Fight for Economic Recovery Also Needs Commitment on Globalization

Perhaps, it is the right time WTO Chief came up with his statement when countries (irrespective of the level of development of their economies) and their leaders are looking at protectionism as a short-term means to ride on their road to economic recovery. After all globalization ball started moving recently in the last decade or so to reach the scales to finally see a ‘market inclusive’ global economy leading to the ultimate optimal allocation of the resources to achieve global economic sustainability and create a win-win for all the participant countries.

According to the press statement “World Trade 2008, Prospects For 2009”, the collapse in global demand brought by the biggest economic downturn in decades will drive exports down by roughly 9% in volume terms in 2009 i.e. the biggest such contraction since the Second World War, WTO economists forecast today (25 March 2009). They expect the LDCs (who were supposed to be the largest beneficiary of the globalization process) to be most affected, which is most unfortunate. There is no doubt why WTO Chief Mr. Lamy says “Trade can be a potent tool in lifting the world from these economic doldrums. In London G20 leaders will have a unique opportunity to unite in moving from pledges to action and refrain from any further protectionist measure which will render global recovery efforts less effective,”. The larger question is, “Does the future of developed economies at risk due to the potential roll-back in the global trade volumes and are the global leaders committed to fight this out rather than complimenting the financial meltdown of 2008?”

Microfinance in India Needs a Clear Policy Direction

China, 70% of whose population lives in rural areas like India, too has the same tasks to achieve like India: narrow the rural-urban divide and achieve ‘inclusive growth’, and it seems to have a clear policy direction towards micro lending. A report titled "Microfinance in China: A Growing Footprint in the Wake of New Guidelines", quotes Liu Ke Gu, ex-banker, National Development Bank (China), as saying that microfinance has made a significant contribution to relieving employment pressures in China, and is thriving as the most vibrant sector in the whole (Chinese) economy.

In comparison, microfinance in India, which can enhance rural incomes by diversifying rural economy into areas other than farming during off-season and at times of adverse weather, etc, to contribute towards ‘inclusive growth’, seems to have lost its way. "Growth without purpose and direction" is what best summarizes a recent report on microfinance in India, titled 'the State of the Sector Report 2008'. It points out that the past trends of (a) credit growth in high-growth areas and among better-off clients with no effort to consciously target the poor; (b) high costs for borrowers due to lack of access to cheaper sources of funds; and (c) lack of good services continue to remain matters of serious concern. In an era where the government is investing in shoring up rural infrastructure, it is time microfinance be provided with the necessary thrust to make ‘financial inclusion’ true and meaningful by promoting and nurturing entrepreneurship in the rural belt.

It is time the microfinance bill (Micro Finance Sector Development and Regulation Bill, 2007), reportedly mired into controversy and needing amendments, gets Parliamentary clearance at the earliest, to pave the way for effective micro-financing, thereby contributing to ‘inclusive growth’.

Full report: Microfinance in China: A Growing Footprint in the Wake of New Guidelines

According to Dun & Bradstreet, India may slip into deflation by April 2009, driven largely by higher base effect. But D&B does not expect a pronounced deflationary trend in the Indian economy.

Deflation is a general decline in prices that is often caused by a reduction in the supply of money or credit. Will this deflationary phase in India be temporary or a long and painful phase?

In this respect, it is noteworthy to read a column by Olivier Jeanne (Professor of Economics, Johns Hopkins University; visiting Senior Fellow, Peterson Institute for International Economics and CEPR Research Fellow) proposes the organization of a round of "multilateral consultation", under the auspices of the IMF, on how to avoid worldwide deflation and hence the trap of depressionary spiral. Ineffective fiscal and financial policies mean that attention will inevitably return to monetary policy – policymakers should be prepared. Getting the main central banks to agree on a basic set of principles would reduce the fog of Knightian uncertainty prolonging the crisis. We need a multilateral consultation on how to avoid global deflation

Mr. Jeanne, under head "Monetary policy in a credit crisis", discusses monetary policy-makers should not let the economy become entrenched in a Fisherian debt-deflation spiral. He says "flexible inflation targeting" would be the right thing to do in a credit crunch. A clue for our policy makers to further reduce the rates amidst falling prices?

