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G. Chandrashekhar

Mumbai, Oct. 29 Does the Indian Government stand sufficiently chastened by the ongoing financial crisis that has had its roots in the launch of complex financial derivative products (of which many understand little), rampant leveraging, excessive risk taking and ineffective regulation? Lessons have no doubt emanated from the ongoing turmoil and it appears some of them may have been absorbed by policymakers back home.

Reports quoting the Finance Minister, Mr P. Chidambaram, are a case in point.

Speaking in New Delhi at a banking summit on the north-eastern States earlier this month, the Minister is reported to have said: “A banker can only be a banker. If he tries to be something else, we will face the same crisis as the US and Europe are facing.”

If the Minister is serious about what he reportedly said, there is a message here for the markets, especially commodities market.

In the last 2-3 years, there has been a concerted effort from commodity futures exchanges and brokerages, ably supported by the regulatory authority, to persuade New Delhi to permit commercial banks, mutual funds and foreign institutional investors to trade commodity derivatives.

The push for a policy change actually started sometime in early 2005 when the commodity futures trading volumes were expanding by leaps and bounds, and the exchanges were too keen to rev it up. The demand gained momentum after Reserve Bank of India recommended that these entities be permitted to trade commodity derivatives in order to broaden and deepen the market. Going along with the RBI recommendation, the Forward Market Commission (FMC) too recommended it to the Government.

A note of caution was, however, sounded by Business Line way back in late 2005, saying that participation of banks, MFs and FIIs can potentially distort the market instead of advancing it, as too much money would start chasing commodities in short supplies and result in inflation.

A quote from the article, titled Huge Fund Flow in Commodity Futures Dangerous (November 7, 2005), may be pertinent. Policymakers have to exercise utmost caution in allowing huge (speculative) funds to flow into the commodities (derivatives) sector, especially agricultural goods.

The ground-level problems of farmers have to be addressed in right earnest. The country’s priority is not promotion of futures trading, but strengthening the real economy.

Also, and importantly, it has always been clear that banks in the country, particularly the public sector banks, lacked adequate product and market knowledge to be able to beneficially trade commodity derivatives. It is the good fortune of the country that policymakers went slow on the recommendations of both RBI and FMC. Since 2007, the commodity markets, both physical and derivatives, have been subject to policy risk as the Government felt threatened by unabated inflation caused first by food articles and later by fuel and metals prices.

Events of the past 2-3 months around the world have surely led to introspection among policymakers. Rampant leveraging and lack of due diligence have become the bane of banks and financial institutions. This exactly is what one believes the Finance Minister is cautioning Indian banks against.

To be sure, banks’ dharma is to lend money; it is also expected to be its core competency. Banks have exposure to their customers and not to the commodities their customers deal in. If the lending banks want to be cautious, they must ask the borrowers to hedge their price risk in a futures exchange, and not hedge themselves.

Given the lack of product knowledge and market knowledge among Indian banks and given the huge volatility of commodity markets, these institutions run the risk of losing money rather than safeguard it.

Mr Chidambaram has become wiser after witnessing the global turmoil. Hope those in charge of making the policy for banks and the commodity market heed the Finance Minister’s advice.

More Stories on : Financial Markets | Commodity Markets | Commodity Commentary

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