Basel II: Banking on commodity derivatives

V Shunmugam and Prasad

http://www.rediff.com/money/2007/jul/21com.htm

It is an established fact that as an economy develops, it moves in to specialising in manufacturing from agriculture and later in to services including banking and other financial services.

In fact, India is passing through this transition phase accompanied with development of the financial sector thanks to the MNC banks that have entered the country. A recently released report on banking industry by PricewaterhouseCoopers (PwC) indicated that foreign banks are bullish about the Indian market.

The industry got wider attention as the report indicated that the banking sector is likely to grow significantly faster than the GDP of the E7 (India, China, Brazil, Russia, Indonesia, Turkey, and Mexico) countries as they develop. The report estimates that the total domestic advances in the E7 economies is likely to overtake total domestic credit offtake in the G7 economies within the next 40 years.

Significantly, the report states that India is likely to emerge as the third largest domestic banking market in the world by 2040 and could grow faster than China in the long run. Even before this was revealed by the above recently released report, many of the foreign banks have set up shops in India and in the process bringing in global business practices and domesticated global financial products. That was a wake up alarm for the domestic banks to spruce up themselves.

The report identified demographics, the economic cycle, politics, regulation and reporting, and technology as the five principal drivers of growth of banking industry in these countries. With the industry is in the transition stage, let us focus on regulatory issues that would decide its future growth prospects.

Tougher competition, stricter regulations, continued privatization, slow infusion of global norms and high profile business failures have put traditionally conservative public sector banks under constant pressure to perform better while effectively managing their business risk.

To sustain in the business, it is essential that they are aware of various risks such as credit, interest rate, foreign exchange, and liquidity risks along with appropriate avenues to mitigate them.

Risk management is often a highly complex process requiring sophisticated tools and techniques to operate within the existing regulatory requirements. Basel II norms have come into existence, in an effort to implement global banking norms to facilitate the globalization of the industry in line with the major role of central banks to infuse global economic stability.

What is Basel II? Simply put, Basel II is the new international capital regulation, which seeks to promote banking and financial sector to avoid financial disaster and thereby providing economic stability.

Basel II provides various guidelines with regard to credit, market and operational risk measurement in the banking industry and a bank in compliance with Basel II norms would be in a position to better understand, monitor and manage its credit risk exposure.
Though in India, as per the regulatory requirements, only banks receiving more than 20 per cent of their businesses from abroad would have to implement Basel II norms, most other banks have shown interests in implementing Basel II norms in a phased manner.

The three pillars of Basel II are minimum capital requirement, supervisory review process, and market discipline requirements (improved transparency, effective risk management, sound financial system, etc.)

One of the critical success factors for a bank under Basel II would remain risk identification/ measurement/mitigation and minimum capital allocation. Typically, a bank would face three types of risks; operational risk, credit risk and market risk.

The advent of derivatives trading in India has thrown doors open enormous opportunities to manage some of these risks. Commodity derivatives are another such avenue that banks could tap in an attempt to adhere to Basel II norms.

But, the path for the banks to comply with Basel II norms is being made arduous by the increasing customer base, growing product profiles, lack of effective risk management tools, impending regulatory reforms, etc. For example, existing regulatory norms allow aggregate exposure of any given bank to capital markets not exceeding 40 per cent of its net worth.

To mitigate the risks involved in capital markets, it would be a best practice on the part of the commercial banks to avail various opportunities and derivative instruments in a systematic way to mitigate their risk within their own constraints and regulatory norms.

In the same way, if banks are allowed to operate in commodity derivatives market within a set of regulations, it would lend more balance and would help in propping up its portfolio of investments and spread its risk various asset classes.

In fact, extensive use of derivatives by banks as an evolving phenomenon has recently been reported in the international media, of which a larger part has been held by them to manage their own risk.

For instance, available statistics suggest that participation by banks in derivative markets had increased dramatically during the past decade, rising from notional amounts of $7.34 trillion as on December 31, 1991, to about $ 84.18 trillion by September 30, 2004.

By the very nature of the operation of the Indian banks it is inevitable that they are exposed to several risks such as interest rate risk, foreign exchange risk, commodity price risk and the resultant credit default risk. All these risks in one way or the other are manageable by sharing it across the ecosystem by way of participation in the derivative markets with varied underlying.

An analysis of outstanding operating credit of Indian banks to different industries had revealed that on the average banks might tend to loose 23 percent of their aggregate lending based on the annualized volatility in the commodities of importance to these industries.

Further, it has been found out that in select stocks of companies with intense exposure to primary commodities, which are traded on the commodity exchange platform there is an inverse relationship in their price movement indicating an opportunity for the banks who had invested on those stocks to hedge their exposure on the related commodity derivatives.

An analysis of the relationship between the select stocks and the related commodity prices on the commodity markets reveal a high degree of relationship between their basic raw material prices and stock prices.

This high correlation between equity prices and the prices of the underlying commodities (in which they primarily deal with) such as the MCX platform as shown in the table provides an opportunity for the equity market players including banks and funds to hedge their risk by taking relevant positions simultaneously in both the equity and commodity futures market.