Complete article: We need a multilateral consultation on how to avoid global deflation

Information key to price formation on futures markets: IOSCO report

Studies by various agencies (organizations, central banks, regulators, etc) worldwide following public concerns over the rising commodity prices before July 2008 (e.g. crude oil) ascribe the phenomenon to economic fundamentals, rather than to the speculative activity that happened in the commodity markets. The IOSCO Task Force on Commodity Futures Markets, looking into the issue, emphasizes a good, transparent flow of information into the markets as the key to understanding the role of speculative and commercial activity in commodity futures markets and trading activities in, and the structure of, the underlying markets that may affect price discovery on futures markets. The Task Force offered several proposals to improve the quality and availability of fundamental commodity information, including promotion of transparency in the physical market.

Full report by the IOSCO Task Force on ‘Commodity Futures Markets’

Full report by the ADHEC Risk and Asset Management Research Centre on ‘Role of Speculation in Oil Prices’

USING FUTURES TO CONTROL INFLATIONARY PRESSURES
COMMENTARY - BEHAVIOURAL ECONOMICS

V SHUNMUGAM
Jun 03, 2008
http://staging.livemint.com/2008/06/02215059/Using-futures-to-control-infla.html?d=1
A well-known oncologist in Chennai who recently operated upon a relative to remove a cancerous growth alerted the latter’s son during the pre-surgery consultation against speaking to the patient about the surgery to shield him from panicking. The idea was to accelerate recovery and avoid post-operative complications.

The medical metaphor illustrates how inflation can be compared with cancerous growth to emphasize the crucial role of behavioural sciences in inflation management.

Cancer is an excessive growth of cells, and inflation is a flare-up in the prices of items of common consumption that make them inaccessible to a larger section of population.

So, the behaviour of the stakeholders should be managed better for any anti-inflationary measure to succeed.

Inflation, a function of prices themselves, is the net result of perceptions of the market participants about the value of a commodity based on its supply and demand and their reactions to it. Behavioural sciences come into the picture the moment the market reacts to demand exceeding supply estimates, or to short supply.

Perceptions about stocks of commodities are another key factor. Strengthening long-term stocks, essentially by using a long-term tool to curb short-term volatilities, is the solution. However, identifying the nature of stocks, whether public stocks or private hoarding (a short-term tool traders use to create volatility in the markets and benefit from it) is a challenge.

The behavioural theory also stresses that economic stakeholders react bullishly to perceived price hikes stoking it further. The reaction hap pens at multiple levels—at the individual, social-group and political economy levels.

At the individual level, a perceived price rise would lead us to the theory of inflationary expectations as propounded by J.M. Keynes during the early 20th century. Individuals with varied objectives would purchase and store commodities of consumption, trade and production. An individual consumer may tend to stock, at least for the short term, creating a short-term scarcity and, hence, a further price rise. Or, in anticipation of a price hike, they may demand higher wages, again leading to a further price increase. Producers or traders would always store and sell in a market where prices are expected to move up.

In the midst of all these rational choices, the question is: can this be prevented through micro-management? The cost of micro-management would be higher than the benefits it provides, and an inefficient bureaucracy would muck it up. Therefore, the solution would be to have an advance indicator of price rises and their origins, so that the root causes can be better addressed.

It is to prevent inflation from occurring rather than trying to cure it after it starts moving up.

There are many devices to gauge inflation expectations, including forecasts by renowned institutions, and individual analysts and economists, information emanating from the financial markets (debt markets, for example), and information flowing from trading of commodity futures and indices on the exchange platforms, to help policymakers take better preventive measures.

Indeed, commodities are the root cause of inflation in any economy and, hence, we looked at the possibility of Multi Commodity Exchange of India Ltd (MCX) commodity futures having indicated the high price rise that could happen in April 2008 (through the prices of April maturity contracts) about two months ago, in February 2008.

The April prices of these commodities had indicated an expectation of 7.7% price rise after adjusting for the carrying costs two months ago. Though the selected commodities constitute only about 2% of the gross weights of the Wholesale Price Index, the futures markets had already indicated a possible price rise in those commodities.

These futures, being individual in nature and unlike any other composite indicators, can make the policymakers’ task of targeting price-control measures more effective, and controlling the inflationary pressures at their very origins, better. In fact, futures prices discount the best possible information about relevant domestic and international fundamentals, policy decisions, and market sentiments.

If these price signals can help the market stakeholders to take effective production, consumption and marketing decisions, why not the country’s economic managers?

Traders or producers would stock commodities in a rising market, and this tendency would increase with increase in market volatility, particularly in a northbound market.

Again, price volatility is inversely related to the transparency in information about the price-moving factors.

