The Hindu Business Line : Commodities: Effect of global integration

. The process of economic liberalisation that India adopted in July 1991 meant the gradual dismantling of controls and restrictions on the commodities market. Licensing, storage limits, movement regulation and selective credit control measures of commercial banks had combined to stymie the natural growth of the market until the early 1990s. Foreign trade was highly restrictive with several commodities banned, canalised or restricted for import.

Free trade

Mid-1990s saw a major transformation in the policymakers' approach to the market. Convinced that a free trade environment was the way forward, the government did away with most controls and restrictions that impacted both internal and external trade. On the external front, the long `negative list' of imports was gradually pruned. International pressures, including from many trading partners too, contributed to the opening up.

Quantitative Restrictions (QRs) were removed five years back. This meant a reasonably free trade regime for players in the commodities market. Freedom to trade has resulted in an expansion in trading volumes. Simultaneously, economic growth has translated into higher demand for a large variety of commodities — food, fibre, energy and metals. Therefore, more investment is flowing into production facilities to cater to growing demand.

Global tunes

The net result of the commodity market liberalisation, , is that the domestic market has begun to integrate with the global market. Gone are the days when the Indian market was `inward-looking' and insulated from global influences. Take cotton, for instance. The domestic cotton market was, by and large, insulated from global influences. Players in the domestic market had to look only at domestic demand and supply fundamentals to take a view on prices.

Today, such a simplistic approach may be counter-productive. Market participants have to look not only at domestic demand and supply fundamentals, but also at the global market situation in terms of production, consumption, stocks and trade. An Indian ginner or exporter, for instance, will have know the export surplus in the US; China's import requirement; and what India's competitors are doing. Indeed, in addition to fundamental factors, there are also non-fundamental ones such as the impact of funds and weather on global commodity prices. These factors behave in such a capricious manner and often catche unwary players by surprise. The crude and gold market are highly susceptible to geopolitical concerns. In other words, market-moving factors are wide and varied, all of which have to be tracked closely to operate successfully in the marketplace.

Degrees vary

Though the Indian commodity market is integrating with the world market, the extent of integration varies for different commodities. For example, in the case of gold, the Indian market prices reflect the prices quoted in London and New York — two principal markets for bullion. This is because almost all the country's needs are imported. India produces just about 10 tonnes of gold a year, but the consumption demand is in excess of 800 tonnes. .

For each commodity, the level of market integration varies, depending on the level of imports required to meet domestic needs. For edible oil, India's import dependence is as high as 40 per cent, while for pulses it is 15-20 per cent. Because of the size of the trade, India's policies — especially tariffs — affect global commodity prices.

Liberalised trade environment and integrating markets have no doubt heightened the risk perception. Contrary to general belief, today the price risk in the physical market is much more than it was, say, 20 years ago.

In the1970s and the 1980s, it was easy for traders to go `long' — that is, buy today in the hope of selling later at a higher price. Then, there were chronic shortages, restrictions on trade and inflation, all of which drove prices higher. All that has changed now. If there is a shortage of any commodity, someone promptly imports it and augments supplies. If international market prices are low, they depress domestic prices.

Therefore, to address the issue of heightened risk perception in the marketplace, we need instruments for risk mitigation.

We need a tool for price risk management. Commodity futures trading provides an excellent risk management instrument for market participants.

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