Tuesday, April 22, 2008

Futures Trading in commodities

There is an interesting debate raging in India about the role of futures trading in driving up commodity prices. Many opinion makers, including the vocal left parties in the ruling coalition, allege that forward trading in commodities has played a significant role in raising prices. Faced with mounting pressure to control foodgrain prices, the Government first banned futures contracts in rice, wheat, and pulses. Now there have been calls for banning futures trading in other commodities, including most recently on metals and mnerals.

However, a reality check indicates that these attempts have yielded limited results. The ban on futures trading in foodgrains have had little impact on their prices which have continued to rise unabated. In contrast, sugar and potatoes which are traded in the futures market, have not experienced any rise in prices.

Paul Krugman highlights an interesting observation on the role of speculative trading and the recent commodity price increases. He explains that the high global commodity prices are the result of a huge global demand-supply mismatch, and not the result of any speculative bubble or high interest rates. He has this graph from the World Economic Outlook 2008, which shows how global metal inventories have been declining since mid 2003, even as the prices have been rising.

As Krugman argues, any speculation driven higher futures prices will ultimately result in higher spot prices only if there is a shortage of commodities. In case of speculation this occurs by way of hoarding, which would naturally translate into increase in inventories. But in contrast, inventories have been falling, thereby laying to rest the theories of speculation driven commodity price rise.

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