Banks apart from funds with their connectivity to customers shall also act as market access providers to the common man and small producers in the commodity derivatives market which would not only provide a business opportunity but also contribute to the central banks basic role of infusing economic stability.

Further, a comparative analysis of the average daily volatility of MCX comdex and NSE S&P Nifty (as provided in Table II), MCX Comdex (indicative commodity futures prices) is much more stable than NSE Nifty (equity market).

This makes a strong case for banks to be allowed in commodity markets when they are allowed in equity markets, as commodities are less risk prone and are tightly regulated despite the high leverage.

A comparison of the regulatory tools and principles, business practices, and rules and regulations of the domestic stock and commodity exchanges vindicates that both commodity and stock exchanges are regulated professionally with the same set of principles and under the same spirit.

Hence, there are no reasons for the banks to be kept away from an existing opportunity to effectively mitigate direct or indirect risks associated with commodity price volatility. An early action to allow domestic banks to participate in the commodity markets would not only help in improving their competency but would also help in develop their trading and product development skills in commodity derivatives in line with the international banks operating in India but would also enable them to effectively adhere to the Basel II norms by managing their risks effectively.

Authors are Chief Economist and Economist, Multi Commodity Exchange of India Limited (MCX).

Markets can help slow down global warming

http://www.financialexpress.com/news/markets-can-help-slow-down-global-warming/347097/0

V Shunmugam

Posted: Monday, Aug 11, 2008 at 0033 hrs IST

Updated: Monday, 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

Farming Reforms – Budgetary Efforts
Agriculture Today July 2009
V. Shunmugam[1]
Unlike his western brethren, no Indian farmer, however large his holding may be, has ever been keen on budgetary announcements to assess the future prospects for his farming business, nor have there been any obvious attempts to lobby for what he needs from this onerous effort made by our FM every year to utilise the country’s financial resources to put the economy on a sustainable higher growth path. The fact that in the past neither the agriculture sector had been taxed nor had there been attempts to infuse capital directly into farmers’ households substantiates their lack of attention. Few learned among them would know this budgetary process transfers enormous amounts of financial resources from other sectors to the agriculture sector in the form of subsidies, funding for research, technology development and dissemination, capital formation, price support through procurement, etc. Of course, the last announced mass loan waiver was also an effort to transfer revenues collected from other sectors to agriculture. Why do we need such large resource transfers? Are they efficient enough for achieving the goals? Despite all these resource transfers, why does the farming sector remain eternally indebted? What did this budget do to break the path trodden by its predecessors? Can this be sustainable? Here is an attempt to resolve all these riddles.

Agricultural commodities are much more essential to the mankind than other commodities, and farmers, unlike other participants in any other organized economic activity, are least equipped to bear the brunt of business cycles that operate in the economy. Also, we cannot afford to keep them away from farming with an output that barely meets the consumption need of our 1 billion-plus population and yet keep the livelihoods of about two-thirds of our population secure. Despite the agri-production shortage, growing population and their incomes, in general, prices of agri-commodities have never kept pace with the prices of other goods and services. That in general needs resource transfer from these sectors to agriculture not only for the sake of sectoral balance but also for its developmental needs. Given that the 28% of our population still lives in poverty, the prices had always been kept lower than their potential through various policy measures. Hence, to sustain farming activity it becomes necessary to subsidize its costs e.g. fertilizer subsidy. However, defeating its purpose, fertilizer subsidy over a time became a payment for inefficiency in both the fertilizer industry and agricultural production as it made farmers turn blind to nutritional requirements. In this regard, the FM announced a nutrition requirement-based subsidy to improve efficiency in its application. This is an innovative deployment of resources to correct inefficiency, but its success will depend on implementation.

Also, a rise in food prices has always evoked strong consumer reaction and a fall is not in the welfare of producers. Hence policymakers adopted a two-pronged approach to managing the same over a long period: price support for crops of economic importance and food subsidy to agricultural products of food importance — one is a direct transfer to farmers and the other indirect — continuing to support availability and affordability of food. This continued support since independence helped us attain self-sufficiency and reduce the incidence of hunger, but inefficiency in its delivery model continues to keep it hurting for the exchequer. With inadequate risk management and stiffness of price expectations, this cost continued to increase. The need of the hour is an innovative, cost-effective mechanism that adds value to both producers and consumers till such time they are equipped to face the market.

Despite large investments irrigational capacities continue to dwindle due to lack of maintenance needing focused attention. In this scenario, plans to effectively tap rainwater to augment groundwater will save our farmers from the declining groundwater tables. Effective plans to recycle wastewater from industrial and household usages will also increase water availability for sustainable agriculture growth. Focused research and targeted delivery of technology of the public sector will help maintain equity among farmers and make farming a sustainable activity. Strengthening of policies and providing incentives to promote private investment in technology development, market infrastructure, alternative marketing platforms and information dissemination for effective decision-making will go a long way in helping our farmers face the markets rather than look to the government or public sector spending for support.