Thus, in a way, the producer is paid only for the real scarcity of the produce and not for lack of information about it. Healthy futures market trading would help bring in transparency in the market and prevent inordinate price movements as well as hoarding.

It is necessary for the government or the managers of the political economy to get price signals in advance, so that they can better plan inflation management in such a way that the stakeholders in the economy do not know about them and hence, do not react irrationally.

The commodity futures market can definitely provide clues well in advance and, thus, help policymakers deal with the behaviour of individuals and groups, as well as the markets in which they participate, and hence, the economy.

The author is chief economist at the Multi Commodity Exchange of India Ltd. These are his personal views and do not reflect those of the exchange.

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There is no need to panic, our economy is stable
http://www.dnaindia.com/report.asp?newsid=1166162
Friday, May 23, 2008 23:59 IST
There is a visible rise in the price of fuel, and there is a valid reason behind it. Since many years now, we haven't found a considerable mass of crude oil. The demand for fuel is rising day by day and there isn't an increase in the supply. So there is a rise in prices and, in turn, the common man is the one who has to suffer. This is a well-known market principle. But there is also a rise in our incomes at the same time. So I don't think it will be a problem. In spite of recession hitting the US economy, our economy is still quite stable.

Every human being has the tendency to adjust. For instance, not all people are comfortable using public transport. They will either have to adjust, or will be left with no other option but to pay more for the fuel and use their private vehicles.

This indicates the level of dependence of our population on crude oil, which then encourages a further rise in prices. With the rise in the price of crude oil, there is a rise in the standard of living at the same time. Crude oil is the best source of fuel for transportation due to its unique performance level. We need not fear about our future. Our rise in incomes will be balanced with the rise in fuel price.

V Shunmugam is chief economist,
Multi Commodity Exchange Ltd. of India.
He spoke to Shikha Shah

Should FDI in commex be capped?
Feb 2008, 0423 hrs IST,
http://economictimes.indiatimes.com/Debate/Should_FDI_in_commex_be_capped/articleshow/2754062.cms

Varied ownership will boost valuations

The government’s decision to cap foreign investment in commodity exchanges at 49%, with limits on FDI at 26% and FII at 23% with a clause that no single investor may hold more than 5% is a welcome move. The capital market needs to follow best practices: diversity in the ownership and knowledge sharing methodology. A varied ownership provides a boost to valuations, technological upgradation, product development and risk management. The knowledge, experience and global trading practices of foreign players would provide growth momentum both in exchange management and day-to-day commodity trading. Allowing FDI in commodity exchanges will give a significant push to the nature of contracts pertaining to spot prices, forwards, and futures (options are prohibited currently) by facilitating the introduction of more sophisticated trading instruments. The commodities market, which has grown to $858 billion in 2007 from $16.9 billion in 2002, could expand to $1.8 trillion by 2010, according to Assocham. Also, with its trade offers of carbon credits, Multi Commodity Exchange of India has put itself in an elite group along with the Chicago Climate Exchange and the European Climate Exchange. This growth calls for an efficient functioning of the exchanges in the entire value chain, including trading, warehousing, and delivery and processing. The fear that FIIs/FDI in commodities trade would lead to speculative trading, and thus hurt farmers, could be defused if strict rules, process and the approach is adopted under the relaxed FDI norms. Several countries follow different practices in allowing FDI in stock exchanges. The government announced key initiatives on January 22 to prevent speculative trading and give a boost to the country’s commodity markets. The Banking Regulation Act, 1949 is being amended to allow FIs and MFs to trade in commodities futures. The government is also considering allowing 100% foreign direct investment in warehousing and the cold storage sector. The government’s strategic decision to move in a calibrated manner would not only improve the efficiency of the commodities market but also make it more transparent.
Ashvin Parekh National Leader, GFS*, Ernst & Young (*Global Financial Services)

