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The entire blame on inflation and volatility in commodities is being shouldered by the commodity derivatives market. If these criticism is to be taken at face value, the entire supply-demand fundamentals, marginal cos..

09 Jan 2014

By Sreekumar Raghavan
Inflation is a dreaded word for most policy makers and analysts apart from being a constant worry for India's aam aadmi. However, there is still no clarity as who is the villain in this game: big traders, middlemen, players in commodity derivatives including index investors.

I was just going through a working paper of Reserve Bank of India titled 'Global Liquidity, Financialisation and Commodity Price Inflation' by Kumar Rishabh and Somnath Sharma.

The authors have painstakingly gathered several studies that point to the fact that speculation, execess global liquidity had contributed to high volatility and inflation.

If that is the case then fundamental economic theory of supply, demand and marginal cost principle wouldn't work at all.Financialisation of commodity markets have been blamed for several instances of volatility and inflation in agri,metals and energy complex in recent years.

Several commodity indices notably the S&P GSCI and Dow Jones-AIG Commodity Index tracks the underlying commodity futures prices, the quantity traded equivalent to market capitalisation in equities. Each month managers of funds tracking the GSCI index will sell the contracts of the commodities expiring that month and buy futures contracts for the next month. This process known as the Roll helps investors make money as the contract being sold will be worth more than the contract being bought, according to Kevin Morrison, a leading financial journalist in his book, Living in a Material World: The Commodity Connection (John Wiley and Sons, London, 2008)

However, those who point fingers at commodity futures and options market are often at a loss to explain how commodities that are not in futures trading also witness hyper-inflation. The recent case of Onion in India is a perfect example of this.

"The high commodity prices since the early 2000's up to the latter half of 2008 was due to index investors pouring in money in the commodity futures markets. The subsequent decline in prices occurred as the investors started unwinding their positions in commodities, when the losses in the US housing and other markets became huge and it became necessary for many funds to book their profits to cover losses or provide liquidity for other activities," according to the RBI working paper.

According to those who oppose speculation in commodity derivatives, excessive volatility and inflation in commodities rose from 2000 onwards till 2008. Following the onset of global financial crisis, hedge funds reduced their positions which caused a fall in commodity which were to recover again in 2010.

The huge exposure of investment banks such as JP Morgan, Deutsche Bank, Barclays. Rabo Bank and several others in futures and physical commodities have forced regulators to put tighten rules and make them allocate more capital to cover the losses in proprietary trading. The Volckers Rule which is part of the US Dodd-Frank Act of 2010 are all part of this strategy to rein in banking industry's speculation in commodities.

Many banks had already taken the decision to reduce their exposure to commodity business or sell off following the tighter regulations across the globe. Inherently, there was profit to be made in index investing and control of warehouses in metals and energy. That explains why banks were there in the first place. In some nations, banks and mutual funds aren't allowed to trade in commodities as in India while in US pension funds have huge exposure to commodities through index investing.

According to Kevin Morrison,there have been several attempts to corner markets in crude oil, gold, silver and several agri-commodities in the past and the recent episode of natural gas market manipulation by Amaranth Advisors and its head energy trader Brain Hunter proves that such attempts are short-lived. The buying spree of natural gas contracts by Amaranth may have been responsible for pushing natural gas prices higher but it was short lived and the market reverted back to the price that reflected market conditions.

Many academics acknowledge the rapid growth of emerging economies as one of the reasons for huge growth in commodity demand and prices. However, their criticism of commodity futures and derivatives seem to be quite misplaced. Commodity futures market may not benefit by strong criticism against it but through tighter regulation so that it performs the role of price discovery and hedging in an effective manner. Stock markets and housing markets haven't been immune to speculation and manipulation-- just as the tech bubble in the 2000's caused huge losses for investors, the inherent belief in the goodness of equity markets to raise capital for industry has not diminished at all.

So the next time, some one singularly blames the futures market for volatility and inflation, ask them for data to support it- just as a 'Freakonomist' does. The result would be: Silence.

(The author is Managing Editor/Chief Strategist at Commodity Online Group and is a keen follower of economic debates and trying to make sense of them to readers. He may be contacted at sk@commodityonline.com)

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