CHAPTER ‘I: INTRODUCTION
Agricultural commodity futures are market-based instruments for managing risks and they help in orderly establishment of efficient agricultural markets. Future markets are used to hedge commodity price risks. They also serve as a low cost, highly efficient and transparent mechanism for discovering prices in the future by providing a forum for exchanging information about supply and demand conditions. The hedging and price discovery functions of future markets promote more efficient production, storage, marketing and agro-processing operations and help in improvement in overall agricultural marketing performance.
Although India has a long history of trade in commodity derivatives, this sector remained underdeveloped due to government intervention in many commodity markets to control prices. The production, supply and distribution of many agricultural commodities are still governed by the state. Free trade in many agricultural commodities items is restricted under the Essential Commodities Act (ECA), 1955 and Agriculture Produce Marketing Committees (APMC) acts of various State Governments. The forward and futures contracts were, till April 2003, limited to only a few commodity items under the Forward Contracts (Regulation) Act (FCRA), 1952. However, in 2003, GOI removed all restrictions on commodities, which could be traded on commodity exchanges.
At present, 25 commodity exchanges are in operation in India carrying out futures trading in as many as 81 commodity items. Most of these exchanges are regional and commodity specific exchanges. During 2003, National Multi Commodity Exchange (NMCE) status has been accorded to four commodity exchanges, viz., National Multi Commodity Exchange (NMCE), Ahmedabad, National Board of Trade (NBOT), Indore, National Commodity Derivative Exchange (NCDEX), Mumbai and Multi Commodity Exchange (MCX), Mumbai.
The Forward Markets Commission (FMC), established under the Forward Contracts (Regulation) Act, 1952 is the agency which regulates commodity derivatives trading in India in the same way as SEBI does for securities markets. The FMC recommended that a National level Institutions like NABARD playing a promotional and developmental role in setting up broad based modern, transparent and vibrant commodity exchanges. In line with this thinking and the priority accorded by Government of India, NABARD is keen to participate actively in fostering efficient spot as well as futures agriculture markets. It is expected that participation of NABARD in the equity of commodity exchanges will facilitate integration of agriculture credit, securitization of agricultural produce and futures markets, leading to more efficient price discovery of farm produce. With the achievement of this, NABARD has taken a conscious decision to enter into partnership with leading national level commodity exchanges and participated in the equity of two national level commodity exchanges ‘ National Commodity Derivative Exchange (NCDEX), and Multi Commodity Exchange (MCX). NABARD’s strategic partnership with NCDEX and MCX shall enable to the two national level institutions. NABARD and national level commodity exchanges are to work synergistically and to achieving the objective of establishing an efficient and transparent agricultural market in India. In the larger interest of farming community for better price realization of their farm produce (Agricultural Commodity Futures’ Markets)
Evolution of Commodity Futures Trading In India
Organized futures market evolved in India by the setting up of “Bombay Cotton Trade Association Ltd.” in 1875. In 1893, following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association, a separate association by the name Bombay Cotton Exchange Ltd was constituted. Futures’ trading in oilseeds was organized in India for the first time with the setting up of Gujarati Vyapari Mandali in 1900, which carried on futures trading in groundnut, castor seed and cotton. Before the Second World War broke out in 1939 several futures markets in oilseeds were functioning in Gujarat and Punjab.
Futures trading in Raw Jute and Jute Goods began in Calcutta with the establishment of the Calcutta Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd. was set up in 1927 for organizing futures trading in Raw Jute. These two associations amalgamated in 1945 to form the present East India Jute & Hessian Ltd., to conduct organized trading in both Raw Jute and Jute goods. In case of wheat, futures markets were in existence at several centres at Punjab and U.P. The most notable amongst them was the Chamber of Commerce at Hapur, which was established in 1913. Other markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad and Barielly in U.P.
Futures market in Bullion began at Mumbai in 1920 and later similar markets came up at Rajkot , Jaipur, Jamnagar , Kanpur, Delhi and Calcutta. In due course several other exchanges were also created in the country to trade in such diverse commodities as pepper, turmeric, potato, sugar and gur(jaggory).
