Budget Expectations: What Commodity Markets want?

23 Jan 2024 , 09:28 AM

COMMODITY MARKET VOLUMES – STORY OF FY23

Talk to any commodity market trading and the standard complaint is about dwindling volumes in the commodity market segment. They are not entirely wrong. A combination of stiff upfront margins and the highly debated commodity transaction tax (CTT) have resulted in two outcomes. Firstly, there has been a sharp fall in commodity volumes in the organized markets. At the same time, traders apprehend that much of the volume shift may have happened to the informal markets. One only has to look at the numbers. 

For FY23, the trading volumes on the NCDEX were down 55% over the previous year. NSE and BSE also saw a fall in the commodity volumes, but they are much smaller contributors to the commodity market volumes. The leader among commodity markets, MCX, saw volumes up 68% in value terms. However, that is largely deceptive as most of the spike came from a rise in the price of gold and oil. However, the average daily turnover still dipped indicating much lower investor participation.

Union Budget 2024-25, presented in February, will be an interim budget. While, it may avoid deep reforms, it can set the tone and agenda for the full budget. Here is what are the key expectations of commodity markets and commodity market traders from Budget 2024-25.

1. INVESTMENTS IN A NATIONAL WAREHOUSING SYSTEM

Today, there is a lack of a coordinated effort to handle the logistics needs of agricultural commodities. The commodity futures market in India signifies a confluence of the physical and the futures & options market. Hence proper warehousing lies at the core of aligning the physical agri commodity markets and the F&O markets. A modern warehousing infrastructure at a national level should include grading and quality certification services. 

Such an infrastructure can have cascading benefits for the commodity markets at multiple levels. This will ensure that farmers get a good price, they are able to sell directly in the futures market and the prices of these commodity do not become too volatile. Normally, when the prices become too volatile, the government is forced to intervene by imposing higher margins or by putting trading limits. That brings us to the second point.

2. SHOULD GOVERNMENT REVISIT TRADING BANS ON COMMODITIES?

It is tough to legislate on such issues, but the markets can be assured by the government that the ban on any commodity from trading would be an extreme step only taken as a last resort. In short, it will be the exception in the commodity markets and not the rule. Currently, several agricultural commodities like wheat, non-basmati paddy, chana, mustard seeds, soya bean, crude palm oil and moong are the commodities under trading ban. 

That really puts off traders as they would not want to get into contracts that stand a chance of being banned. Many commodity traders have pointed out that there has been no proven empirical correlation between commodity trading and commodity inflation. However, each time there is volatility in the price of any commodity, the first casualty ends up being the commodity futures trading. The demand is to make such a ban as a last resort measure, only in very extreme circumstances. Such bans do distort the market mechanism.

3. UNIFICATION OF COMMODITY REGULATION UNDER A SINGLE REGULATOR

Today, there is a major problem of regulatory dichotomy in the commodity futures market. For instance, the trading on the exchanges like NCDEX and MCX of futures and options on various agricultural and other commodities comes under the aegis of SEBI regulation. However, the commodity spot markets are still under the regulation of the respective state governments. That creates a huge gap when commodity futures are settled by delivery. 

The future / option leg of the transaction is conducted under the aegis of the SEBI and the clearing corporations. Hence that process is smooth. However, the settlement of the spot leg of the transaction is still an OTC settlement and that is based on some broad rules and framework prescribed by SEBI (and formerly the FMC). There has been a demand in previous budgets also to unify the regulation (at least with respect to settlement of both legs), so that the process can become smooth and seamless.

4. GOVERNMENT CAN USE PUT OPTION AS OFFICIAL MSP TOOL

The government fixes the minimum support price for all agricultural crops each year. The principle has been to offer the farmer a return of at least 50% after considering all the costs and allocations. This rule has been consistently followed with the result that the farmers are getting a good price for their produce. However, the market expectation is that still better can be done. For instance, the government can devise a mechanism by which they can give support to the farmer by offering the counter party as seller of the put option to farmers. 

Under the scheme,  the farmers can pay a small premium and get a put option to sell at MSP or better. This enables farmers to lock in a price and shield from the risk of price volatility. The farmers should have the option to also sell in the open market if the market price is better than the MSP. Such a tool would not only help farmers to cover price risk, but also ensure that there is an institutional mechanism for delivering the MSP to farmers. This is important because the current crop insurance only covers losses from loss of crops, not the loss due to unremunerative prices. The put option can fill that gap.

5. ALLOWING NRIS INTO COMMODITY MARKET TRADING

Currently, the commodity markets are available for trading only to resident Indians and not to non-resident Indians (NRIs) or to foreign nationals. While it is ok to keep foreign nationals out of the commodity trading circle, it is time that NRIs are allowed into commodity trading. When NRIs are allowed into equities, F&O and mutual funds, there is no reason to not allow them into commodity trading. Most NRIs have been keen to participate in the Indian commodity markets but current regulations do not permit them to do so. 

Allowing NRIs into commodity markets can add more depth and breadth to the commodity markets trading in India. While the government may still keep the NRIs out of the agricultural commodities, the bare minimum that can be initiated in this budget is to permit NRIs to trade in the commodity futures of precious metals, industrial metals, and energy products. That would be a good start to bring greater depth and variety to Indian commodity markets.

6. INVITING PARTICIPATION FROM COMMERCIAL BANKS IN COMMODITY MARKETS

This has been a slightly delicate subject. The RBI has had its own doubts about Indian banks participating in any kind of derivative markets due to the potential of escalating losses. This includes equity F&O, index F&O and commodity F&O. While equity and index F&O may be largely speculative in nature, commodity F&O is a different ball game altogether. Also, commercial banks with exposure to certain commodity sectors in their lending portfolio, would be able to hedge their risk through commodity futures. 

For instance, a good hedge against a trouble airline lending portfolio amidst rising ATF prices is a long call option or futures on crude oil futures. This is a new area which the government can explore with the RBI and start off in a limited way on a test basis. The bottom line is that it not only provides depth to the commodity market, but also brings in a player with substantial hedging sophistication and with the need to use commodity futures to hedge loan portfolios. The participation of banks in commodity derivatives will deepen and widen the derivatives market and encourage more scientific price discovery. 

7. TIME TO ABOLISH THE COMMODITY TRANSACTION TAX (CTT)

When the CTT was introduced in 2013, it was to replicate the success of the STT In equities and F&O. However, the CTT has had the negative impact of reducing the volumes in the organized commodity markets and pushing more of the business into informal markets. That is not a good position to be in and defeats the very purpose of introducing CTT in the first place. Higher cost of transactions has been one of the big roadblocks to the development of commodity market business in India. 

This can be a boon for farmers and warehousers looking to hedge their price risk in agricultural commodities through the use of market traded futures. Hedgers are likely to come back into commodity markets in a big way, if the cost of hedging is sharply reduced. Equity STT is generating over Rs32,000 crore for the government revenues, but the same cannot be said about CTT. The other option is to allow CTT to be treated in the form of TDS and adjusted against the final tax liability of the trader. This can also be a boost.

India has a very modern equity and F&O trading mechanism, but commodity markets are still caught in the crossroads. Perhaps, it may be too optimistic to expect everything to happen in a single budget. The least we can expect is for the Budget 2024-25 to make a small start in this direction!