Healthy Growth of Sovereign Hedging Culture – Role of Policy and Regulatory Reforms

With strengthening forces of globalization, increasingly liberal movement of capital and commodities across sovereign borders and widespread adoption of financial markets, risks have not only become inevitable evils of market economy but also made transparent for policy makers to be aware of and accountable to as well. As the pressure on sovereign finances increased prior to and with the onset of the recent financial crisis due to volatile market conditions, the cult of sovereign risk hedging is becoming predominant among emerging sovereign and sovereign owned businesses to manage their costs and revenues in a more prudent manner besides the risk of capital costs. Taking a step further, even the private airlines of the oil producing Middle East have started hedging their oil costs contrary to common understanding that they remain hedged through consuming oil at production cost which remains fairly stable than the price of oil in markets. Countries from Mexico to Morocco and Sri Lanka have increasingly adopted to the concept of risk management using instruments which are customised or standardized derivatives from plain-vanilla to complex and exotic instruments. Such products also range from publicly traded exchanges Strengthening of institutional participation and their financial products design and research capabilities provided strength to the emerging cult of sovereigns attempting to manage their risk exposure with their help.


The financial markets arm of the banks stood as counterparties on OTC hedge products which were offered to sovereign states or state owned agencies. In some of the instances, the research and technical advisory were provided by the arm of the institution which gave them the product to hedge their exposure. Lack of strong corporate governance among both the hedge seller and buyer could make the hedge buying firm in a vulnerable form due to information and technical knowledge arbitrage that professional agencies may look to earn on. Besides, the treasuries of sovereign institutions do not manage positions proactively in the market and that these are OTC products benchmarked to prices collected and disseminated by private agencies, needs that the financial arm of these institutions should follow strong corporate governance norms and policy promoting transparent to protect buy-side sovereigns. However, the recent regulations such as Volcker Act would potentially restrict geographies from which these firms could offer such products to sovereigns limiting competition that would have otherwise provided better products and brought in increased transparency.

 Thanks to its active hedge program, Mexican government was able to wade through the oil market crash of 2009. Mexico is reported to have spent about USD 450 million during 2014 to lock in their oil price realization, exports of which are done through a state-owned Mexican oil company contributes to nearly a third of their annual budget. This hedging plan as executed in advance of at least 1 year by the state-appointed investment bankers helps them manage their expenses and insulate their national finances from commodity price fluctuations. Reports indicate that Mexico’s oil exports have been insulated from a fall in oil prices below USD 81/barrel during 2014 and the same was done at USD 86/barrel during 2013. While Mexico had moved from plain-vanilla futures (in its early attempts at hedging its energy exports) into put options and collar spreads (to reduce cost but at a risk to the costs of hedging), Moroccans are new species into this world of sovereign hedging who attempted to hedge their energy exposures using call options on diesel provided by a domestic bank which bought a backup hedge with a multinational bank. In the process, it could have led to higher cost of hedging due to longer chain of intermediation. Such cases indicate not only that the sovereigns would have to strengthen their risk assessment and management capacity but also have shorter and direct access to cost effective products, matching their risk profile and cost expectations. As all of these sovereign hedging happens in the OTC markets, the broader market participants have no clue of sovereign assessments of price conditions and hence have the potential to stray away from the OTC market leaving arbitraging opportunity for the hedge providing institutions to take advantage of. Though the current G-20 transparency and OTC market clearing aspirations and the emerging Dodd-Frank and MiFID II regulations are an effort in this regard but their slow but steady adoption given the complexity surrounding territorial claims, margining, reporting of the data, it needs that sovereigns hedging their exposure shall make it transparent their hedge positions immediately post the trades were executed and should also insist upon the hedge providers to clear the same through central clearing parties which would also be making it public their clearing data within a given standard time interval. Such an effort would not only plug the unique arbitrage opportunities available to hedge providers but also remove undue speculation about sovereign positions in the broad public traded markets. The incident of Ceylon Petroleum Corporation which incurred losses to the tune of $1 billion is a case in point where the prices went against the positions of the sovereign hedging party either due to wrong guidance/expectations about the oil price movement or due to negligence arising out of market opacity and/or wrongful understanding of the product used in hedging.