While the resource transfer remains unduly high compared with the lost value (of total agri-commodities transacted in the markets) due to government policy restrictions, canalisation of these resources remains the key issue due to which farmers continue to remain indebted despite being free of any tax burden and a colossal Rs. 16,500 crore (2009-10 Budget estimates) proposed to be invested in the agriculture sector. Fertilizer subsidy canalisation as per nutrient requirement is innovative in terms of bringing in use efficiency, and only more such innovation in delivering the rest of the resources targeting the problem areas to provide the best possible solutions can make our farming sector more vibrant.
[1] Author is Chief Economist with Multi Commodity Exchange of India Ltd., Mumbai. Views are personal.

This Budget – A Solid Statement of Growth Account
V. Shunmugam[1]
Dalal Street Investment Journal July 2009
It was a bold attempt on the part of the finance minister to state the government’s objective to put the country on a long-term growth path, taking a chance at the deteriorating fiscal situation especially at a time when the human memory is getting shorter. It should have sent to the markets the signal that they can have a higher P/E ratio and, thus, invest in the economy to reap the demand created for the organized sector-offered goods and services. However, the markets (at least the cumulative index indicator) went swirling down keeping everyone — except those who pulled them down — baffled about who seemed to know or better analyzed the impact of the announcements being made by the FM on the floor of Parliament before reacting to it in the markets and as to is it so market-unfriendly a budget to talk about. It leaves one wonder: why did the markets react so strongly (almost the steepest decline in the past decade – see table), making a large portion of the investors run for cover in apprehensions that lower-than-expected returns were already built into their investments?

Worth to note that both electronic and print media debated the episode widely, putting the reasons on the expectations of the markets and the disappointments. What came out clearly was that the government had failed to detail the fine lines of the reform measures that it was expected to carry on, thus making investors lose faith in the expected growth story and reform measures that would carry the economy and, hence, the markets higher ups. Besides, the central fiscal deficit was also an area of concern for the large number of institutional (domestic and foreign) investors.

Even two months ago when the UPA government, largely consisting of reformists, won the second term at the Centre, the markets reacted strongly, surging ahead by almost 17% in expectations that the new government would carry out various reform measures during its next 5-year tenure. People who thought this budget did not propose any reform measures should not miss that it did touch the tip of large reform measures that the FM would want to bring in terms of rationalizing revenues and expenditure. For example, it trod upon an area almost none of the previous budgets had touched: reforming the fertilizer subsidy and more innovatively so based on nutrient need assessment and targeting the farmer directly. Also, the FM announced a committee to reform petroleum derivative pricing apart from various other minor reform measures, which will be a big stride towards economic liberalisation. However, the strength of the intent was overtly missing in the announcements (including disinvestment) read out on the floor, and the markets probably missed reading the fine line. Those who could read the fine print of the budget can be sure: those who sold on the day in the market would envy and those who bought would be envied in another month or so. Of course, the proof of the pudding will be in its making.

Also, on the other hand, fiscal deficit at this point of time should not be a concern for a country flush with resources to be able to repay conveniently in future. Of course, a para from the FM on his mid-term policy on deficit management could have done a world of good to the markets. One who looks at deficit should also look at other hard and soft infrastructure investment that the government is intent on making. While, on the one hand, it would generate enormous demand in the immediate term, it would also streamline economic efficiency over a long period in time making the economy more competitive in a globalized scenario — what we strive to achieve. For example, I fail to understand why the markets failed to look at the rural sector spending which will convert cent percent into consumption on the one side and the commodity demand and employment generation — a natural corollary of hard infrastructure investment as proposed in the budget. After all, the markets just lost a part of the flesh that they had put on during the day of election results announcement. The lesson to take home: Rome is not built in a day — a measured reaction is always good for the markets than unwieldy expectations.

[1] Author is Chief Economist with Multi Commodity Exchange of India Ltd., Mumbai. Views are personal.