After independence, the Constitution of India brought the subject of “Stock Exchanges and futures markets” in the Union list. As a result, the responsibility for regulation of commodity futures markets devolved on Govt. of India. A Bill on forward contracts was referred to an expert committee headed by Prof. A.D.Shroff and select Committees of two successive Parliaments and finally in December 1952 Forward Contracts (Regulation) Act, 1952, was enacted.
The Act provided for 3-tier regulatory system:
(a) An association recognized by the Government of India on the recommendation of Forward Markets Commission
(b) The Forward Markets Commission (it was set up in September 1953) and
(c) The Central Government.
Forward Contracts (Regulation) Rules were notified by the Central Government in July 1954.
The Act divides the commodities into 3 categories with reference to extent of regulation viz:
(a) The commodities in which futures trading can be organized under the auspices of recognized association.
(b) The Commodities in which futures trading is prohibited.
(c) Those commodities, which have neither been regulated for being traded under the recognized association nor prohibited, are referred as Free Commodities and the association organized in such free commodities is required to obtain the Certificate of Registration from the Forward Markets Commission.
In the seventies, most of the registered associations became inactive, as futures as well as forward trading in the commodities for which they were registered came to be either suspended or prohibited altogether.
The Khusro Committee (June 1980) had recommended reintroduction of futures trading in most of the major commodities, including cotton, kapas, raw jute and jute goods and suggested that steps may be taken for introducing futures trading in commodities, like potatoes, onions, etc. at appropriate time. The government, accordingly initiated futures trading in Potato during the latter half of 1980 in quite a few markets in Punjab and Uttar Pradesh.
After the introduction of economic reforms since June 1991 and the consequent gradual trade and industry liberalization in both the domestic and external sectors, the Government of India appointed in June 1993 one more committee on Forward Markets under Chairmanship of Prof. K.N. Kabra.
The committee has submitted its report in September 1994. The majority report of the committee recommended that futures trading be introduced in:
1) Basmati Rice
2) Cotton and Kapas
3) Raw Jute and Jute Goods
4) Groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them.
5) Rice bran oil
6) Castor oil and its oilcake
The committee also recommended that some of the existing commodity exchanges particularly the ones in pepper and castor seed may be upgraded to the level of international futures markets.
The liberalized policy being followed by the Government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management.
The National Agriculture Policy announced in July 2000 and the announcements of finance minister in the budget speech for 2002-2003 were indicative of the Governments resolve to put in place a mechanism of futures trade or market. As a follow up the government issued notifications on 1.4.2003 permitting futures trading in the commodities, with the issue of these notifications futures trading is not prohibited in any commodity. Options trading in commodity are, however, presently prohibited (http://www.commodityonline.com/learning/4/Evolution-of-Futures-Market.html)
Indian Economy and Role of Agricultural Commodity
It is well-known that commodities are the foundation of the economies of most developing countries by way of providing food, creating income-generating opportunities and export earnings to the people directly involved in agricultural activities. Like others, Indian commodity sector has also been experiencing tremendous surge towards a more sophisticated structure during the last decade. Being a key sector, occupying almost 17% share (at constant price of 2004-05) of India’s Gross Domestic Product (GDP) during 2009-10, agriculture and allied sectors plays a very important role in the Indian economy. Therefore, unlike of other countries all over the world where the share of that specific sector in their respective GDP is quite marginal (except in some Asian countries like Pakistan, Bangladesh, Sri Lanka, Indonesia, China, Thailand, Malaysia, etc.), the growth of agriculture and allied sector has a significant role in the overall growth of Indian economy, as clearly depicted. In most of the agriculture driven economy, it has been commonly observed that the agricultural policy (s) made by the Government tends to protect and promote the agriculture sector through different procurement and administered price mechanism. At the same time, in view of reduced direct support to agriculture under the Agreement on Agriculture with the World Trade Organization (WTO), there is a tremendous policy shift towards the market oriented approach.
