The Hindu Business Line : Commodities Transaction Tax — Why it could lead to greater volatility

The imposition of commodities transaction tax will add to the cost of transactions in all these commodities, including those having a modicum of liquidity, with serious adverse consequences.

M. R. Mayya

Recently, the Finance Minister stated that the Government would take a call on the date notifying the CTT, adding that, at least in the first year, it is not intended to be a great revenue-earning measure.

The CTT proposed is Rs 17 on a transaction of Rs 1 lakh. Mr Chidambaram’s statement that “commodities futures have come of age” is not really correct. India had a flourishing futures market in commodities in the late 1950s, duly regu lated by the Forward Markets Commission (FMC) under the Securities Contracts (Regulation) Act 1952.

The border clashes with China in 1962, followed by severe drought conditions in the country in the mid-1960s, led to the imposition of a ban on all commodities, one after the other, excepting a few export-oriented commodities such as lime, pepper, castor oil and turmeric.

Recommendations of Expert Committees

Three expert committees appointed by the Government went into the question of the desirability or otherwise of permitting futures trading in commodities.

The Dantawala Committee, which submitted its report in the mid-1960s, strongly favoured resumption of futures trading.

So did the Khusro Committee, which examined this question once again; its report, submitted in 1984, made a strong case in favour of futures markets in commodities.

Yet another committee was appointed by the Government under the chairmanship of Kamalanayan Kabra (of which I was a member). This Committee, after long hours of deliberations, observed in its Report submitted in 1994 that futures markets have a positive role to play in a market economy and, as such, futures trading should be resumed.

In spite of favourable recommendations by all the expert committees, the Government took nearly four decades to resume futures trading in commodities, and that too after proddings by the World Bank.

Futures trading in commodity markets resumed about four to five years ago, under the ever vigilant eyes of the Forward Markets Commission.

The Commission misses no opportunity to ensure that the culprits involved in malpractices such as violation of regulatory provisions, manipulation of prices, and so on, are duly punished. Yet a ban was imposed on futures trading in rice, wheat, tur and urad in January 2007.

Again, in May 2008, four more commodities — chana, soya oil, rubber and potato — came under the ban following clamour by the Left parties, which citied rising inflation as the reason, conveniently forgetting that China, which is facing a higher level of inflation, has flourishing markets, even in sensitive mass consumption commodities such as wheat, sugar, soyabean, soyabean oil, corn, rapeseed oil, green beans, palm oil, barley, cotton and fuel, not to speak of such other commodities as copper, aluminium, natural rubber, etc.

The movement of prices of banned commodities in a span of one month (which can be a barometer to judge impact of futures trading on prices) has already indicated that, excepting urad and potato, prices of the other six commodities have risen further after the ban.

Cost of Transaction

Although futures trading is conducted in a number of commodities, breadth and depth of the market is observed in hardly half dozen commodities, while the markets are narrow and not quite liquid in all other commodities.

Transaction costs are already high, in terms of impact cost — the spread between the bids and offers — and brokerage, service tax and stamp duty.

The imposition of CTT will add to the cost of transactions in all these commodities, including those having a modicum of liquidity, with serious adverse consequences.

Instead of “bringing some order and reducing volatility in the markets”, as claimed by the Finance Minster, there will be higher volatility due to shrinking volumes if CTT is imposed.

According to an expert study conducted by two eminent IMF economists, Karl Habermier and Andrei Kirilenko, “transaction taxes or such equivalents as capital controls can have negative effects on price discovery, volatility and liquidity and lead to a reduction in the informational efficiency of markets.”

The study also points out that “if trading becomes costly, as a result of transaction taxes, dealers cannot manage their risks effectively”.

The impact of the levy on day-traders, arbitrageurs and jobbers, who constitute the backbone of the market and provide it liquidity, constantly buying and selling at small bulges in prices, would be serious. Not only would the spreads widen, but the volatility of the market would also increase.

It also needs to be noted that the Food and Agriculture Minster, Mr Sharad Pawar, under whom the commodity markets function, and the regulatory body, the FMC, have strongly opposed the levy of the CTT.

Any further levy on commodity futures, liquidity in which is yet to develop sufficiently, can and will lead to driving the market outside the country to those who understand the intricacies of cross-border trading and who continuously arbitrage their operations round the global markets.

Many of those, if not all, who confine their operations to the domestic market, will switch to the underground illegal markets, popularly known as ‘dabbas’ operating sans prudential norms, margins, etc., which protect the safety and integrity of the operations in regulated futures markets.

(The author is a former Executive Director of the Bombay Stock Exchange.)