Raise the cap to make them competitive

Capital at affordable cost is a major handicap to economic development of any developing nation. With lower interest rate in developed economies, money is bound to cross borders especially to developing countries like India with potential to give greater returns. Foreign capital brings its own positives such as efficient investment practices, although it might have some negative impact. Rather than curtailing inflows, a more sensible approach is to address the negatives with better regulations. FDI in India’s employment-intensive sectors has so far been minuscule; same being the case with infrastructure as well. So, shouldn’t we leverage foreign capital to provide the necessary impetus to our enterprises? As commodities play a vital role in the fortunes of enterprises and our economy, India’s commodity market needs to be made more vibrant. Therefore, infusion of cheap capital (read, foreign inflows) is a must. Apart from price discovery and price risk management, commodity exchanges undertake capital intensive activities such as dissemination of price information, outreach to widen the market to help the rural masses unlock the value of what they produce and own. If economic growth were to be made sustainable we should make it ‘market-inclusive’ to take its benefits to rural masses as well. Estimates suggest that in the next four years the development of commexes is likely to create at least 5 lakh jobs in the rural areas. To make it happen, the industry needs robust capital support. Though the nod for foreign investment in commodity exchanges is a welcome move, doing away with the 49% cap would further propel the exchanges’ competitiveness to newer heights, bringing in global best practices, technology, and efficiency to enable the industry to take benefits of economic growth to rural India and bridge the urban-rural divide. Further, given that economically sensitive sectors such as banking (private banks), telecom, mining, petroleum and natural gas are allowed more than 49% foreign investments, our policy makers should consider relaxing the cap when the policy is reconsidered.

V Shunmugam Chief Economist MCX
(Views are personal)

Markets can help slow down global warming
http://www.financialexpress.com/news/markets-can-help-slow-down-global-warming/347097/0
V Shunmugam
Posted: 2008-08-11 00:33:07+05:30 IST
Updated: Aug 11, 2008 at 0033 hrs IST
Unlike the markets for other technologies where the value of technology arises from the resource/cost savings it can contribute only, the market for clean technology is driven by yet another factor, which is the return on savings on greenhouse gas (GHG) emissions to which it can contribute. However, the earnings from GHG savings measured in terms of certified emission reductions (CERs) issued by the United Nations Framework Convention on Climate Change (UNFCCC) emanate from a market that has been created with a scientifically felt need in mind. A tangible economic justification is yet to be done.
In an ever-changing world, the long-term valuation of clean technology would have to be measured by both the savings and returns to emissions reductions that it can contribute to. However, the returns on CERs that clean technology buyers may look for have so far been highly volatile as the regulator (UNFCCC) had left the choice of deciding rules of the game to the buyers themselves in the long-term interest. In addition, the buyers are concentrated in non-Annexure I countries whose IPR protection regime is not yet proven. It contributes to an additional risk when it comes to transferring the technology.
And in such a case, the long-term potential of clean technology becomes blurred. It could lead to evaluation of the technology based on medium-term cost savings that it can contribute to. As a result, most technologies that could contribute larger emission controls stay only within the confines of design rooms, much to the disillusionment of the objective behind creation of the markets for emissions reduction. So, it is necessary that we have markets that not only decide returns on the existing technology but also provide a fair valuation on it. Additionally, this would also bring in sustainability to these markets by providing adequate signals to the policymakers on how to sustainably develop this market regime.
The emission markets today face two sets of risks that are closely related to each other. The origin of these risks lies in the policy regime that directs these markets and their own supply and demand. While it would take time for these markets to structurally mature before the policy regime stabilises, there are several other factors that would contribute to the price risk that exists in these markets for CERs. Most of these risk factors could ideally be mitigated by the implementers of CDM projects in India through strategies in the physical markets or by hedging it on the respective commodities that may contribute to price risks in CERs or in the CER futures such as the one recently introduced by MCX. Such risks include the risk related to prices of natural gas, crude oil and power from other sources that may lead to large emitters such as power generators or the transportation sector to switch their consumption in order to remain competitive. It would lead to demand volatility in buyers’ markets (Annexure I countries) leading to price volatility.
As the implementation of CDM projects might involve additional costs on technology or other accompanying inputs, its success would revolve around the savings in costs it could generate and the potential revenue it could earn out of additional business opportunity the implementation would entail or the revenue accruing from the CERs. Most of the CDM projects implemented in India largely rely upon the revenues from CERs rather than the other two factors. And in such a situation, there is a dire need for markets that could give long-term price signals, taking into account the demand (managed from the policy side and the fundamentals) and the supply factors (affected by fundamentals). In short, this needs vibrant futures markets that are indulged in green trading. Green trading would include trading on emission reductions, renewable energy and energy efficiency that are interrelated. It would help in generating market-based incentives to meet the goals of deployment of new, cleaner technology to meet rising demand for energy, which is the major culprit behind the process of climate change that has attracted the attention of the world through IPCC’s path-breaking techno-economic research report.
After the failure in achieving the process of slowing down the climate change through commands and controls and fiscal instruments, it has widely been accepted that markets would remain the ultimate saviours as evidenced through the wider acceptance of the Kyoto Protocol. However, with the rules of the game left to the players in the market, the EU-ETS trading mechanism as it existed two years ago was much unsettled compared with the current conditions due to the policy risk arising out of allocating allowances. It took almost about three years for the EU-ETS markets to come to a position where they are now. Though the stability of the current CER prices in the EU-ETS markets falls short of the players’ expectations, it might have given a fair understanding of the markets to the players in the physical markets. If not for the futures exchanges such as the European Climate Exchange (ECX) and others such as EEX and Nordpool, and the transparency created by them, this understanding and policy stabilisation would not have happened in largely opaque markets.
If we were to achieve the objective of creating efficient markets to mitigate the process of climate change through the CDM mechanism and ultimately through development and transfer of clean technology, the opportunities for participation in the markets should be extended for Indian participants as has been the effort of MCX through the launch of CER and CFI contracts on its platform. In addition, the technology developers shall hedge their interests if their implementers fail to do the same. Efficient futures markets could not only facilitate technology development but also help CDM developers get the best of technology valuation during transfer negotiations.
The writer is chief economist, Multi-Commodity Exchange of India. These are his personal views