Historically, the Government intervention is found at every stage of the marketing of major agricultural products. These includes, setting minimum support prices for selected commodities, regulation of every activity of marketing such as transportation, storage, credit supply and international trading of these commodities, etc. But Government intervention has significantly declined after the initiation of liberalization and economic reforms since 1991. The impact of agricultural commodity is of great importance in the stabilization of Indian economy, as reflected through the share of primary articles, especially the food articles in derivation of the price indices (WPI and CPI) in India. The current weight of primary articles in 2004-05 series of WPI in India is 20.11815%, out of which the weight of Food and Nonfood articles are respectively 14.33709% and 4.25756%. On the other hand the weight of Food and Beverages in CPI in India is currently fixed at 47.13%. These facts clearly indicate the necessity of significant growth and stability of agricultural sector to foster the overall growth of Indian economy.
Derivatives and its Role in Commodity Market
In the given standing International Commodity Agreement, a regular attempts are made worldwide to establish the necessity of managing the risk of agricultural market, rather the market itself. It has been clearly observed how the policy of market intervention and stabilization of agricultural commodity market have shifted towards policies that emphasized on the management of the concerned risk through market-based instruments. Prices of agricultural commodities are determined increasingly by market forces of demand and supply. Hence fluctuation in demand and supply of agricultural commodities is expected to result in high price risk for agri-business. Various studies such as Varangis (2002), Morgan (2000) have strongly indicated that due to the radical transformation of commodity market policies in most of the Less Developing Countries (LDCs) from its original interventionist roots to market-based approaches would be able to successfully deal with commodity price risk and will bring the necessary market stability.
Application of several market-based instruments to deal with the commodity price risk basically focuses on the introduction of derivatives viz. futures and options contract on several commodities. In other words, it is widely proposed to setup an efficient derivative market for commodities to strengthen the agricultural market. It is internationally appreciated that if the derivative markets function adequately, some of the important policy goals regarding price volatility of agricultural commodities can be addressed in a market oriented manner. The basic need to trade in commodity derivatives in general and commodity futures in particular arises essentially to get the necessary support from any variation in the commodity prices. This is nothing but what we call Hedging. Hedging can be represented as just taking a required amount of counter position (Buy or Sell) in a standardized futures contract against the corresponding position (Sell or Buy) of the related underlying commodity. This counter positions in the futures contract help to offset the loss expected to incur from the adverse price movements of the underlying commodities. Therefor, it is very important to develop futures and other forms of derivative trading in all commodities those are vulnerable to large and erratic price fluctuations. The growth in the production of principal crops in India over the last two decades, as tabulated supports the requirement of such futures contract to facilitate the necessary growth in agricultural sector in India. Commodity futures also help to discover the future prices of underlying commodities.
This anticipation of commodity prices as on some future dates makes the underlying market more strong and vibrant. Therefore, commodity futures market is expected to have a built-in mechanism for stabilizing commodity prices which are otherwise prone to fluctuate in response to any swing in the demand and supply forces. But at the same time it is also important to ensure that the commodity futures market is free from any manipulations, which otherwise lead to price distortion and resist the market from performing an effective price discovery function. This summarizes the simultaneous growth of the whole economy and also of the Agricultural sector with the growth in commodity futures trading in different countries or regions all over the world over the last decade.
Even if it was generally felt that the initiation of derivatives trading on commodities will successfully achieve its primary goal of managing the price volatility observed in the commodity market, especially after the withdrawal of regulators’ intervention on agricultural commodities, the role actually played by such market-based instruments in different LDCs have come under a severe doubts among the market players.