Easing of Agriculture Growth Wheels Essential for Economic Recovery Aspirations
Agriculture Today June 2009
V. Shunmugam[1]
The fact that the economic performance of Indian agriculture still affects more than half of our population, whose economic fortunes are directly/indirectly linked to it, makes it necessary to look at the factors that affect this performance. In fact, all the years that recorded higher national GDP had strong agriculture output following a good monsoon (see table). It is clear that howsoever small the contribution of agriculture GDP to the overall GDP may be; it plays a critical role in deciding the performance of the country’s economy.
While a host of factors affect the performance of agriculture with almost two-thirds of India’s cultivated area dependent on monsoon and monsoon-led recharging of ground and land water systems, the performance of monsoon is very crucial in deciding the fate of those dependent millions. In fact, it takes at least two years of good monsoon for growers to recover from the impact of one bad monsoon year and invest more in their cultivation process. This is clear from the bad monsoon year of 2004-05 that the credit flow continued to increase during the next two years.
Credit flow determines farmers’ ability to make most of a good monsoon and is, in turn, determined by interest rates. Lower interest rates boost demand for credit, while higher credit demand does not necessarily affect interest rates. Here, the relative or real price change, i.e. inflation or deflation, plays an important role. Easing or tightening of interest rates determines farmers’ access to credit from formal and informal sources. This macroeconomic cycle persists in the economy and affects the real GDP. Therefore, though monsoon plays a critical role, credit flow into agriculture is also vital to boost agriculture economy. In good production years too, prices of commodities may fall and hence the agricultural GDP. In contrast, GDP of the services and industrial sectors may rise as the prices of their inputs may have increased or there may have been a perceived rise in the value added by them. Also, the terms of trade between agriculture and other sectors as determined by existence or non-existence of certain policies and institutions play an important role in the same.
Increase in agriculture production and productivity also significantly depends on capital formation both in the public and private sectors as it largely determines the existence of efficient infrastructure for production and marketing of crops. Though the fact that GCF in agriculture as a proportion to total capital formation had continuously declined at the start of this century, relative to the agriculture GDP it had shown a growth to 12.5 percent in 2006-07 from 9.6 percent in 2000-01. Implementation of expected policy changes, including that of Warehousing Development and Regulation Act, would go a long way in improving investments if an enabling environment also develops along. Besides monsoon, credit flow, interest rates, input availability, and infrastructural availability, a major factor that affects farmers’ decision-making towards growing a crop or investing in it is assured returns and the availability of a market. The statutory support prices (by the government) from time to time also determine farmers’ sowing decision. The availability of market for whatever a farmer can grow given his risk/return perception would still be a limiting factor considering the lack of physical and information connectivity between producers and end-users. Reforms in agricultural marketing policies, market infrastructure development, and growth of initiatives such as the National Spot Exchange would only determine the ultimate freedom of choice of growing a crop that a farmer would like to have.

Given the current economic slowdown, the performance of agricultural GDP would play an effective role in regaining the growth momentum we aspire for. It is, therefore, essential that policymakers ensure that necessary investments are made and healthy returns are derived thereof, besides enabling a policy and institutional environment that is conducive to a higher growth path for agriculture.

[1] Author is Chief Economist with Multi Commodity Exchange of India Ltd., Mumbai. Views are personal.

Landmines to clear on the 9 percent growth path
V. Shunmugam[1]
Dalal Street Investment Journal June 2009

Economic growth as revealed by the recently released GDP numbers for 2008-09 came as a surprise to economic pundits and financial analysts alike. While important international organizations such as the International Monetary Fund and the World Bank that are monitoring the health of the economy on all its parameters predicted a grim growth rate of 4-5 percent, between them, for the Indian economy during 2008-09, the economy seemed to have come out unscathed with an estimated growth of 6.7 percent, according to the recent economic data release. It is, therefore, critical to look at what made this difference. To top it all, much to our joy, the prime minister recently assured that the economy would take the 9 percent growth path with a call for greater public spending in infrastructure. Accordingly, the markets reacted too.
What made most of the difference in the last year’s balance sheet of the economy is that the government spending alone increased by 20 percent during 2008-09 compared with the previous estimates. While a major chunk of it would have gone into offsetting the high global energy prices, the rest is estimated to have gone into formation of capital assets, as reflected in strong growth in capital formation. While one would have insulated the individuals and businesses from the oil market volatility that existed during 2008-09, the other is essential for long-term sustainability of the growth momentum in the economy. However, the fact that increased government spending came on the back of a higher estimated fiscal deficit (6.2 percent) would make the individuals and businesses a worried lot, as it would be collected from them along with interest costs in future. The moot question: will there be enough collective ability among the stakeholders to pay it back when it is due?
The past experience of deficit-driven growth suggests that the current level of deficit in percentage terms to GDP is not abnormal in our economic growth path. International examples also suggest that this level is much prevalent in a moderately aggressive growth-oriented economy. Also, our systematic repayment of the historically high external and internal debts while managing the cyclical movement of the economy in the past indicates that it is not something to be seriously worried about given the positive side it generates for investor sentiment; the need of the hour for keeping alive the growth momentum. The situation of the government in this case is much the same as that of an individual who yearns to own a home for his physical and financial security by leveraging 20 years of his future income. Of course, bankers know that not in all cases such loans go bad, given the strong risk management principles they adopt.
With the economy expected to pick up the growth momentum, not many jobs lost in the past during the meltdown years would be created in the near future, income of private individuals would remain flat in most cases, and the role of increased government spending vis-à-vis private spending assumes greater prominence. However, it is also critical to see the source of such expenditure that the government can make: as in this case, the revenue from perpetual source of taxes would in all probability shrink slightly or remain the same despite the buoyancy reported in the first two months of this fiscal year. Hence, it would become obligatory on the part of the government to reduce unproductive expenditure (including subsidies) and administration costs; seek additional sources of revenue such as sales of assets and stakes in the public sector; increase the cost of public services, and so on. While it is important to augment the sources of revenue, it is equally important that increased expenditure is parked prudently on such avenues that would strike a balance between short-term and long-term gains. The physical and social infrastructure typically stands for short-term and long-term gains to the economy. A neglect of one can only happen at the long-term cost to the other.
Although these appear to be logical economic solutions to help the new government in achieving its target growth rate of 9 percent for the current fiscal year, it would be interesting to see how the political cost of it unfolds.

