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Deriving the commodity advantage

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V. Shunmugam

"Cars to be dearer soon" is an oft-heard refrain in the media. Such decisions are attributed to the rising input costs, mainly raw materials, such as iron, steel, and copper. Given the indigenisation levels in the auto industry, most of the raw material requirements, such as flat steel, aluminium, and copper, are met by domestic suppliers, whose prices move along global fundamentals.

The same is true for all globally-linked commodities, making industries vulnerable to the increase in raw material costs. Rarely do the domestic automobile/ancillary industries manage their input costs effectively, and neither do their raw-material suppliers, chiefly because of the lack of policy guidelines allowing them to effectively participate in the international markets and, to some extent, lack of awareness.

National exchanges

The establishment of national-level commodity exchanges, which have global tie-ups, provides an alternative platform for industrial users of primary commodities, making access and trading easier.

Major global commodities traded on the Indian commodity exchanges include bullion, copper, aluminium, steel, crude oil, natural gas, and refined soybean oil. The fundamentals of most of these commodities are largely determined by the world supply and demand rather than by domestic developments. Hence, exposure to futures markets with global linkages becomes necessary for users to hedge their risk. This would include participating in exchanges trading in contracts, whose prices are linked to those discovered in the global benchmark exchanges. In the absence of such an arrangement, trading on the exchanges that has the right mix of arbitragers between domestic and global benchmark exchanges should do.

The second option would not be workable due to lack of clear norms for participation in global commodity exchanges, making indirect participation a costlier option for most corporate hedgers.

Effective benchmarks

Benchmarks that could map the Indian commodity derivatives industry among the global markets would include price correlation, volume (including futures multiplier ), bid/ask price spread, and ability to send price signals to the global markets. Price correlation indicates the capability of Indian exchanges to arrive at prices close to the one for that commodity arrived at the global benchmark exchanges.

Volumes are an indicator of how much easier it would be for players to move in and out of the market, and its ratio with the physical market size determines the effectiveness of the futures market to discover efficient prices of the underlying commodities. The depth of the market would make the entry and exit of the participants simpler. The integration of these primary or secondary commodities into the economy as measured by the number of contracts traded per million dollar of GDP would indicate how much deeper the efficient prices discovered on these platforms have pervaded into various sectors.

Good performance

Despite the short history of commodity markets in India, the national level online commodity exchanges have performed well capitalising on the speculative/hedging/arbitraging interests among the business and investing community. This means that the efficiency of price discovery is slowly getting transmitted to the physical market that would lead to increased competitiveness both in the manufacturing and the services sector.

The price correlation in the globally traded commodities, especially that of the metals and the crude oil, indicates that the prices discovered in the Multi Commodity Exchange (MCX - which commanded 60 per cent share for the FY-2006 in the Indian commodities derivatives market) had more than 95 per cent correlation with their international benchmarks indicating that the prices moved in tandem with the international markets, following an efficient combination of domestic and international fundamentals. This makes the domestic online exchanges a cost-effective and superior alternative to their international counterparts. Though the domestic commodity exchanges have covered much ground within three years of introduction of national online trading, the current futures multiplier and the present annual trading volume indicate that there is still a long way to go compared to the international exchanges in the case of base metals. However, the volumes of the domestic exchanges, in particular that of the MCX in bullion, have increased phenomenally in the past three years, making it the fourth largest exchange trading in bullion.

Positive trends

Despite various restrictions to trading in instruments such as options and indexes, and to the participation of the commercial banks, mutual funds, and institutional investors, growth in trading in the Indian commodity exchanges has outstripped that of its global benchmark counterparts. While ascending up the current high-growth trajectory with right global partnerships, the domestic exchanges have also effectively adopted global best practices from the benchmark exchanges to move forward and attain higher levels of efficiency and trading volumes.

In turn, these efficient market places transform the economy's competitiveness and help raise the global competitiveness of Indian companies. This would help India to not only become an efficient global manufacturing hub but also to shore up its performance on the external trade front. While the Indian markets are trying to reach the heights achieved by their global benchmark counterparts, it is essential to have the right mix of players with enough depth and width of liquidity from both the buy and sell sides that can put them in the right place in the global commodity markets map.

Rather than waiting for the volumes to build up to participate in the commodity markets, corporates and physical market players should participate in the commodity exchanges, which would streamline trading by bringing into the market information on the fundamentals and further improving the price discovery process to make it more efficient. This would also bring in corporate best practicesinto the market and fine-tune its functioning.

Given the current trend in globalisation of the economies, competitiveness would remain a major factor for many of these economies to survive in the liberalised trade environment. Competitiveness of an economy not only includes competitiveness of the manufacturing or the services sectors, but would also mean competitive markets, which would lead to competitive products and services being marketed in the world economy.

(The author is Chief Economist, Multi Commodity Exchange of India Ltd, Mumbai. The views are personal and do not reflect those of the organisation.)

(This article was published in the Business Line print edition dated November 17, 2006)
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