Evolution of a ‘Price Setting’ Market
Dalal Street Investment Journal May 2009
V. Shunmugam[1]
With India being the largest producer and consumer of numerous commodities and its markets increasingly opening up amid rapid globalization, it has been a top priority of our policymakers to transform our markets into a ‘price setter’ from their current status of a ‘price taker’. It is time the markets of the world’s fourth-largest economy (in PPP terms) get liberalized from outside forces and start discovering prices driven by their own fundamentals.

For this the first logical step would be to democratize our markets to enable an efficient flow of information for effective determination of commodity prices. In fact, the online electronic commodity exchanges of India have already taken up this responsibility, thanks to policy liberalization of 2002-03 which coincided with ICT developments that helped penetration of these exchanges through reduced participation costs and growing awareness. While proliferation of products and participants is evident from the phenomenal 159% CAGR at which these bourses’ trade grew between 2002-03 and 2007-08 (FMC and Economic Survey data), in many global commodities the participants tended to discount global price-moving factors rather than domestic information. Again, in many domestic commodities, particularly essential agricultural products, lack of an audit trail left the policymakers doubting the integrity of market participants in the eventuality of a sudden uptrend in the prices sustained by a set of information not clearly available to them, as passed on by the derivative market participants.

Next, it is necessary to have a strong information database for the markets to leverage. Information flowing into a market can be broadly classified into two sets: one that affects overall price levels and the other that represents a particular commodity ecosystem. The first set includes broad economic parameters such as GDP growth, WPI, Interest Rate, Unemployment, etc and, hence, largely affects equity indices and equities with broad economic exposure, besides commodities that are pervasive in all economic activities or are used to hedge against broad economic parameters such as gold, crude oil and electricity.

An analysis of general past trends shows that COMEX gold prices moved in line with the differences between the expected and actual CPI based on US data releases. In the equity markets, the two major barometers of the US economy — Non-Farm Pay Rolls (released by the US Bureau of Labor Statistics) and Personal Consumer Expenditure Index (Core) — took the Dow-Jones Industrial Index of NYSE to levels in line with the difference between the expected and actual data. Similarly, our own BSE Sensex reacted more sharply to the forecast error in inflation compared with the expected levels. But in the case of gold, domestic prices seem to be less driven by the domestic demand for gold as a hedge against inflation than global price signals and traditional demand. This is unfortunate as, with India sharing about 22% of world gold consumption, it is expected that our markets not only discover own prices but also transmit their price signals to other major markets to incorporate them seamlessly.

The second information set consists of data on global and domestic fundamentals of commodities and financial instruments, price information emerging from other markets, investment in marketing infrastructure, weather, rainfall, etc, affecting the respective financial instrument and commodity or its ecosystem. The analysis shows that data on advance retail sales affected Wal-Mart equity prices on NYSE in line with the momentum in the actual data compared with the market expectations, as also was the case with the GM equity price movement based on the vehicle sales data.

The crux: information plays a key role in price determination in any market. Our markets should, therefore, enable cost-effective participation of all those with information to effectively discover prices.

While the participatory strength would be determined by the policy and institutional environment, the amount and accuracy of information available to the participants would need intensive private and public efforts in identifying data sources, cost-effective collection and, wherever possible, attaching a suitable commercial value and innovative ways to publicize and market it. Accuracy can be improved by proactively recognizing the user and market needs. Over a period of time, market participants would drive the accuracy based on the returns to it. Private efforts in strengthening information databases would need incentives and innovation for information to be more coherent and, hence, meaningful to be adequately leveraged. This along with participants’ efforts to leverage the information in a cost-effective way would ultimately drive Indian markets to become a ‘price setter’.
[1] Author is Chief Economist with Multi Commodity Exchange of India Ltd., Mumbai. Views are personal.