History of Commodity Derivatives Market in India
Commodity derivative trading in India has a long but chequered history extending over more than a century. The long experiences gained by India in regard to commodity derivatives are of two folds experience during Pre-Independence era and Post-Independence. India has experienced its first futures market for cotton at Mumbai in 1875. Subsequently futures trading had started for oilseeds (Mumbai, 1900), jute (Calcutta, 1912), wheat (Hapur, 1913) and bullion (Mumbai, 1920). After a few years of lackluster trading, the markets underwent rapid growth between the two World Wars. As a result, before the outbreak of the Second World War, a large number of commodity exchanges, trading futures contracts in several commodities such as cotton, jute, oilseeds, groundnut, wheat, rice, sugar, silver and gold, flourished at various locations across the country. But the Defence of India Act, 1943 was invoked to prohibit futures trading in some commodities during the Second World War.
After independence, on the recommendation of the Forward Market Commission (FMC), futures trading were initiated on 16 diverse commodities and started trading at recognized associations. Consequently, the total number of commodities traded and the number of recognized associations moved respectively to 50 and 30. But this growing status of commodity futures market in India could not last for long. In the wake of recurring agricultural shortages, rising prices, and a growing apprehension that speculating activities on commodities through futures trading may fuel inflation in Indian economy, the then central government banned futures trading in most of the commodities. Even if the Dantwala Committee (1966) recognized the benefits of commodity trading even at the time of commodity scarcity, the recommendation are ignored by the concerned authorities. This banning process continued till end 70s, followed by formation of Khusro Committee in the year 1980, the recommendation of which supported the revival of futures trading in most of the major commodities including even potatoes and onions. The ban on all other commodities still continued with the misconception that speculative futures’ trading destabilizes the prices of commodities. But during the new era of liberalization in 1990s, the government appointed another committee in 1993 under the chairmanship of Prof. K.N. Kabra to have a re-look on the necessecity of commodity futures in Indian economy. The Kabra Committee (1994) recommended the reintroduction of futures trading in a wide number of commodities and also the up gradation of existing commodity exchanges to facilitate futures trading at the international level. But ultimately the actual reform started after the intervention of international bodies followed by the submission of World Bank ‘ UNCTAD report in the year 1997. The international pressure leads the Government of India to accept and implement the majority of the recommendations of Kabra Committee (1994). This eagerness to stimulate commodity futures trading in India not only lead to recognizing and strengthening of various regional commodity exchanges, but also to build up national level muti-commodity exchanges. Accordingly four national level multi-commodity exchanges (MCX, NCDEX, NMCEX, and ICEX) were recognized for online futures trading which started their operations since the year 2003. Therefore, the year 2003 is considered to be a turning point in the history of Indian commodity futures market.
Current Scenario of Commodity Futures Trading in India
With rising prices, the functioning of futures markets came under suspicion during 2006’07 and the government ordered a possible delisting of futures contracts for commodities like Urad, Tur, Wheat and Rice to avoid the abnormal rise in their domestic spot prices. Followed by this, Sugar, Oil, Rice and Potato were also added to the list in 2007, but were subsequently delisted in 2008. In a similar line of thought, the India Government again banned future trading in Chana, Potato and Soya oil in May 2008. However, a steady process of opening up has been visible in future market for commodities over the last two years.
As a result of significant policy change, liberalization of world markets and other developments, Indian commodity markets notched up phenomenal growth in terms of number of products on offer, participants, spatial distribution and volume of trade. The cumulative value of commodity trading in India during April to December 2010, as reported by FMC, is 82.71 lakh crore with a growth of 49.66% from the same period in the last year. The overall growth of commodity futures market in India over the last decade can be depicted through Figure F1. Even if the growth in all commodities is quite significant, the growth in agriculture commodities in India for the same period is found to be only 7.48%. Futures trading in India is currently permitted in 4 national level multi-commodity exchanges and 18 regional level commodity specific exchanges, and almost 200 different futures contract written on almost 100 commodities. Out of the total, number of agricultural commodities traded in national level exchanges is almost 28 to 30. In fact, there seems to be no limit to the number of commodities eligible to be traded in commodity exchanges, except the fact that the commodity should fulfill the criteria of becoming ‘Goods’ as defined in the Forward Contract Regulation Act (FCRA) 1952. In order to widen the scope of commodity futures trading in India, it has also been proposed to widen the definition of commodity through the necessary amendments in the concerned laws, and allows the exchanges to trade even on immovable and intangible assets like real estate, commodity price indices, rainfall, weather indices, carbon credits, etc.