Mapping Indian exchanges on the global exchange services mosaic
http://www.financialexpress.com/news/mapping-indian-exchanges-on-the-global-exchange-services-mosaic/305164/0
V Shunmugam
Posted: 2008-05-04 01:19:57+05:30 IST
Updated: May 04, 2008 at 0119 hrs IST

As India opens the door to trade and transactions, it is logical that domestic goods and services would move from a high cost economy to a low cost economy. Comparative advantage in costs would remain the mirror of the efficiency of the economy’s manufacturing and services sectors. Commodity futures trading service offered by the national online exchanges would be no exception to it when it comes to competing within themselves and competing with the global exchanges, as borders disintegrate with a country’s progress in its path towards globalisation. While competing within themselves, national exchanges follow established domestic benchmarks or establish their own benchmarks by way of their own innovative business practices, in all to add value to users of the platform. Upon opening up of the borders to foreign currency transactions, the participants would benchmark even the efficiency of the domestic benchmark exchanges with that of their global counterparts in terms of their ability to deliver value for money.
Value for money on commodity derivative transactions is a composite function of a number of factors that could begin from the design of the contract, healthiness of participation, availability of information, effective management of trading risk, impact cost (a function of volatility and trading cost), efficient price discovery, liquidity, etc. Of these, while some are within the control of the exchanges governing their own rules and regulations besides the exchange practices and trading procedures, the others are beyond the ambit of the exchanges. Hence, it is clear that the exchanges by improving their operations, contract design, stricter surveillance, etc, shall be able to contribute towards an increase in their service delivery efficiency. This would finally contribute not only towards improving their operational procedures and efficiency but would also push themselves towards benchmarks. These benchmarks could be domestic or global, depending on whether the markets for exchange-traded derivatives are close or open both the ways.
Apart from having a larger production capacity by sheer cultivable size of the area in the case of agricultural commodities and larger reserves in the case of certain mineral ores such as iron and aluminium, being a billion plus populous country puts India in the position of an influential player in global primary commodities markets along with China. It necessitates that the primary markets are efficient not only to squeeze the supply chain costs but also to send the right future prices signals to the secondary or the tertiary sector. Hence, it is not only necessary that these markets should be competitive for the participants to trade in them, it is also necessary that these markets discover efficient future prices of commodities.
Commodity exchanges trade primary commodities that are at the bottom of the economic pyramid of our country and hence any inefficiency in the price discovery process is more likely to have a magnified impact on the economy as these pass through several hands in the supply channel and on most occasion gets value added as well. An efficient futures market is one that enables effective participation of traders with varied objectives (facing other risk management alternatives), converging all possible information about the fundamentals on the platform to discover the best possible price. The more efficient the discovered prices of commodities on a futures exchange platform is, the most effective would be the business and policy decisions that were taken based on these prices. The efficiency of price discovery depends on the robustness of the trading platform, its regulations, having the right mix of participants with relevant price information, making their participation cost effective vis-à-vis the alternatives available for risk management or investment, effective management of risk of the participants, and last but not the least - a robust clearing policy.
To make participation effective, it is necessary that the risks to the participants are effectively managed. Tools of risk management include margining, limits on open positions, and effective surveillance (Refer Table). Price volatility of various commodities on an exchange platform is an indicator of how effectively these tools are used by the exchange managers to improve the efficiency of the prices discovered on their platform. Price discovery efficiency in layman’s term refers to the ability of the futures contract to better predict its maturity prices ie the percentage deviation between the first traded price of the contract and the last traded price of the contract. The efficiency of price discovery can also be indicated by the closeness of spot and futures price movement. In the case of the MCX gold contract, the correlation between domestic futures and spot prices is around 99.2% in the last two years (2006& 2007) indicating strong inter-linkage between domestic spot and futures market, while the correlation with COMEX gold futures contract at around 99.4 (2007 and rupee adjusted) reflects how good is the Indian futures market in capturing global cues.
The efficiency of the MCX gold contract seems to better its global benchmark the Comex gold in terms of price discovery (table). More importantly, it is notable that the efficiency comes at the lowest impact cost of trading on MCX gold ie a typical combination of low cost of participation and lower volatility. Lower volatility is the result of close monitoring and the robust margining system adopted by the Indian commodity exchanges vis-à-vis the same adopted in domestic and global benchmark exchanges. Notably, MCX follows strict vigilance with an automated system in place for the same. For example, the system is designed such that it provides automated alerts when member’s margin utilisation crosses various levels and if margin utilisation crosses 100%, the concerned member is put automatically on a “Square Off” mode. Apart from the functional efficiency of trading, the robustness in technology (both the hardware and software) also adds value to the participants through reduced costs. Any additional cost burden on them in terms of taxation would only impair the efficiency of their service delivery in this globally competitive market, leading to flight of trades or their disappearance into the ground.
Having come to India just about four years ago, the national online commodity exchanges seemed to have exceeded the expectations of the policy makers catching up with their age-old global peers in terms of performance. As one would recognise Indian commodity exchanges after reading this for their global feat, it may not last longer in their minds unless they understand the efforts that had gone behind it. It includes choosing commodities relevant to the stakeholders, right contract design, taking it to appropriate participants, creating awareness, besides expanding infrastructure, etc. No doubt that the professionals with strong domain knowledge and technology, exchanges’ efforts to reach out, besides vigorous procedures have taken Indian commexes to their current position. Considering the large production and consumption base of the country, Indian commexes have the ability to outwit the existing domestic/global benchmarks and set their own mark at the global level given an appropriate policy dosage.
The author is chief economist, MCX. These are his personal views

