Local Exchanges Can Make Contracts Less Speculative
February 23, 2012 We entered into new era of cotton in 2008 with a price bubble in commodities across the world. The supply and demand scenario wasn’t alarming, but in the second half, of 2008, the asset bubble in financial markets popped and as a result, cotton prices corrected by 60%.
The physical trade was also greatly impacted by the upheaval in the financial markets. Cotton traders faced tsunami-like storms of price movement. Cotton saw record prices in both spot and futures markets in 2011, peaking at $2.43 and $2.27 per pound, respectively, before a 160% correction occurred. These movements are so fast that by the time you realize and adapt to the change, businesses are already hurt badly – if not killed.
Hedging tools that were meant for protection became destructive weapons. Even those companies that do not speculate, but always hedge, have suffered heavily.
The crisis has most likely changed the way business is done for a long time to come. Faith in the derivative instruments for hedging is very low.
The volatility has driven the traditional cotton traders out of business. Innumerable traders defaulted on their contracts. Sharp rallies in cotton prices and hence in its value chain will impact the already dwindling share of cotton in the global fiber use.
But there are several steps that can pave the way forward:
1. Major cotton-growing countries should have their own commodity exchanges to run cotton futures underlining local contracts. Having a local futures contract is necessary to reduce dependence, and thus volatility, on a single global futures contract. Domestic contracts will accurately reflect the local fundamentals and give local players an instrument for hedging. The basis created by these local contracts will have a proper price discovery mechanism and also create opportunities to do arbitrage trading between exchanges. Diversity will also make the contract less speculative. The government of India is encouraging multicommodity exchanges to run cotton futures; countries such as Pakistan, Brazil and Australia should follow suit.
2. The aftermath of the current crisis will change the way physical trade is conducted. Share of spot trade will increase relative to forward trading in total volume. Progressive ginning factories will opt for direct trade with the consumers and as a result, traders’ share will decrease and they will have to adapt to low margins for survival. Consumers, traders, and ginners will learn to run their businesses with low inventories. While this may reduce the risk of default, long-term stability suffers.
3. Governments and banks have realized that volatility in commodity markets cam be very dangerous and unhealthy. In India, bankers have started looking at the end use of borrowed money in addition to scrutinizing the balance sheet. For example, they give concessional rate of interest for exports and manufacturing financing as compared to borrowing for speculation. Globally, there are nations that have begun separating investment banking from traditional banking to reduce the risk to depositors’ money.
4. Make cottonseed a co-product instead of a by-product. Today, the share of cotton seed oil in the total market of edible oil is less than half a percent. Promotion of the cottonseed oil consumption will serve two purposes: Farmers will have a better price realization for their crop and at the same time cost of fiber will be contained, while byproducts like de-oil cake for cattle feed and cotton linters as a raw material for viscose fiber and paper will add value to the product.
5. Cotton research should be funded and strengthened by the cotton community and efforts should be made to improve the quality of cotton and increase ginning output, in addition to seeking higher yields.
Change is the consistent companion of trade and commerce in modern times. Only by managing risk and achieving competitiveness can one remain in the cotton business in the long term.
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