Despite the fact that the national level exchanges, with a modern state-of-the-art technology with electronic online trading system, are eager to provide their facilities to the doorstep of the commodity market functionaries, the potential users, both hedgers and speculators, especially in agricultural commodities and their related products, seems to be reluctant to avail the services and facilities. This unsatisfactory growth of futures contracts in agricultural commodities in India, as depicted in the Figure F2, has placed a great question mark on the benefits and feasibility of futures trading and labeled them as the main factor of rising inflation in Indian economy. But at the same time, if the annual growth of derivatives (futures and options) on agricultural commodities in some of the other developed markets is taken into consideration, as figured in Figure F3, then it will be very clear that the concerned growth is quite unstable in almost all the markets.
Therefore, it has found to be very important for all agriculture sector participants, especially the farming community across the country, to understand the process of dissemination of spot and futures prices of agricultural commodities. As a result, after being identified in the 11th Five Year Plan by the Planning Commission, the Forward Markets Commission (FMC) in collaboration with the exchanges and other related bodies have undertaken a project of disseminating the agricultural commodity prices across the country on real time basis by installing an electronic price ticker boards in all mandis / APMCs which are networked under the AGMARKNET project.
Futures Trading and Price Movement of Agri Commodities in India ‘ Critical Analysis
Giving due importance to the advantages of futures contract, the introduction of commodity futures are now becoming an important issue for the increasing rate of inflation in India and also for the volatile spot market, especially for the agricultural commodities.
As against the argument of Price Discovery, Hedging of Price Risk, Risk Sharing, etc. as the important functions of futures market, several arguments are also offered against the unbridled trade in the commodity future market in India. These are:
i. Possibility of future trading leading to a rise in spot prices and inflation;
ii. Possibility of future trading leading in driving up spot market volatility;
iii. Possibility of future trading not necessarily to be in transparent or costless manner
The critics have widely pointed out that in the presence of any future bad news in the market, the speculators tend to hoard the concerned commodities and hence artificially drive up the prices. As a result of these speculative activities of major market players, the volatility of the underlying spot market for those commodities also increases sharply. Unlike as claimed, the trading opportunities are generally monopolized by large traders/farmers, and give a little space for others to take part in the commodity market.
In the wake of consistent rise in rate of inflation started during the first quarter of calendar year 2007 and responding to the concerns expressed at various form and by various opinions, an Expert Committee was set up under the Chairmanship of Prof. Abhijit Sen, Member, Planning Commission to examine the presence and extent of contribution of futures trading on the unexpected rise in the prices of agricultural commodities. The committee revealed that even if the agricultural price inflation is accelerated during the post futures period, the same cannot be attributed only to the trading of futures contract in essential agricultural commodities. A part of the price acceleration of agricultural commodities in the post futures period may be due to rebound/recovery of the past trend of relatively low agricultural prices observed during the pre-futures era. At the same time, they have also stated that the period during which a future trading has been in operation in India is too short to discriminate adequately between the effect of initiating futures trading and a normal cyclical adjustment. Many of the myths surrounding trading in commodity derivatives in developing markets like in India arise out of widespread volume of speculation in such trading. Perception of common people about speculation is not different from that of gambling. In other words, general people normally fail to differentiate between allowing speculation and allowing the market players to manipulate the market. Therefore it is very important to understand the distinction between speculation, and gambling or manipulation. Even if the nature of any transaction by way of speculation, or gambling, or manipulation looks same, but their purpose can be clearly distinguishable from each other. Even if the motivation for both speculation and gambling are ultimately profit driven, but the very basic difference between these two is that, speculators intend to take the risk which is already there in the market, whereas gamblers create the risk just to satisfy their requirement. The success of a gambler is purely a matter of chance, where the successfulness of any speculative movement depends on the market knowledge, intelligence, and forecasting capability of the speculator. Gambling cannot be considered as an economic function and has no role in making a market, whereas speculation plays an important role in market making, especially a new market. A speculator seeks profit from any expected price change due to anticipated change in the demand and supply of the underlying asset or commodity. On the other hand, a manipulator also attempts to make a profit, but by forcing the price to change in his favorable direction, without justifying the prevailing demand-supply equation in the market.