The index of commodity futures investing

http://www.thehindubusinessline.com/2007/01/04/stories/2007010400060800.htm
V. SHUNMUGAM D. G. PRAVEEN
Investing in commodity indices that are efficiently designed would serve the dual purpose of removing the fear of physical deliveries besides better returns with a moderate risk — the key areas of concern in India. Confirming after a study vis-à-vis other key markets that India has sustained a bull run in commodities, V. SHUNMUGAM and D. G. PRAVEEN think that index investing is the way to go.

There is a general wariness, especially among retail investors (though often institutions are also extra cautious), in trading in commodity derivatives for fear of ending up in a delivery situation and the lack of an efficient portfolio that would keep the value of their investments in commodities growing.

A way out would be investing in commodity indices that are efficiently designed for such purposes. This would remove the fear of physical deliveries besides ensuring better returns with a moderate risk. Such commodity indices not only provide an investment opportunity, but also an alternative risk mitigation mechanism for investors. As such, investing in indices is not new to investors in India, as indices based on spot and futures securities market are popular on the stock exchanges.

Derivative indices
However, commodity derivative indices are different from their financial counterparts in that the underlying physical assets range from paper pulp to gold, to live cattle and crude oil, sourced from diverse corners of the world.

Globally, half a dozen popular indices reflect the futures prices of commodities from different underlying markets. The list includes the Goldman Sachs Commodity Index (GSCI), the Dow Jones-AIG Commodity Index (DJ-AIGCI), the Reuters CRB Commodity Index (RCRBCI), the S&P Commodity Index (S&PCI), the Rogers International Commodity Index (RICI), and the Deutsche Bank Liquid Commodity Index (DBLCI). According to Goldman Sachs, about $80 billion is invested globally in the commodity derivatives of which 60 per cent (about $48 billion) goes into passive index-tracking instruments.

Commodity vs. Stock Indices
The prices of exchange-traded stocks are available on a continuous basis; hence, construction of index based on this data is simple and possible real-time. Contrarily, prices of commodities (of a particular quality) are not readily available on a continuous basis. To have an index that reflects the fundamentals and is actively tradeable, it would be best to construct an index using future, rather than cash, prices in the absence of effective spot exchanges for commodities. However, futures contracts expire on the date of maturity. So in order to have continuous futures prices, commodity indices are constructed such that the futures prices of given maturities are considered and replaced with (rollover to) the subsequent month's contracts.

