Commodity Futures Trading: Are We to Stop it?

Politicians rush in where economists fear to tread.

“Sonia wants commodities futures trading stopped”, so screamed one of the headlines of The Economic Times of 2nd August. The anxiety behind these comments is quite palpable, for the politicians cannot remain silent when aam aadmi is exposed to a price spiral. The inflation has risen to 4.82% of which the contribution of primary articles is said to be 32% plus. The robust domestic demand for agricultural commodities accompanied by erratic monsoon has only added fuel to the fire. All this cumulatively reflected on the rise in prices of food grains, pulses and other essential commodities. The net result is: Congress chief ministers, as press reports indicate, accused futures trading as the key cause for the current rise in wheat prices, while the Left parties demanded total ban on futures trading.

Now the question is, is it theoretically right to assume that futures trading results in price rise? To figure it out, let us start from the beginning. It is commonsensical that rise in prices of any commodity usually results from the shortage in its supply. This shortage could be either artificial – resulting not from supply deficit but more due to speculative hoarding – or natural, which again could be a temporary passing phase or of a long-term nature – which means hiccups in supply logistics resulting in dislocation and thus causing shortage and the consequent price rise only for a short-period or a genuine structural deficit in supply that is likely to last for quite sometime.

As against this, what we are witnessing today in the wheat market is more of a “fundamental” nature arising out of a genuine shortage in its production. Market reports indicate that wheat production in the country has stagnated at around 70 million tons for the last 4 to 5 years. Interestingly, the growth rate in GDP continued to hover around 8% during the same period. It means that while the per capita income rose resulting in a shift of people from consumption of coarse grain such as Jowar, Maize, etc., to finer grains like wheat and paddy, the wheat production remained stagnant, which obviously widened the gap between the supply of and demand for wheat.

Even otherwise hoarding of wheat with speculative intentions does not theoretically make any economic sense. To elaborate it further, wheat is harvested in the month of April and then the “market” stores it for release at such intervals as defined by the “demand” till the next crop is harvested. On the other hand, if hoarding is attempted with a motive to increase prices, a hoarder cannot normally enjoy the benefit of sudden jump in demand and the resulting price rise, since wheat has a steady consumption cycle. Indeed, such hoarding suffers in want of a release mechanism. And this is common for all agricultural commodities, for our consumption cannot go up suddenly because its supply is pretty high nor does it fall because of its acute shortage. Incidentally, if this were true, when the government announced its intention to import wheat for easing the prices, the hoarders would have flooded the market under the fear of fall in prices, but that didn’t happen. It only vindicates that it is neither the futures trading nor the hoarding, which caused the current rise in price of wheat.

However, the same cannot be said about the failure of the government’s procurement program in acquiring wheat, since no farmer came forward to sell wheat at the declared minimum support price of Rs.650 per quintal.  This act of farmers not coming forward to sell their wheat at the minimum support price is certainly because of the futures trading in the commodity exchanges that ultimately informed the farming community about the current price trends—both in the domestic and global wheat markets.

Theoretically, futures trading leads to the participation of a variety of market participants with varied perceptions of the market using the same instrument for hedging and speculative motives. As investors with different risk preferences, expectations and attitudes buy and sell the same contract, information aggregation gets stronger and this new information reflects well in the resultant prices in the cash market segments. Futures trading thus offers more information on aggregate economic factors such as money supply, interest rates, exchange rates, demand supply status of relevant commodity—both domestically and globally—commodity index, etc., helping price discovery of the underlying asset.

In the ultimate analysis, it is the better information flows about the decline in the global acreage under wheat, the weather forecast about poor rainfall/drought in some traditional wheat growing areas, the resulting gap in supply-demand equilibrium as reflected in the prices for future delivery via futures trading that has made the farmers wise enough to defer their sale at the minimum support price under the hope of realizing a better price in the coming 2 to 3 months but certainly well before the next harvest.

Futures trading in the commodities exchanges has only helped farmers in discovering the likely future price of their produce and it is only the failure of government in maintaining buffer stocks to average out the resulting price rise in a situation of genuine short supply, which has resulted in rise in prices of wheat.

Accusing trading in commodities futures for the current rise in wheat prices is therefore as good as accusing the messenger for the bad news. So, to stop trading in commodities futures is economically dysfunctional.

(September, 2006)