The prevalent influence of commodity futures trading in intensifying the price inflation in India can be primarily tested through the co-movement of Indian price indices, viz. Wholesale Price Index (WPI) and Consumer Price Index (CPI) with the total traded value of commodity futures trading in India. The co-movement of these two price indices with the growing size of commodity futures trading can be reflected through the concerned figure (Figure: F4). Given the fact that there is an upward co-movement, reflecting the influence of commodity futures trading on rising inflation, the influence is essentially expected to be temporal in nature and it will be quite extraneous to blame the growth of commodity futures market for such inflationary situation. There are several other which can also be significantly accounted for such rising inflation in Indian economy.
Even if there are considerable amount of arguments for and against the introduction of futures contract especially on essential commodities, the significance of such market-based instruments cannot be ignored in an era of liberalization and economic reforms. The only things that need to be ensured are the presence of an efficient spot market and an effective Risk Management and Regulatory framework. There is no dilemma among the market players that the underlying commodity market in India has large number of infirmities. The presence of these infirmities will lead to various difficulties in the functioning of commodity futures markets. There is no doubt that the futures markets can act as a catalyst of change for spot markets, but whenever futures markets grows faster than the under developed spot market, the gap between the two gets widened thereby exposing the futures market to criticism of being driven by speculators, even if closely regulated by the concerned regulatory bodies (Abhijit Sen 2008)”(MPRA – Munich Personal RePEc Archive Impact of Futures Trading on Indian Agricultural Commodity Market Mukherjee, Dr. Kedar nath National Institute of Bank Management, Pune, INDIA 14. February 2011Online at http://mpra.ub.uni-muenchen.de/29290/ MPRA Paper No. 29290, posted 04. March 2011 / 07:06)
Statement of the problem
1. To study and asses the role of Agriculture commodity markets in India.
2. To analyze trends and fluctuations in the prizes of Future trading in agriculture commodities trade in Indian Exchanges.
3. To assess the co-relation between Spot and future prices of agriculture commodities trade in Indian Exchanges.
4. To identify the bottlenecks in Future trading in Agriculture Commodity Exchanges.
5. To suggest the measures for efficient working of Agriculture Commodity Exchanges.
Choice of the topic with reasoning:
Government tries to protect the interests of the poor Indian farmers by procuring crops at remunerative prices directly from the farmers without involving middlemen in between. This way government maintains sufficient buffer stocks and at the same time provides the farmers safeguard against the fluctuating food crop prices. But government at the same time has restricted this traditional sector by fixing prices of crops at a particular level and also by imposing several other restrictions on export and import of agricultural commodities. So according to many economists liberalization of this traditional agricultural sector could have been of great benefit to our economy. A sudden price crash of food crops will have disturbing effects on farmers. Here comes the significant role of futures market. If the buyers in the commodity market anticipate shortage of a particular crop in the coming season, future price of that crop will increase now and this will act as a indication to the farmers who will accordingly plan their seeding decisions for the next season. In the same way, an increase in future demand of food crops will be reflected in the today’s price in futures market. In this way the system of futures market can be of great help to the Indian farmers preventing them from being directly exposed to the unexpected price changes all of a sudden. Futures Market will act as a smoothing agent between the present and future commodity market. If the price, which is going to prevail in future, is high compared to what it is now, then the arbitragers would like to buy the commodities now to sell those in future. The reverse process is also true. So the existence of a futures market is always good for any economy. It opens up a new opportunity to people to protect themselves from unexpected risks.
Purpose, Scope and limitations of study