The previous fiscal year proved to be a contrast in a way. While the year started with banning of a few commodity futures contracts from the national bourses, the year wrapped up with the allowance of FDI / FII investment in commodities sector and amendment of the archaic Forward Contracts Regulation Act.
Proactive measures were also undertaken by the Government to make large allocations for giving autonomy to the Forward Markets Commission and to institutionalise the development of market mechanism, support institutions, capacity building and development of strong forward and backward linkages between markets, producers, traders and consumers.
But in the Union Budget for the financial year 2008-09 in a move to bring the commodity derivatives market under the umbrella of higher tax regime, the finance minister in his budget speech, made three observations. The observations, which are being enacted from the new financial year are, hike in short term capital gains, commodity transactions tax (CTT) and non-availability of the benefit of treating profit or loss from futures as normal business income or loss.
Perhaps measures were taken to bring the commodity and securities markets at par. But we must understand, securities derivatives and commodity derivatives have different genes and are performing different economic utility functions.
In India, the commodity derivatives market is at an embryonic stage. It has been operational on an institutional level for only 5 years now. We have restricted participation in the market and no participation at all from banks, mutual funds, financial institutions and FIIs.
Wider participation
We have not introduced Options contracts, index futures and futures based on intangibles. Therefore, the appropriate approach would be to let the market flourish, enabling all types of instruments and participants and then bring it under a higher tax regime. In retrospect, when the Securities Transaction Tax (STT) was imposed in the equity markets, it was already mature and all types of contracts were available on its platform and there was wider participation by various classes of investors.
Rationalisation measures such as increasing short-term capital gains tax from 10 per cent to 15 per cent will eventually make some of the risk management transactions costlier for groups of assets from which returns are already lower in a differential interest rate and currency regime currently in India vis-a-vis global markets. Particularly, the trading class in the commodity exchanges would find it less attractive to manage their risks through domestic comexes, especially at this stage of the market (compared to the large size of the physical market). Again, commodity markets are global in nature and are comparable with currency markets, where transaction cost sensitivity is severe. Considering this fact, a sudden increase in transaction cost will make commodity markets highly inefficient, dormant and illiquid.
Potential manipulation
For instance, gold, soya, crude oil, sugar, cotton, etc. are traded on various global exchanges. Any cost increase in India will induce hedgers to shift their hedging activity to overseas exchanges or parallel markets on which the government will have no control (which was the status before the ban was lifted in 2003).
Without liquidity, the market prices can be influenced relatively easily with a single transaction, thus leaving it exposed to potential manipulation. Further, without liquidity, market participants would not get an incentive to participate in the market.
In such conditions, participants may have to accept highly unfavourable prices in order to take positions in the market. Finally, liquidity is a prerequisite for effective hedging. Without liquidity, the futures prices of a commodity will not correlate with the underlying cash markets and in these circumstances hedging would become a futile and perhaps expensive waste of resources.
The impact of the CTT can be calculated per Rs1 lakh transaction as follows:
These measures may have an effect on the efforts of the exchanges to bring the market on a more transparent and greater regulatory framework. Also, this action of the Government would create a regulatory arbitrage between national electronic commodity exchanges and regional ring based exchanges and may lead to under reporting of transactions. The “futures” market has recently seen an increase in participation by corporates, who have identified a definite advantage of hedging their price risk in accordance with global best practices. A move like this is going to see an exodus of the same corporates and in its wake would leave us with a structurally weak market system. In a ground breaking research, Euna Shim provides a thorough investigation of conditions necessary for the success of derivatives exchanges across seven countries, her conclusions worth quoting here:
“Macroeconomic stability and government regulations that are favourable to futures trading were almost prerequisites for successful local futures exchanges. Meeting these preconditions, a contract that is significantly different from existing ones or with a large basis risk backed by a large physical market was an essential element for a new exchange to attract a viable level of liquidity.
Financial intermediaries
Even with all these set and subset of conditions, a market could fail if well developed financial intermediaries were not present. Financial intermediaries are the distribution channels of futures markets, and when these channels are blocked, the market extension was hard to accomplish.”
Considering the critical macroeconomic functions that commodity derivative exchanges play in terms of providing price signals for allocating resources efficiently and help participants manage their risks, it is worrisome to note that the triple whammy of service tax, commodity transaction tax and non-availability of the benefit of treating profit or loss from futures as normal business income or loss as in securities market, unless reconsidered, would make the exchanges non-viable in providing the economic utility of risk management and price discovery.
Governments looking at commodity derivatives markets should understand whether their commodity markets offer the potential for a mechanism of price risk transfer and play any development role in the economy, before embarking upon their creation and more importantly, their regulation.
The writers are with the PriceWaterhouse Coopers India. The views expressed are personal. The writers can be reached at chiragra.chakrabarty@in.pwc.com and ankan.mondal@in.pwc.com