[1] Author is Chief Economist with Multi Commodity Exchange of India Ltd., Mumbai. Views are personal.

Improved Logistics to Boost Agricultural Economy
Times Shipping Journal April 2009
V. Shunmugam[1]

Despite spending about 15-40 per cent in logistics for transportation and storage of our grains, fruits and vegetables, it has been widely estimated that we stand to lose about 20 per cent of our grains and 30 per cent of fruits and perishables annually due to the poor quality of available logistics or the lack of logistics in some cases. As urban infrastructure developed over a period in time, the nearby urban markets remained the main assembling centres for traders to cater to the demand spread across the nation for a given commodity value chain. Additionally, these also remained the major centres for value addition leading to loss of value addition opportunities and the associated investment and employment benefits at the rural marketing centres. Over a period of time, this led to increasing pressure on the available urban resources not only making marketing and value addition costlier but also leading to a higher cost of available transportation capacity and poor quality of handling and storage.

What ails the Indian agricultural economy? Things have changed over the last decade or so. Technology has played a key role in spreading information across the rural canvass and empowered producers to take decisions based on their need and convenience. Also, increased investment in rural infrastructure (markets, roads, storage facilities, etc) and the expected entry of mechanisms such as warehouse receipts are likely to prop up the balance sheets of agricultural producers. However, nothing may actually change in terms of efficiently and cost-effectively reaching the produce to the consumer. This is mainly because of the fact that due to better the availability of connectivity and transparency, ‘assembling markets’ would continue to play a significant role in accumulating the produce at one place and send it to satellite consumption centres. Despite the current improvement in rural infrastructure, producers would continue to depend upon the major marketing centres due to lack of transparency within and among the rural producing centres compared with urban marketing centres which are more organized and well connected in terms of supply chain participants. The result: assembling as a function continues to add pressure on the transportation and storage logistics infrastructure, eventually reflecting upon the consumer rupee.

There are two ways in which the burden of excessive dependence on the urban assembling markets and the associated logistics can be reduced. One, by way of setting up agricultural logistics parks and connecting them to the info highway; this can reduce the concentration of produce in a particular centre and lessen the burden on the existing logistics thereby cutting on the wastage and costs. The other way in which this can be achieved would be through slow penetration of the national online electronic spot exchanges such as the National Spot Exchange Limited (NSEL) that would facilitate market access and transparency which otherwise was not available at the producing centre level and even if available, open access to make purchases was either restricted due to regulatory reasons or lack of means by which these can be accessed by buyers across the country.

Instead of competing between them these two new initiatives would actually compliment each other to coexist for their mutual benefits. While providing the spot exchanges and their buyers with a one-stop solution to getting agricultural commodities delivered, the logistics parks would also certify their quality and enable transportation to buyers located in satellite consumption centres. The national online electronic spot exchanges would enable buying and selling in these logistics parks, connecting the interests of buyers and sellers across the nation. Added to this, the two entities existing side by side would bring in transactional efficiency in trading of agricultural commodities close to other goods enjoying the benefits of organised logistics.

As far as perishables are concerned, a large part of their wastage can be prevented by putting up cold storages nearer to the production centres rather than the assembling centres. Agricultural logistics parks can house cold storage facilities near the production centres preventing potential losses due to longer-duration transportation. Development of consumption habits among the consumers of perishables in terms of the processed products starting from highly seasonal/high-value products would go a long way in curbing wastages. An agricultural logistics park housing such processing facilities would reduce time and costs besides creating employment opportunities and boosting investment potential in the rural economy.

As these entities develop and advance on to the national agri-horti landscape, necessary policy and institutional changes would have to be brought in to boost their growth and reach. Given the public and commercial interests that exist in coming up of these entities, a slew of fiscal measures, along with public-private partnership mode of operation of this model with stricter guidelines, would go a long way in creating a win-win situation for both producers and consumers. Hence, improving access to the markets and improved logistics would go a long way in boosting the rural economy.

[1] Author is Chief Economist, Multi Commodity Exchange of India Limited, Mumbai. Views are personal.

Prioritizing the Pending Bills

Dalal Street Investment Journal May 2009

V. Shunmugam[1]
Being mandated to be at the helm for the second consecutive term, the UPA government is faced with the daunting task of discussing a few critical finance bills if it intends to take the reforms to the next level, for higher economic growth. Selection and rejection of these bills would be challenging as each of them would have its own merits for an early clearance. While clearing these bills it may not only be useful to heed the issues raised by the respective ministries and departments in deciding the priority but it would also be in the fitness of situation to take the call keeping in view the broader need of the economy.

Having clocked around 9 percent growth every year over the last five years, the economy is set to slow down during the current financial year. The situation is predicted to deteriorate further during 2009-10, with many international and domestic agencies pegging the growth at less than 5 percent. The direct impact of this slowdown is being felt in terms of losses in jobs, as many facilities have either closed down or scaled down their operations in light of plummeting demand. According to the labour ministry, about half a million Indians lost their jobs in a matter of just three months between October and December 2008. The situation is not likely to reverse any time soon given the longer reversal time. While an increasing number of unemployed labours would, understandably, become a social threat, the government, on its part, has been making earnest efforts through stimulus packages.