Futures indices
The popularity of the commodity futures indices would have wide implications on the futures segment itself. Investment in indices is normally a long-term strategy that can excite interest in futures contracts for various commodities as investors get a grip of the fundamentals. Another interesting proposition could be that participants can take strategic positions in the indices and the underlying commodities to profit from arbitraging opportunities. A comparative financial performance analysis of four global benchmark indices and MCX Comdex was done for the period December 2005 to December 2006 to look at their performance and to find if the Indian commodities were on a "bull-run" during this period.

Goldman Sachs Commodity Index (GSCI): The most widely followed commodity index was created in 1991. The weights are assigned to the underlying commodities based on their average production value in the last five years of available data. The liquidity on the exchanges is also considered. Weights and composition are reviewed and re-assigned annually.

Dow Jones AIG Commodity Index (DJ-AIGCI): Created in 1998, it comprises 19 commodities. The weights to the underlying commodities are assigned and re-adjusted annually based on average global production and average trading volume over the latest five years.

Reuters/Jefferies Commodity Research Bureau (R/J CRB) Index: Developed in 1957, it is one of the most popular indicators of overall commodity prices. It reflects prices of 19 commodity futures traded on benchmark exchanges. CRB was traded first on New York Board of Trade (NYBOT).

Rogers International Commodity Index (RICI): Developed in 1998 by Jim Rogers to record the price movements of raw materials on a worldwide basis, it has the largest basket with 35 commodities.

Weights for the underlying are assigned monthly according to their importance in international commerce.
MCX Comdex: It was created in June 2005 to mirror the commodity prices discovered at the Multi Commodity Exchange of India (MCX). Like the GSCI, there is no limit on the number of underlying commodities. The MCX Comdex now tracks 10 commodities selected on their liquidity and their importance to the physical market. Equal weights are assigned at group level (energy, agriculture and metals). It relies on a unique combination of liquidity on MCX and physical market size to determine its component weighting. Only near or near-deferred contract months are taken for the index computation.

Currently, gold, silver and copper represent the metals group, while energy and agriculture groups comprise crude oil, and soya oil, cottonseed oilcake, wheat, rubber, urad and guarseed. The index is not traded on any of the exchanges in India due to regulatory constraints. Among the benchmark indices studied only MCX Comdex and RICI had positive returns for the period. The Indian benchmark MCX Comdex provided the highest annualised return of about 18.33 per cent with a moderately higher annualised risk (19.31 per cent). This was followed by the RICI, with an annualised return of 5.56 per cent (annualised risk: 17.04 per cent).

The other benchmarks showed negative returns, ranging from 1 per cent to 7 per cent. This implies that the Indian index has been steadily bullish compared with its global counterparts most of which are in the negative return zone.

Over-emphasis on energy
Looking at the basket of commodities considered for these indices, the over-emphasis on energy has made GSCI highly volatile compared with others with an annualised risk of 22.87 per cent. The high volatility reduced the return-risk ratio to - 1.35. Measured in terms of return-to-risk ratio, at 97.5 per cent, MCX Comdex again tops the charts leaving its counterparts way behind.
Despite the closed borders in various commodities, MCX Comdex had a very high correlation with its global counterparts ranging from 66.1 per cent to 82.7 per cent due to its unique combination of metals, energy, and agricultural verticals representing the entire range of primary commodities.

Through its innovative design, MCX Comdex had not only proved that Indian commodities had a steady bull run in the international markets during the last one year, but also that it is a better barometer of the primary commodities price complex by having better correlation with its global counterparts.

(The authors are, respectively, Chief Economist and Manager, Multi Commodity Exchange of India Ltd. The views are personal. They can be contacted at v.shunmugam@mcxindia.com or Praveen.d@mcxindia.com)

Getting the right inflation measure

http://www.thehindubusinessline.com/2007/07/06/stories/2007070650020800.htm

Friday, Jul 06, 2007
When inflation is discussed as the measure of prices affecting the common man, why should the Wholesale Price Index be used, when the more relevant Consumer Price Index reflects better the prices at the retail level, and that too with the focus on various classes of consumers, ask and V. SHUNMUGAM D. G. PRASAD.

