Commodity markets have globally clocked greater volumes on global bourses compared with securities. The returns are comparable, if not better at times, with securities while the risk is perceived to be lower. Given that they have been virtually moribund in the country for around 35-40 years, the recent fillip provided by the Ministry for Consumer Affairs and direction given by the Forward Markets Commission augurs well for the market at large. What exactly are the numbers we are looking at?
The numbers registered in FY05, which is the first full year when the national level commodity exchanges have been in operation, were fairly mind-boggling. Aggregate volumes rose from Rs 1300 bn to Rs 5710 bn, which is significant given that a lot of effort was spent in creating awareness of commodity trading by the exchanges. In FY06, volumes increased by a staggering 274% over the previous year to Rs. 21,345 bn and the same momentum has been maintained in 2006-07. Volumes in FY07 were close to Rs 37,000 bn.
The top three National Level Exchanges were amongst the top 20 Commodity Exchanges in the World. This is significant considering that the National Level Exchanges have been in operation only since late 2003. The acceleration in volumes is reflective of the adaptability of the trading community which has been able to adjust to the new state of affairs with promptitude. Also this process has been facilitated by the online trading platforms that are available with the national level exchanges.
We do have various conjectures on the potential of commodity markets in the country, with the numbers ranging from a multiple of 2 to 3 times the size of India's GDP. While the assumptions made and the optimism expressed does vary, the indisputable fact is that there are large volumes to be had given that India is basically a commodity driven economy. Commodities span the spectrum of agricultural, industrial, energy and bullion products. Agriculture and industry in particular have a lot to identify with commodities. The spectre of the oil crisis which is only temporarily stable which means that users of such products would have an incentive to hedge on the exchange platforms.
Commodities have also offered returns to investors in the region of 15-25%, which are comparable with those on equities, with a lower modicum of risk. Therefore, commodities like gold and silver, which have been traditionally investment avenues, continue to be preferred by investors. Other commodities such as Chana, Guar seed, Urad, Wheat, Sugar etc have also provided to be good investment avenues, though it would be necessary to study the markets carefully after doing some research, before taking such decisions.
Further, globally, intangibles such as indices have a major role to play in guiding markets, which however, are not permitted by the domestic regulatory structures. Indices provide a more macro view on the product groups and instead of trading on a single metal; one can take a view on the entire metals group as such. As an extension, weather indices are widely traded overseas as they provide a cover for volumetric risks for the farmers at large. This again would need certain regulatory facilitation before being tradable.
Two significant developments are expected in the near future that will provide a further boost to the markets. The first is corporate participation. Increasingly corporates will be finding hedging on Comexes necessary to buffer themselves from price fluctuations both as users and sellers of various products. Typically, raw materials account for over 50% of the cost of production depending on the industry and could also go up to 90% for some products. Intuitively, one can see that in inflationary times, it does make sense for them to hedge this risk. On the other side, industries in the metals sector are confronted with global vicissitudes wherein prices of steel, copper, lead etc are influenced by international prices too. Under these circumstances companies should ideally be selling part of the products forward on these exchanges so as to assure themselves fixed prices, especially where global influences could have an impact on them.
The second major factor that will have an impact on the growth of the commodity markets would be institutional participation in the form of Mutual Funds, FIIs and Banks. Mutual funds would be interested in trading in commodities too. So, just like we have debt funds or equity funds, we could have commodity funds. This will really help in bringing in the retail customers, who are today totally out of the picture for various reasons. The small investor, it must be remembered in the case of the securities market, did help to grow and develop these markets. Similar growth may be expected when this move fructifies. The same holds for FIIs which have had a definite impact in the securities markets which can be replicated in the commodity space.
Related to Mutual Funds, Banks will make a difference in these markets. The RBI Committee has already indicated that banks would be having a major role to play to bring the farmer to participate on the exchanges. Once this is through, we could really see larger number of farmers participating on the exchanges. Banks would also have an interest in proprietary trading when it comes to covering their own risk which arises when lending to the commodities sector: which includes both agriculture and industry. Agriculture today accounts for around 18% of total lending of banks, while industry has a share of 40-45%. Quite clearly, there is a big credit risk which needs to be covered by the banks because the ability of a borrower to replay would be contingent on the profitability of the entity which in turn, is dependent on commodity price movements. Therefore, any such risk cover should automatically lower their credit risk, which in the medium run can be considered when working out the capital adequacy of banks.
The market today permits only the use of futures as a derivatives instrument, which is a shortcoming as players do not have scope to take advantage of the upside in the movement of prices. Therefore, there is need to have Options on futures in the commodity market, which is under active consideration of the Regulatory authorities. Such an instrument will allow hedgers to take advantage of the spot price at the time of settlement in case it is favourable and forego the premium which has to be paid to exercise this right.
Also, globally, it has been observed that trading in intangibles is significant and what is pertinent here are indices. Indices span not just the physical commodity spectrum such as commodity indices as explained earlier, but also exotic derivative products such as weather indices, freight, carbon emissions and so on.