It needs that the sovereign corporations that hedge positions on behalf of a larger portion of the national demand should follow strict adherence to corporate governance norms, have well trained staff manning hedge desks, access to all sources of market data about the product they are hedging and follow transparent public accounting and reporting norms. Besides, it also requires that the board may have specialists who can adequately govern risk management practices and guide the staff in doing the same. As pressures on public finance are increasing and as the culture of financial markets is slowly getting imbibed into policy making across sovereigns, the cult of sovereign hedging is likely to grow. Recent hedging by few of the African nations and Airlines owned by sovereigns of the Middle East is a clear indication of this trend. But it is essential that the growth of this cult would have to be nurtured appropriately with right set of policy reforms and regulatory structure so that it serves that larger public cause than denting the public finance.

Sovereign Hedging of Risks – Time for Market and Institutional Reforms

As the pressures on fiscal budgets surge with sovereigns increasingly recognizing the risks of their exposure arising out of global market movements, it had led to increasing acceptance of hedging as the means to conserve precious capital to spend in more productive ways than using it to protect its balance sheet from the impact of inevitable price fluctuations. As successful sovereign hedging models have emerged from Mexico to Ghana, it is likely to have considerable ‘demonstrative power’ on others. Nations with strong public sector are more likely to adopt sovereign hedging as the mode of risk management than nations with competitive private sector. Same will be true with sovereigns whose resources are nationalized and revenue from nationalized resources are more likely to affect national balance sheets compared with revenue from other economic activities. At the outset, it may seem to be a simple function of concentration of market risks on sovereign balance sheets. But sovereign hedging is a function of several other factors right from identification and quantification of such risks to access to knowledge and ability to manage risks, besides the existence of right set of policies and institutions. To make this process a smooth, fair, balanced and transparent process, it needs much of global and local transformation in markets, market advisory services, institutional, regulatory and policy reforms. The fact that markets are getting transparent and goods and services are moving to markets not only makes risks transparent and quantifiable but also help markets develop products to manage these risks in an effective manner and to seamlessly slice risks among investors who are willing to mop them out.

 While trading in financial markets involve paper instruments, these instruments would have to benchmark on physical or spot market transactions or prices discovered in a fair and transparent manner plugging all arbitration opportunities that might arise. It requires that spot markets be efficient and transactions shall ideally be reported/monitored for benchmarking purposes. In a policy environment which is aspiring to move from polled prices to transacted prices for benchmarking, it would be far fetching to talk about reported/monitored spot market transactions. Also that doesn’t block underlying interests of transacting parties to benefit from any anomalies in prices that might exist, which needs a mandatory market identity requirement such as a LEI, reporting mandate with all necessary data points to a central market data repository that may make data public while masking the identities of transacting entities as is the case with modern electronic market platforms. On the other hand, as sovereigns take positions to hedge their huge exposure, neither the transparency nor the opacity works in favour of efficient and arbitrage free functioning of the financial markets. Hence, it should be made mandatory that sovereigns/sovereign corporations make public their hedging intentions well in advance and their positions be published with minimum possible delay to help market soak up the information in a slow and steady manner and plug any arbitrage opportunities that might arise.

 In addition, these strategies being made public will help financial pundits have a public scrutiny and help make governance of such activities stronger. It will help the sovereigns/corporations in two ways. One, the financial analysts community shall help fine-tune the sovereign hedging strategies with their knowledge and past hedge performance at their back. Secondly, it will help the government as the broader financial activism would help keep hedged positions to the market and manage them cost effectively. Overall, financial activism would help in evolution of healthy sovereign hedging strategies through a vigorous two-way feedback mechanism and advance strong governance in sovereign financial activities. In fact, lack of such activism could lead to extreme downsides aided as well by the absence of strong governance mechanism and practices such as lack of active management of hedged positions, hedge through complex financial instruments, and/or benchmarks polled or collected from opaque markets. While for the sovereign hedgers the focus shall be on cost savings, it would be advisable to implement those hedges after appropriately estimating the cost and benefits of hedge including costs associated with tail side risks which weighed heavily against Ceylon Petroleum Corporation in their supposed to be a hedging program during 2010 against crude oil price movements.