With such clouds of uncertainty, arising from the ongoing financial crisis, casting their shadow over the domestic economy, it may be just apt for the government to supplement its monetary and fiscal measures with the passage of reform-oriented bills to fight the slowdown. And it may not be much difficult to identify such bills if the importance of strengthening regulation to avoid any major misadventures of firms that could risk the economic growth and employment, and the need to propel the economy are kept in mind. In other words, the bills seeking to strengthen regulation and boost economic growth should be given priority.

Coming to the pending bills, the most striking in the current context is the Banking Regulation (Amendment) Bill that seeks to provide the RBI with more flexibility in tinkering with its monetary policy, providing, among others, more operational flexibility to the central bank to fix the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR) so as to make more funds available for stirring growth taking into consideration the inflation target. The amendment also provides the banking regulator with the larger regulatory power to order special audits of cooperative banks for increased effective supervision in public interest that could help in inclusive growth by strengthening the cooperative sector and improving their performance.

The bill that assumes urgency, next, for clearance is the amendment to the Forward Contracts (Regulation) Act, 1952 bill. This aims mainly to restructure and strengthen the regulator of the Indian commodity futures market, the Forward Markets Commission (FMC), on the lines of other key regulators such as SEBI, TRAI, and IRDA. FMC currently enjoys limited power yet regulates a large portion of the country’s commodity derivatives market. For an important and sensitive sector like commodities in India where a large segment of population still lives below poverty line, the need for proper monitoring and, hence, a powerful regulator become all the more critical. A well developed and regulated commodity market would, no doubt, create more direct and indirect investment and employment in the real sector.

Prominent among other bills are the Companies Bill (2008) and the Insurance Laws (Amendment) Bill (2008). By replacing the existing Companies Act, 1956, the Companies Bill does away with the criterion of minimum paid-up capital to start a company, provides for appointment of minimum 33 percent independent directors on board, and allows a single person to set up a company to encourage entrepreneurialism. The domestic insurance sector holds huge potential of new investment since the penetration of insurance is currently abysmally low with insurance premium collection estimated at 3 percent of GDP against the global average of 8 percent. Microfinance Bill which was expecting clearance for long could be another catalyst for inclusive growth. The passage of these two bills would impart a much-needed stimulus to investment and employment besides ‘inclusive growth’. Keeping in focus the broader objective of essentially catapulting the Indian economy to a higher growth trajectory, taking effective care of systemic risks would help the new government serve its mandate.

[1] Author is Chief Economist with Multi Commodity Exchange of India Ltd., Mumbai. Views are personal.

Improving Terms of Trade: Agricultural Vs Other Commodities
Agriculture Today May 2009

V. Shunmugam[1]
Often farmers are thought of as producers whose production process involves a minimal and stable cost, and hence any rise in the prices of agricultural commodities is looked at by many to be in favor of the farming community without any consideration for the cost increase that the farmer would have faced in the light of increasing cost of other goods and services that he would consume either in his production process or for own wellbeing. Only a few, especially those from the policy making domain and academics close to economics of agriculture, would know that there is a strong input-output relationship (either directly or indirectly) that exists between agricultural and other commodities. More directly, these goods and services refer to those starting from production and marketing of agricultural inputs to those involved in marketing of these agricultural commodities. For example, a rise in crude oil prices, as was witnessed worldwide during the first half of 2008, would have made a small contribution to the farmer’s production cost due to the use of diesel in his tractor or pump. However, a larger contribution to the cost increase would be constituted by the rise in his marketing costs (directly – transportation).

Long supply chain is another deficit in our agricultural marketing system that rubs salt on the already bruised farming community, eating a lot into their margins – requiring a series of institutional and policy reforms in agriculture to tune the marketing efficiency in agricultural commodities. Ignoring that, an attempt has been made here to look at the simple terms of trade (TOT) between agricultural commodities and metals (as shown in the table below) i.e. proportionate amount of agricultural commodities that would be needed to produce a given amount of metal. Though our farmers are not constant consumers of metals in their daily life or production processes, this does affect the transportation cost of other agricultural commodities and inputs that they consume to be in the production process. Hence, it is a litmus test to see how the markets for agricultural commodities move unconnected with prices of metals.

A look at the numbers compiled from 2005 reveals that TOT had slightly been favorable to agriculture. As the financial boom progressed during the next two years, it is the metal commodities which have reaped gains and, thus, left the agricultural commodities way back in comparison – as is evident in the deteriorating TOT numbers during 2006 and 2007. However, with the financial meltdown and dwindling stock levels, increased industrial use of agricultural commodities (such as biofuel) during these years led to a turnaround in TOT in favor of agriculture during 2008. Globally also, TOT between agricultural and metal commodities did improve during 2008, passing on its partial effect into the Indian markets as well. The turnaround in TOT at the global level has not been as pronounced as in India, though many agricultural commodities are financially traded globally contrary to what critics might believe. More so, this interconnectedness between metals and agriculture commodities in India has deteriorated during both the burst years and the boom years unlike the normal years and the global experience where both the commodities are financially traded.