The so called aam aadmi, or the common man, comes into focus when the media and policy-makers wake up to rising prices, and his hardships, so far unnoticed, get instantly highlighted. Though increasing inflation certainly impacts the aam admi, do the numbers one reads or hears of in the media really affect his spending pattern?

In India, the Wholesale Price Index (WPI) is the official measure of inflation and its effect on the consumption pattern of the common man; so, the question is whether the WPI is a precise indicator of inflation, especially when we talk about the ultimate consumer in the economy. Basically, the WPI, as its name indicates, is designed to measure the changes in prices at the wholesale transaction of all commodities.

The other key measure of inflation is the Consumer Price Index (CPI), which is oriented towards the spending of a family of largely homogenous target population in any economy.
Apart from tracking items that have more relevance to a particular class of masses (ultimate consumers) compared to the WPI, the CPI even accounts for the retail margins and taxation and levies at the retail level that would directly impact the ordinary citizen’s consumption pattern.
The question is, when inflation is discussed as a measure of prices affecting the aam aadmi, why is the WPI used when the more relevant CPI reflects better the prices at the retail level, and that too with the focus squarely on var ious classes of consumers. In fact, both have their benefits and limitations. A look also at the other issues so as to identify the more appropriate index as a yardstick for inflation.

The CPI remains the official barometer of inflation in many countries, such as the US, the UK, Japan, France, Canada, Singapore, and China. Of course, the constituents of the commodity basket for CPI measurement vary from one country to other, as do their consumption patterns.
In most countries mentioned above, the economic authorities review the commodity basket of the CPI at least every four-five years, or whenever they think it deserves a review. In the case of non-food items, there is in various countries an increased weightage for telecommunications and extended coverage of modern information and communication technology products.

Non-food components
Most of the countries referred to above have even included health, recreation, and cultural functions, considering their share in the total expenditure. For instance, even the cost of ‘Tummy Tucks’ and ‘Nose Jobs’ form a part of the CPI in Spain, which uses this index to measure inflation.

But, unfortunately, in India this shift has been overlooked and we still look at those items that are slowly becoming less important and voicing concern about increase in prices of some commodities that are losing their share in total consumption.

In the present-day context, where people’s lifestyles and consumption patterns are changing rapidly, there is a need to review the CPI regularly to make it a more appropriate measure of inflation.

Policy-makers often track the WPI as it indicates the price movements well before the commodities hit the retail market so they can take the necessary steps well in advance to rationalise prices at the retail level. Theoretically, this could be right but analysis shows it need not always be so. The effect of the crude oil price basket on the CPI and the WPI was analysed, it being a key influencing factor on inflation. One interesting finding was that the correlation between the Indian Crude Basket (ICB) and the two-month lagged WPI was the highest, at 90.81 per cent.

As for the ICB vis-À-vis the CPI, again the two-month lagged CPI had the highest correlation. This indicates that both the WPI and the CPI more or less reflect the effect of price movements in the crude markets around the same time. India follows an administered price mechanism (APM) in pricing crude oil and derivatives, thus preventing both the indices from getting influenced directly by global crude oil prices. Yet, theoretically, the WPI should capture the effect of a global rise in crude oil prices well in advance of the CPI. Further, the volatility of the WPI is 0.55 per cent while that of the CPI is 0.82 per cent. This indicates that the CPI, which is closer to the common man, should be watched more closely than the WPI to rightly assess the impact of inflation on the common man.

An interesting dimension of this analysis is that, though there is an APM operating in crude oil/derivatives, the effect of the prices at which the Indian Crude Basket is purchased is captured only with a lag. Hence, the lower crude prices in the global market during the first two months of this year are expected to reflect on the inflation trends in the coming period.

So, the policy-makers need not worry excessively about inflation as it is supposed to come down in the near future combined with the arrival of foodstuff, post harvest, in the market and with the timely onset and satisfactory progress of monsoon. This is supported by the fact that the ICB had fallen last October and November, which was reflected in the WPI for December (valued at 207.9) and January (208.5). Is this, then, the right time to shift to the CPI as the official indicator of inflation? The answer might differ betweeneconomists.

Perhaps, then, it is time to take a look at the commodity indices compiled by the futures exchanges and to try and strengthen trading in futures derivatives so that the behaviour of primary commodities can be captured and supplemented with the data provided periodically by major manufacturing entities and service providers.
This should help the Government in effective price management.
(V. Shunmugam is Chief Economist and D.G. Prasad is an Economist with the Multi-Commodity Exchange, Mumbai. Their views are personal. The authors can be reached at v.shunmugam@mcxindia.com)