to do with bikinis? The late Aaron Levenstein would have made the connection immediately. His famous, and prescient, quote: “Statistics are like a bikini; what they reveal is suggestive, but what they conceal is vital,” succinctly sums up the situation.

The Abhijit Sen Committee set up by the government to study the impact of futures trading on commodity prices found that in the post-futures market period, inflation has accelerated in 14 commodities, including wheat, rice, chana and pepper, while it has decelerated in seven items, including soya oil, soya bean, rape seed/mustard seed and potatoes. That is the “suggestive” part of this particular set of statistics, and was, perhaps why Sen personally favoured a continuation of the ban, imposed by the Forward Markets Commission on January 23 last year, on forward trading in rice, wheat, tur and urad. “The suspension of futures trading in these four sensitive commodities should continue and, in the case of sugar and edible oils, discussions should be held with processors on how much hedging benefits they currently derive from the futures markets, and a decision should be taken accordingly,” he has been quoted as saying.

However, as with the bikini, these figures conceal a “vital” point. Of the 14 commodities in which price acceleration took place, 10 had witnessed negative inflation during the immediate pre-futures period. It is, therefore, probable that the acceleration in the growth rate of Wholesale Price Index (WPI) in these commodities is simply a rebound, albeit one helped along by more efficient price discovery. Similarly, of the seven commodities in which WPI growth was lower, six had unusually high pre-futures inflation. It is possible that the observed deceleration is a reversal of trend (see Inconclusive Evidence). “Both trends could well be the result of the commodities catching up with the market,” says Prakash Apte, Professor at IIM Bangalore and a member of the Abhijit Sen Committee.

This may explain why the committee, which submitted its report to the government on April 29, noted, despite its Chairman’s personal views, that “data analysed in this report does not show any clear evidence of either reduced or increased volatility of spot prices due to futures trading”.

Under normal circumstances, that should have been the end of the matter. But these aren’t normal times—the Karnataka Assembly elections this month are the first of a busy year at the hustings, and the big one, the 2009 general elections, is due in exactly one year, almost as a grand finale to the 10 lead-up battles in the states. And, as everyone knows, the government must not only do the right things before elections, but must also be seen to be doing them. And placing curbs on businessmen have traditionally paid dividends in the polling booths.

 Finance Minister P. Chidambaram indirectly acknowledged as much. “If rightly or wrongly, people perceive that futures trading in commodities is contributing to a speculation-driven rise in prices, then in a democracy, you will have to heed that voice,” he said in a recent statement in Madrid.

There is reason for the government to be worried. Wholesale prices rose 7.61 per cent in the week ended April 26, 2008 compared to the figure a year ago. This is the steepest increase in inflation since November 2004 when inflation rose to 7.68 per cent. The contribution of the 12 food grain items, having a combined weight of 5.01 per cent in the WPI, is determined by the increase in WPI of these items relative to their weight in the index. In the post-futures period, the contribution of chana, wheat, urad, pepper, jeera, chillies, potatoes, maize and tur have been much higher than their weight, thus, fuelling the price spiral that is now throwing both household budgets and the government’s macro-economic projections out of gear.

So, the government and the Reserve Bank of India are rightly focussing on inflation control. But having got the diagnosis right, the authorities may well have chosen to prescribe the wrong medicine.

The government banned futures trading in chana, soya oil, rubber and potatoes with effect from May 8 for four months. Within a day, the prices of all vegetable oils, including mustard oil, palmolein and soya oil rose sharply. Palmolein rose the sharpest, from Rs 540 per 10 kg on May 7 to Rs 560 per 10 kg the following day. Spot prices of soya, which has become a proxy for soya oil following the ban, rose Rs 50 per quintal within 24 hours.

The fear is that now, with no domestic price discovery mechanism available, local prices will inch up to international levels, which are 25-30 per cent higher. “Without a free pricing mechanism, how will the consumer know whether to curb consumption or find substitutes for a particular item of consumption? And without price signals, how will producers decide on the optimum levels of supply to the market in the next season?” asks Arjun Chatrath, Professor of Finance, University of Portland, US, and a keen observer of the Indian economy.

The government is believed to have taken the decision to ban forward trading in commodities under pressure from regressive elements like the Left parties. The Abhijit Sen Committee, many people accuse, was merely supposed to provide the post-facto rationalisation for the move. Says Sharad Joshi, Rajya Sabha MP and a member of the Sen Committee: “The panel was set up merely because forward trading and the futures market in commodities, which was allowed by the NDA government in 2003, go against the Central government’s earlier policies with respect to commodity markets. Then, futures trading, being a free market initiative, is fundamentally contrary to the Left’s principles. It was, hence, hoped that the Abhijit Sen Committee would give them the authority to abort it.

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But is forward trading really leading to a speculation-fuelled rise in prices? “No,” says S. Sivakumar, CEO, Agri Business, ITC. “On the contrary, a properly functioning, and deeper, forward market is needed. Bans and other artificial restrictions, will only slow down the development of the market. Instead, I feel that the nascent Indian market needs, among other things, a proper regulatory framework that allows aggregators to buy small lots from farmers that they can then aggregate and sell as marketable lots in the market.”

Abhijit Sen, Member, Planning Commission
Abhijit Sen
So, what is driving the sustained surge in food grain prices? The inflationary trend in food grains can be explained by supply-side factors like domestic production and foreign trade. Joshi feels that irrespective of whether futures trading is permitted or not, in today’s globalised world, the government cannot insulate the domestic market from global price levels. Says Madan Sabnavis, Chief Economist, National Commodity & Derivatives Exchange (NCDEX): “The study (by the Sen panel) only reinforces what we’ve always held: futures trading does not lead to price rise. It’s the other way round—futures prices are determined by the spot market.”

Fiscal conservatives, however, continue to iterate that futures trading leads to speculation and hoarding, which, in turn, increases prices. Counters Joshi: “Contrary to popular opinion, speculators are crucial for the proper functioning of the marketplace.” And, as is becoming obvious, it is the absence of a futures market, rather than its functioning, that leads to speculative price increases.

But is a government bent on populism, and critically dependent on parties clinging to antediluvian economic theories, listening?