The remarkable turnaround in TOT during 2008 could largely be attributed to the longer lag-effect of the metal prices on agricultural commodities and the continued increase in the administered prices of several agricultural commodities, besides a marked decline in the stock levels of several agricultural commodities. Key lessons from TOT movements during the last five years indicate that:
- there is a strong need for closer integration among the markets for agricultural and other commodities
- there has to be increased integration with the global markets through improved trade liberalization to get the pass-on effect into the food economy
- there has to be a market-oriented, transparent food stocking policy to insulate producers and consumers effectively from violent fluctuations in TOT, and
- more importantly, a series of policy and institutional reforms would have to be introduced to improve agricultural marketing efficiency in favor of producers and consumers.

[1] Author is Chief Economist with Multi Commodity Exchange of India Ltd., Mumbai. Views are personal.

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.

Walking the Tight Rope in Petroleum Products Pricing

V Shunmugam

An investor with an uncanny knack for anticipating policy effects on the markets would have balanced his portfolio with the gravity-defying performance of the so-called ‘public sector blue chips’ into crude refining, including HPCL (35.1 %), BPCL (39.2 %), etc., July 11 till Feb-end. Of course, being an explorer of oil and gas ONGC was an exception to the gravity-defying price trend. Thank god, that they were not fully disinvested, which would have otherwise led to the whole of the profits of this price differential between derivatives and crude accumulating into a few private hands. This would make one wonder if our current policy only serves its main objective of protecting the vulnerable sections of the society from market volatility. Given that our administered prices have become stickier of late, it did protect the vulnerable population when the markets were upwardly volatile but have not when the markets were south-bound since July, 2009.

Why did the stickiness get built into a mechanism which was supposed to be flexible? It was expected to be less glutinous as the then government decided to mark the prices of crude derivatives to markets on a 15-day interval during 2002 in an effort to make way for gradual dismantling of administered price mechanism when the crude markets were calm at their bottom. Unfortunately, the spirit behind this pioneering move was lost in few months as was evident in the slowness with which derivative prices were marked to the market movements. The mark-to-market (MTM) policy ran out of steam as crude began its unstinted northward journey. The volatility also remained high due to heightened geopolitical concerns/rigid supplies and the MTM needed more time for political and financial homework to be done than the policy would desire. This was well reflected in the retarded policy response that often matched the policy comfort level than the commercial comfort levels of the PSU and even the private sector (Reliance) refiner who took up aggressive domestic marketing. The complete reversal of the 2002 policy made the then private sector efforts into expanding retail network to be dispersed into thin air. Fortunately, the escalating real estate prices would have helped them make good of their losses.

With the crude prices at the bottom of the market (though volatile) compared with the all-time high of July 11 at $147/barrel, is it the right time for us to think of deregulating petroleum derivative prices? Deregulating is easier said than done in a plural democracy with large inequality like ours unless the common man who is being taken out of the umbrella of administered pricing mechanism (APM) understands and is enabled to assimilate market volatility. With crude being much pervasive in human life today, a sudden removal of the APM without a plan to take care of the economically vulnerable sections of the industry and individuals would have the potential to widen the inequality that already exists in the economy.

How can policy makers prevent APM from benefiting a few individuals or institutions (public or otherwise) due to the political stickiness of prices? Of course, the government is a major beneficiary of the refining and derivative marketing profits, holding a stake of about 50 percent or more in the public sector refineries. However, what would be worrisome for public policy making is to find ways that would prevent inordinate cash benefits from getting accumulated in to the hands of a few individuals and institutions arising out of its own operation.

Assuming that the current stickiness in prices is likely to exist for the time being, with the elections around the corner it would least incentivize any government in power to react radically by dismantling APM though crude is at its low (yet unstable). Against this backdrop, if the crude and derivative prices were to remain at the same level since the last revision on January 28, 2009, it will continue to contribute towards the widening of economic inequality in a small way. Such an inequality would get multiplied at times of financial boom. Hence, it is necessary that profits arising out of a public policy be tapped for public purposes rather than letting it slip into private pockets.

The tools that are available with our policymakers include making the derivative prices less sticky so that the profits from public policy making do not fall into private hands but yet making these PSU industries attractive to the investors. Having taken a plunge in to liberalization, disinvestment will remain a priority and may set the tone for APM dismantling.

The other avenue would be to increase taxes on crude or derivatives without affecting petroleum product prices. However, estimates in the recent past revealed that petrol and diesel were being taxed to the extent of 56 and 38 percent respectively. Is it worth an option to look at? Those who ask such question should look at countries such as the UK, Germany, and France that have taxes on petroleum products much higher than ours. At times of high fiscal deficit and policy constrained high prices it will be worthwhile considering a flexi tax option.