 Also, if not appropriately benchmarked against the underlying and duration, treasury of the public corporations have the potential to overshoot the treasury risk management objectives driven by the profit motive moving away from the original objective of risk management. At times, apart from opacity and lack of MTM practices, undue profit motives could also introduce sovereigns/corporations in to territories of unknown risk as well. While the profit motive could also be boosted by the advisories of institutions such as the trading arm of an investment bank, who may also be acting as counterparties to positions without highlighting risks in such a process. In terms of governance, it needs that sovereign hedgers follow a strict tripartite firewall between the product offering institution, financial markets advisory and in-house research team who may provide quantifiable benchmarks for various financial parameters associated with the hedge instrument to make efficient and impartial decisions while managing risks. It needs that the risk management interface shall be effectively motivated to focus on risks in risk management right from counterparty risks including constant monitoring of the quality of collaterals.

As the developed nations are moving towards mandatory clearing mode for their OTC markets, sovereign hedgers shall also mandate routing their trades through well capitalized clearing corporations. While it will remove counterparty risks from transactions, reporting will make the transactions partially transparent. OTC markets thrive due to the freedom it offers for customisation of financial products but institutions interfacing with the organized market places offering standardized products shall be encouraged to offer customized contracts using standard products available in organized public platforms such as exchanges. However, if one were to go by recent regulatory developments in developed markets, capable institutions such as investment arms of banks would be extinct from this space soon. Even if it were to land up in the hands of capable large brokerages, extinction of banks from such activity could lead to collateral scarcity restricting market’s ability to cater to sovereign needs. Unless there is a reversal with liberalization of trading activities of banks with strong regulation, collateral requirements, monitoring and compliance norms sovereign hedging activities could come under potential pressure. While the recent financial crisis highlighted the pitfalls of uncontrolled growth in OTC markets, it had also highlighted the need for hedging of major risks associated with sovereigns or sovereign corporations leading to the growing cult of sovereign hedging. However, further growth of hedging by sovereigns and sovereign corporations can only be ensured by measured financial market reforms leading to healthy growth of global financial markets and intermediary institutions interfacing with them until nations diversify their economic activities and privatize their public corporations.

Given the analysis below... What reaction is expected of the central bank? Can there be a threshold rate for the central bank?

IMF Working Paper

Middle East and Central Asia Department

Estimating The Inflation–Growth Nexus—A Smooth Transition Model

Prepared by Raphael Espinoza, Hyginus Leon and Ananthakrishnan Prasad

Authorized for distribution by Abdelhak Senhadji

March 2010

Abstract

This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Motivated by the global inflation episode of 2007–08 and concern that high levels of inflation

could undermine growth, this paper uses a panel of 165 countries and data for 1960–2007 to

revisit the nexus between inflation and growth. We use a smooth transition model to

investigate the speed at which inflation beyond a threshold becomes harmful to growth, an

important consideration in the policy response to rising inflation as the world economy

recovers. We estimate that for all country groups (except for advanced countries) inflation

above a threshold of about 10 percent quickly becomes harmful to growth, suggesting the need

for a prompt policy response to inflation at or above the relevant threshold. For the advanced

economies, the threshold is much lower. For oil exporting countries, the estimates are less

robust, possibly reflecting heterogeneity among oil producers, but the effect of higher inflation

for oil producers is found to be stronger.

