Banks, FIIs, mutual funds—all must participate in this market
The Financial Stability and Development Council of RBI has reopened the issue of commodity markets by bringing to the discussion table the case for allowing financial institutions and FIIs to participate in futures trading. This is a positive move that, hopefully, will materialise and take the derivatives market to a new level.
The issue of allowing these institutions is not new and has been on the sidelines for a long time. The commodity futures market has come of age, having been in existence for over a decade, and has been through several upheavals with the misguided notion that such trading affects inflation. It is accepted that futures trading has little links with inflation and instead foretells the same which can prompt corrective action.
There is also a strong case for the restoration of banned futures contracts in products such as tur and urad which gave correct signals in the paston the NCDEX platform. It is time these contracts are restored so that the bouquet of products offered is wide and more meaningful.
Now, let us look at banks getting into these markets. Today, RBI is venting its ire on companies that have forex exposure but do not hedge because, in case the rupee swings widely in either direction, the losses could be large. The same holds for banks when dealing with lending because all farm loans as well as those to manufacturing—which are based on commodities—carry a high price risk, especially with inflation averaging of 8-10% in the last 2-3 years. It is less palpable for manufacturing where inflation has been more moderate at around 3-4%. Intuitively, one can see that the possibility of a loan going bad and turning into an NPA is higher with swings in commodity prices. There could be some natural hedge in manufacturing if producers pass on the cost to the consumer but this does not hold for farmers in case there is a crop failure. Hence, there is a case for intervention by banks.
Banks need to insist on corporates hedging their commodity price risk just as they have to for forex, as directed by RBI. While enforcing the same would be a challenge, the absence of such hedging should mean a higher lending rate with a charge for the same entering the base rate calculation. RBI also needs to work out if we can have an NPA reserve created by banks which is funded by an additional interest cost levied on companies when commodity risk is not hedged.
How about farmers? This is trickier as banks cannot insist on the same, as the lending rate is fixed at 7%. Here, banks have to be allowed to play the role of an aggregator (this was suggested by RBI in its 2005 report on warehouse receipt financing) where the local branch manager has to only pool the product that is kept in the warehouse and inform the banks’ treasury which does the hedging. The local bank branch manager need not have any knowledge of futures trading and only has to pass on the amount to the central office to enable this transaction. Since there is a hedge cost involved, the government could consider providing an incentive by covering it for farm loans which already carry a subvention on interest. But it would still be in the bank’s interest to hedge its exposures to the farm sector given their propensity to turn NPAs.
But there would be a problem in case the price at the time of maturity is higher than contracted—which is a notional loss. A futures contract provides protection against a lower price but does not allow one to take advantage of a higher price. Ideally, options should be permitted and this is where the FCRA needs to be changed simultaneously so as to make this proposition work.
Going forward, one also can think of banks trading in commodity futures as a part of their business with a certain part of deposits or credit being permitted for such trading with the requisite safeguards just as banks trade in forex or manage their investment portfolio.
FII trading in commodities is also a good idea as experiences in the stock market have been satisfying. They have added depth to the market and the same can be expected in the commodity market. While the FMC supported their participation in non-agro commodities as early as in FY06, it did not work out due to regulatory issues because while FMC was under the ministry of consumer affairs, FIIs were guided by Sebi, which was under the ministry of finance. Today, with the FMC being under the finance ministry, this should be easier.
Mutual funds, too, are not permitted to deal with commodities and permitting them will open another avenue for investors. Bullion can give returns between 15-20% while agro commodities like guar, soybean, mustard, pepper and jeera could go anywhere between 10-30% depending on market conditions. As the commodity futures market is trying to get in retail, players who on their own would not be in a position to trade given delivery issues and understanding of fundamentals of commodities which is very different from stocks and mutual funds through commodity schemes, could provide such access.
Are there any safeguards needed? First, the issue of delivery has to be tackled. None of these players would be interested in delivery and, hence, their terms of operations should exclusively preclude delivery where they have to close out on their contracts. Exchanges could consider non-deliverable contracts in parallel. In fact, taking delivery by FIIs can lead to foreign trade issues in case they would, in an unlikely scenario, like to ship them out. Second, to ensure that the markets are not pulled in a particular direction, the position limits should be set for these entities with deep pockets. As they are dealing with non-deliverable contracts, there would be a tendency to take higher positions. Last, regulation has to be firm and surveillance systems of exchanges robust to ensure that the system works well.
Going by the virtually smooth growth of this market in terms of regulation by FMC and conduct of commodity futures exchanges, one can be sanguine that bringing in these institutions will add depth and buoyancy which will lead to better price discovery. Therefore, this should be taken up with urgency and implemented with the regulatory structures in place.
The author is chief economist, CARE Ratings. Views are personal