History reveals that given crude oil as an energy source is widely used for transportation purposes, nations with high dependence on indirect taxes considered taxing crude heavily to capture a part of the advantage that the petroleum products provides it users to help spread it among non-privileged. But our government has a strong dual purpose of increasing the taxes if it at all decides to do so without changing the administered prices. One to continue supporting subsidization of poor man’s fuel — kerosene, and to accumulate funds in ‘oil pool’ to buy back the oil bonds whenever they mature. Secondly, such tax revenue without affecting petroleum prices become all the more prominent at this time of financial crisis is to keep the fiscal kitty healthy. No wonder, a recent media report quoted finance ministry sources as looking at increasing customs on crude when its prices were on an upward spiral!

Between ‘Aam Aadmi’ and WPI

V. Shunmugam
Recent efforts of the print and electronic media to unplug the current zero level inflation as calculated from the recently released WPI from the increasing price trends at the retail level ended up confusing the ‘common man’ rather than clarifying it. Should he be happy about the near-zero level inflation numbers as revealed from the recently released WPI numbers or should he worry about stiff or increasing prices of commodities purchased by him from the next door Kirana shop? The simple fact that the a stubborn CPI and falling WPI had been existing together for the previous long six months leaves one wondering what the recently announced inflation number means to the ‘common man’. Below is an attempt to compare and distinguish underlying currents in the WPI and its relevance to him.

Fundamentally, WPI remains an attempt to index the prices of about 435 commodities collected at the wholesale level and compiled by the OoEA/Ministry of Commerce and Industry and to calculate the extent of price movement on a year over year (YOY) basis. To filter out the seasonal effects that the fundamentals of the different commodities in the WPI basket might have, YOY calculation has been done to measure inflation or the price change. Hence one has to remember that the inflation numbers calculated based on WPI is only a relative number based on the year ago price level and any lower inflation does not mean that prices have reversed but that the rate of price increase had declined. Further, of the 435 commodities represented in computation of WPI Index only about 77 i.e. 18 percent refers to commodities that can be associated with immediate consumption by the common man which has a combined weight of 21.54 percent. Tracking the movement of WPI, it is natural that the price increase which common man sees in many of the commodities of his frequent consumption is likely to remain higher 4.26 percent at the whole sale level. Though appropriateness of the commodities and their weights remains debatable, to preempt the same, authorities should consider conducting expenditure surveys on a frequent basis (as is the case with the United States) or atleast expanding the scope of the NSSO annual surveys to include WPI related commodities as well to make it reflect ground realities more frequently. It would ensure that policies taken to contain inflation yield intended results.

Rest of the commodities undergo industrial processing/value addition before being consumed by consumers directly or indirectly (services/manufactured goods) and can be grouped into three depending on their consumption availability over a short/medium/long period in time. Among them the first group of commodities gets value added and is available for direct or indirect consumption of our common man in a short period in time. This group would have an immediate term impact on the price levels for the common man if not at the same interval as that of the earlier discussed group of commodities. As per the existing WPI basket, it would approximately account for only about 26 percent of total consumption basket of our ‘common man’. With a 1.56 percent increase in WPI and given its weightage of 31.48 percent, the change in the WPI number would take a short period in time to get reflected on prices of the ‘commodities or services’ that our common man would consume. The second class of industrial commodities (7 percent with 6.19 weight in WPI) would take a slightly longer time (6-12 months) to impact the overall price levels or somewhat indirectly reach our ‘common man’. The last group of commodities which represents about xx percent of the kitty had undergone a price change of 49 percent as per the WPI weightage (40.79 percent) but would take more than an year’s time to get reflected in the price of goods and services that our common man witnesses in his neighborhood. Overall, what he sees in WPI will not be what he would get in his kirana shop or would have an impact on the common services that he consumes due to several reasons.

Firstly, WPI is a reflection of prices that exist at the wholesale markets and there exists a long value chain mired in opaque markets which add to its margins often to mark themselves to what our common man sees as inflation at the whole sale level. Reforms in the value chain connecting producers with consumers and increasing market transparency would help in transferring the benefit of lower increase in WPI into CPI in all groups of commodities, more so in the case of first group of commodities which are closer to our common man. Secondly, given the current high volatility in forex rates (11%), equities (46%), interest rates (24%), and commodities (26%), value addition becomes a costlier process due to high cost of risk management which gets passed on to the consumers reflected in increased prices of processed/value-added products. It essentially leads into price-wage loop as it happened in the previous boom, breaking which would need demand shrinkage that has the potential to lead to an unemployment spiral. Existence of derivative markets in the above asset classes with public and private participation bringing in heterogeneity would help not only help corporates to manage their risks effectively but also acts as the conduit for masses and public institutions to express their price expectations for natural or policy enabled smoother adjustment in demand and supply. Thirdly, existence of an effective competition policy and strict monitoring would help avoid collusion among few industries within a given sector thus preventing higher markups in value added commodities. Though the laundry list of inefficiencies in markets, manufacturers, and service providers is infinite, the first three here are obvious. It will be a combination of policy, institutional, and regulatory reforms that would help shrink the spread between the WPI and CPI. Till then for our common man, it will be not what he sees on the media as inflation or somewhere closer to it that he would get in his neighborhood. After all, there is a reason for the Public Lending Rate of the Commercial banks (12.25%) to remain higher than the RBI’s lending rate to the commercial banks (reverse repo rate – 3.5 %)!

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