Drought in South East Asia and South Asia??? Lets keep track of this

WILL IT HAVE A FALL OUT ON INDIA AS WELL??? FAO/GIEWS Global Watch 25 March 2010 Drought in Southeast Asia affects parts of Bangladesh, Myanmar, Thailand,Lao PDR, Cambodia and Viet Nam

Since early November 2009 rainfall has been consistently below long term average in Southeast Asia, particularly causing drought in parts of Bangladesh, Myanmar, Thailand, Lao PDR, Cambodia and Viet Nam (see Figures 1 and 2). Figure 1: Anomaly (mm) from estimated rainfall (RFE) – 7 Year climatology Figure 2: Percent soil moisture Currently a secondary cropping season for rice is underway in most countries in the region, except in Bangladesh and Viet Nam where the current season is the most important one. It is also a season for winter crops such as wheat in some countries (see Table 1 for the calendar of current main crops). Because this is generally a low rainfall period in most countries, compared to the wet season that will start later in the summer from May onwards, the crops gown are typically irrigated. Low rainfall has however reduced river flows and other water supplies necessary for irrigation in many parts. River side farming practices and fishing activities, in particular, have suffered this year due to low levels of water flows affecting livelihood of dependent communities. Table 1: Crop calendar - Main cropping activities during this current season in the countries in the region Mekong River water levels at present, for example, according to the Mekong River Commission CEO, have been lowest in 20 years. Mekong River flows through six countries, namely, China, Myanmar, Lao PDR, Thailand, Cambodia and Viet Nam, covers some 4350 km and affects livelihood of more than 60 million people living by the river side. Droughts in summer and floods during wet season along the Mekong River are a long term environmental concern possibly exacerbated by a pronounced El Nino event this year and the increased number of dams upstream. Contribution of the current secondary paddy season in the annual production varies a great deal in different countries accounting for 15 percent in Lao PDR, 18 to 20 percent in Myanmar, 20 to 25 percent in Cambodia and 25 to 30 percent in Thailand. In Thailand due to much reduced precipitation since the beginning of February and so far in March, the Department of Disaster Prevention and Mitigation has declared 19 provinces in the North and Northeast and 13 in the Central and East regions as drought affected. In addition to adverse weather, damage by brown plant hopper is also reported. Based on FAO estimates, the current second season paddy harvest may hover around 7 million tonnes, down by about 1.4 million tonnes from 2008/09 and from 1.8 million tonnes from 2007/08. Low water levels in the Viet Nam’s Mekong River Delta, the country’s rice bowl, have resulted in inward flow of salt water increasing the salinity in the river water endangering rice paddy and other winter-spring crops on about 620 000 hectares. The full extent of damage to crop yields due to the drought is not yet clear but several localized crop failures are reported. The drought situation and its impact on the winter-spring crops are still evolving and needs to be watched and assessed carefully.

Manage Risks at the Origin – The Commodities Way
V. Shunmugam*
Dalal Street Investment Journal

Pg 16-17; March 15-28, 2010

Being so closely related to the basic existence of mankind, no doubt, commodities will remain the fundamental recommendation of any portfolio manager and that is what makes them so important

Man is born due to commodities, lives with commodities. Not less importantly, his end of the era on the earth also needs commodities to ceremoniously complete the same apart from other things. In short commodities are so essential to human kind’s existence on the planet for which they compete, complement, and compromise to live together in a society to produce, earn, share and use it. It is the way mankind earned these commodities and used them, that had led to the creation of an economy and the opportunities that had come along with it. To share these among themselves according to the innate value these could command for the provider and its outer use value to its receiver, money came into being which also over a period of time transformed from sheep and goats to gold/silver coin and to the current bearer note that we use today. Noted economist Keynes rightly said that money remains the only bridge connecting the values from the present to the future and with the past as well so that transactions among the stakeholders can take place smoothly easing out the happening of economic activities as well.

