Objective is to rein in prices of essential commodities
The story so far: Securities & Exchange Board of India (SEBI) on Monday issued directions to stock exchanges in the commodity derivatives segment for immediately suspending trading in derivative contracts in key farm commodities, namely paddy (non-basmati), wheat, chana, mustard seeds and its derivatives, soya bean and its derivatives, crude palm oil and moong for a year.
The derivative contracts in these commodities were already suspended, as per a SEBI statement on August 16 and October 8, respectively.
What are derivative contracts?
Derivative contracts are between two or more parties where the derivative value is based upon an underlying asset, in this case agri commodities.
The prices of the derivatives are established by the price fluctuations of the underlying assets. Derivatives can be traded on an exchange or over the counter (OTC).
How does the system work and what are derivatives trading?
Derivatives trading takes place when traders speculate on the future price of an asset through buying or selling of derivative contracts to maximise profit, as compared to buying the underlying asset outright.
Traders also use derivatives for hedging to minimise risk against an existing position. With derivatives, traders can go short and make profit from falling asset prices. They also use derivatives to hedge against any existing long positions. The ultimate objective is to profit. This is viewed as a deterrent to bring in price discipline in the market.
What does the SEBI order mean?
No new contract will be introduced until further orders. In respect of running contracts, no new position will be allowed to be taken. Only squaring up of position has been allowed. The imports in such commodities, especially edible oils, would reduce in the short term as traders will not have a hedging platform. Hedging, which is speculative in nature, has been made difficult. This will lead to release of blocked local produce supplies into the market, which should cool the prices. Imports of commodities for speculative gains will be discouraged.
What is the objective of the suspension?
It is to rein in rising prices of essential commodities, which are fuelling inflation. India is the world’s biggest importer of vegetable oil and this measure will make it difficult for edible oil importers and traders to transact business since they use Indian exchanges to hedge their risk.
It is believed that speculators have a role in jacking up prices and this needed to be discouraged to curb inflation and support growth as the economy is recovering from COVID-19 impact.
The suspension of trading in these commodities follows a communication from the Department of Economic Affairs, which is closely monitoring price movements.
How alarming is inflation?
As per the RBI governor’s recent monetary policy statement, CPI inflation went up in October to 4.5% from 4.3% in September, after falling sharply between June and September. The persistence of high core inflation (i.e., CPI inflation excluding food and fuel) since June 2020 has been an area of policy concern as input cost pressures could rapidly be transmitted to retail inflation as demand strengthens.
The governor’s assessment is that price pressures may persist in the immediate term. He observed that supply side interventions by the Government had limited the fallout of continuing high international edible oil prices on domestic prices.
While cost-push pressures continue to impinge on core inflation, the inflation prints are likely to be somewhat higher over the rest of the year as base effects turn adverse. However, it is expected that headline inflation will peak in Q4 of 2021-22 and soften thereafter. RBI has projected CPI inflation at 5.3% for FY22.
What is being done to deal with inflation?
Besides suspension of futures trading in key farm commodities by the SEBI, the Government and RBI are resorting to multiple interventions to curb the rising inflation.
Recently, as prices of edible oil hit near record highs, the Union Government substantially reduced taxes on imports of palm, soy and sunflower oil, but the move had limited impact on combating inflation.
The Union and State Governments had also recently reduced excise duty and VAT on petrol and diesel, which was aimed at bringing down inflation by way of direct effects as well as indirect effects operating through fuel and transportation costs.