While commodity markets in general and commodity derivatives market have existed in India for over 100 years, the official exchange traded mechanism for commodities began as late as 2003. There have been issues of liquidity and issues of multiple regulatory jurisdictions but at least there is a platform for forming a view and trading on commodities. There are some very important functions that commodity markets can perform in the Indian context
Achieve food security through commodity markets
How does the government of India achieve food security through the commodity markets? We recently saw a report about grains worth over Rs.800 crore that were destroyed in Punjab due to bad warehousing. Currently, this is the risk that the farmer is forced to take. These farmers can use the futures market more effectively by selling futures on their grains and locking in a price. This will ensure that farmers are not susceptible to the fluctuations in the prices. Currently, farmers are being hit by weak pulses prices due to oversupply in the Indian market. This can be overcome by selling futures on these pulses at a price that is remunerative for the farmer. In many Western markets, farmers actively use the futures market to hedge their price fluctuation in case of agricultural products.
Greater investment in the agricultural ecosystem
Today one of the big challenges for the agricultural sector is that there is virtual absence of post-harvest infrastructure. As a result, a substantial amount of food grains are lost in the transmission process which worsens the price situation for the end customer without benefiting the farmer. A viable commodity market mechanism will be profitable for the farmer, broker, middleman and the consumer and this will spur greater investments in the agricultural ecosystem in the form of better warehousing systems and improvement transport facilities. Here again a viable commodity market can play a key role in catalyzing the development of this ecosystem.
A mechanism for aggregation and financing
The big challenge in Indian agriculture is that farmers are too small and hence too dispersed. The need of the hour is of an aggregator. Currently, the middlemen play the role of aggregators but then it is not exactly a transparent mechanism. An organized commodity market can play the role of an aggregator of agricultural products more efficiently and more effectively. The market provides an organized and guaranteed mechanism for aggregating and selling agricultural products and small and dispersed farmers can make the best of it. Financing is the second aspect of commodity markets. The commodity markets have an organized and institutional mechanism to raise financing against warehouse receipts. Hence the agriculture sector does not have to depend on unorganized financing.
Retail investors can participate in a new asset class
For long the investment classes for Indian investors had been limited to the traditional gold, real estate, bonds, FDs and equities. While investors have indirectly participated in commodities through the equity market mechanism, they still do not directly participate in commodities as an asset class. The commodity exchange offers an opportunity to small and medium sized investors to actively participate in a new asset class. In the process, they are also able to diversify their concentration risk of the existing asset classes. There is also a wide choice for investors and traders. They can participate in agricultural products or even in precious metals like gold and silver.
Absorbs some of the speculative excesses of the spot market
This is a very important role that the commodity markets play. Let us take the example of gold. A lot of the demand for gold is generated for speculative purposes. Since there is only so much gold that India produces, we rely heavily on gold imports to meet the additional demand. Now gold imports have a major downside. They result in utilization of precious foreign exchange resources without any concomitant productivity benefits. This is more because traders and speculators today prefer to hold on to spot gold. That problem can be resolved with a robust gold futures market as it will absorb most of the speculative demand for gold. In the process, it saves precious forex resources for the Indian economy.
Hedging price and distribution of risk
This is one of the most important functions of the commodity market in that it helps distribute the risk and protects the originator of the risk. Take the case of a jeweler manufacturer who wants to hedge against gold price volatility. The same can be done by selling gold futures and locking in the price. Similarly, an FMCG food products company that wants to hedge against volatility in agricultural products can also use the futures market to hedge their position. What the market does is that the overall risk tends to become granular and more numbers of traders tend to share the risk.
Commodity markets in India are still at a nascent stage and have a long way to go. Having said that; they have an important role to play in discovering the price and hedging the risk of commodities in India.
Role of Commodity Markets In India