Unfortunately, as the innate value and the outer value of commodities differ as it takes several transformations and quite a bit of time to reach the ultimate user, it tends to give excess of money in the hands of all those who are involved in this process under normal conditions. Mankind saved this excess keeping in mind his productive and unproductive period of life besides keeping in mind the uncertainties of life. To save this excess, the economy created opportunities and paid something in return for those who have provided access to this excess in its need of creation of newer opportunities which had longer payback period such as investments in industry, infrastructure and the services sector. To trade these opportunities, mankind also created markets to function under certain own rules and regulations for the smooth conduct of its activities. In this logical sequence, no wonder, why the markets emerged first for commodities to be later replicated for the financial instruments such as stocks, bonds, interest rates and currencies in the ring, if we trace the global history for origin of financial markets. Not only because that it is the savings of the very same mankind that goes into these markets for various asset classes (stocks, bonds, currencies, etc) but also because these are connected in one way or another to deliver the primary commodities as industrial commodities or services to the ultimate users added with mankind’s own efforts (labour) in the process.

While the value addition opportunities tended to flourish in economies as they developed, increasing population and its quest for commodities other than just for its basic existence, led to a situation where commodities were getting scarcer by time and alternatives for them were hardly emerging through. Also, it led to a situation of fear among the stakeholders leading to the building up of irrationality in the markets, naturally, when emotion starts ruling the participants’ mindsets, if one were to cut him off from the short-term fluctuations especially the one which is the result of recent financial crisis there has been consistently secular trend of increase in commodity prices. Besides that, the interconnectedness of the other markets and the irrationality in them had led to a strong cross-influence on the commodity markets as was witnessed during the current financial crisis. In a nutshell, it means that one who has an exposure in one market, will be in one or another way getting affected by what is happening in the other markets. The basic cause remains that producers of goods or owners of asset classes fail to manage their risks themselves in a better way. Even if they were to, perfect risk management by any of the stakeolders is something not feasible in the real world situation.

It makes a strong case for Markowitz’s portfolio theory which suggests that an efficient portfolio should essentially be diversified, not only to yield better returns but also to guard against risks in related asset classes. Being so closely related to the basic existence of mankind, no doubt, commodities will remain the fundamental recommendation of any portfolio manager. If one takes into account the following commodity intensive industries and their raw material prices, as is evident in the table that their stock prices and their raw material/finished produce prices have a strong correlation among themselves. This is fundamentally due to the fact that risks in their raw material costs or finished product prices are not appropriately managed by them. It provides a strong case for those investing in the mentioned stocks in the table to have appropriate position in the raw materials or the finished products produced by those companies which are traded on commodity exchanges so that one can manage volatility in the stock prices directly on the commodity price movements and further earn the pure business profits, the stock of the company can generate.

Easy and cost effective way of managing this risk arising out of price movements in commodities is being enabled by way of electronic national online commodity exchanges such as MCX trading on global asset classes since 2003. While a part of the corporate sector with relevant commodity being traded on the exchange are participating in the platform, another part is allowing these risks to partly eat into their profits or manage these in the same old traditional way of managing it costlier in the physical markets. Hence, the stock market participants have traditionally tracked the international commodity prices and took notice of company’s risk management policy and accordingly decided the stock prices while trading in commodity related stocks. No wonder, why the stocks of the companies taken up for a simple correlation analysis showed a strong and statistically significant correlation with their input or output prices as traded in the commodity markets. However, with companies in themselves participating in commodity price risk management on futures exchanges we had seen some of the companies’ stock prices in the recent times show a very low correlation with the related commodities as traded on exchanges.

Another reason for commodity investing is to protect one’s wealth against inflation, the main cause of which arises out of increases in the commodity prices and hence its contagious effect on the manufactured and the services. The fact that the future is not predictable, makes savings compulsory for most human beings. However, comparative tendency of human beings (inter-personal or inter-temporal wealth) and the natural phenomenon of inflation build expectations of returns among the savers leading to the look-out for the best investment opportunities that exists in the markets. Thus emerged the markets for various such investment opportunities and the pioneer among them globally remains the commodity derivative markets followed by other asset classes. Be it for inflation management or for protecting the risks in portfolio, the best way is the manage these at the origin i.e. commodities.

*Author is Chief Economist, MCX India Limited, Mumbai. Views are personal.

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 %)!