labels: Confederation of Indian Industry
CTT will hit commodity derivatives market: CII news
18 August 2008

Mumbai: The proposed commodities transaction tax (CTT) would lower the volume of futures trading in the range of 18 to 59 per cent, depending upon the commodities, within a week of its imposition, a study by the Confederation of Indian Industry (CII) found.

.  In a significant empirical study on the impact of Commodity Transaction Tax (CTT) on the volumes of futures trading, the Confederation of Indian Industry (CII) has found that

An empirical analysis of a sample of five major commodities representing a significant share of commodity derivatives market for a period of two years between May 2006 - April 2008 revealed that the maximum decline would be felt in the case of gold (59 per cent), followed by crude oil, (57 per cent), chana (56 per cent), copper (53 per cent), and refined soybean oil (18 per cent) in a short span of seven days. 

In a longer term of two years, the study forecasts a sharper fall in the volumes in the range of 93 per cent (chana) to 36 per cent (copper).      

It may be recalled that the union budget 2008-09 had proposed to levy a CTT of Rs17 per Rs1 lakh worth of commodities traded on commodity exchanges. At present traders on the exchange incur an average transaction cost of about Rs2 per lakh. Hence, imposition of CTT would increase the transaction cost to the extent of more than eight times, the study revealed.

CII has observed that no country in the world levies transaction tax on commodities, and hence when it is implemented in India, there is a fear that it would render domestic futures market uncompetitive vis-a-vis the global markets.

CTT has been proposed on the lines of securities transaction tax (STT) as per the budget announcement (2008-09). Data available on the impact of levy of securities transaction tax in the trading volumes of stock markets across countries indicates a high sensitivity of trading volumes to the transaction costs.

For instance, in Sweden the imposition of STT by 2 per cent in 1986 brought the volumes of the 11 most actively trade Swedish stocks down by as much as 60 per cent in a matter of seven years.  Similarly, in the case of Indian debt markets, the announcement about the imposition of STT made on 9 July 2004 had a dramatic impact on the trading volumes. The average volume, which was Rs4,476 crore during 2003-04 witnessed a sharp fall of 80 per cent to Rs898 crore in 2006-07.

The empirical analysis conducted by CII predicts similar effects in select commodities in derivatives markets, after the imposition of CTT.

The study is based on the same methodology as adopted in the global benchmark studies to analyse the impact of imposition of STT on trading volumes in stock markets.  Turnover is found to be dependent upon the following factors viz. the turnover rate of that respective commodity the previous day, the transaction cost, the Sensex and the T-Bill, and Comdex (Composite Commodities Index).

On the basis of the findings, CII has pointed out that the imposition of CTT would lead to lowering of the trading activity. This in turn would reduce the volume of transaction on the commodity exchanges and hence increase the cost of hedging thereby adversely affecting the process of price discovery.

Globally, the markets for commodity derivatives are considered to be vital instruments of price discovery, price risk management, thereby efficiently allocating resources across different sectors of an economy and providing advance price signals to producers and consumers. This helps them make efficient decisions on production, consumption, and marketing decisions, etc, which have a large bearing on their income and cost.

It was with the same purpose, the Government of India liberalised online trading in commodities since 2003. Trading on commodity futures grew organically since then creating infrastructure consisting of alternative markets, quality testing labs, warehouses, which in turn promoted rural investment, funding on commodities, and additional employment opportunities for the skilled and unskilled alike.

Futures are used as insurance products to cover the risk of price fluctuation. Illiquid market means that the entry and exit cost (impact cost) of the market is higher and, therefore, such futures contract would fail to act as a cost-effective insurance product. The reduced trading interest will also make the commodity markets more volatile, which is the risk a liquid futures market is supposed to eliminate by reducing volatility. The same price signals are then passed on to spot markets, which makes commodities costlier as the traders tend to pass on the costs of bearing the volatility over to the consumers thereby contributing to inflation. Increased volatility will lead to more speculative activities and will make the commodity exchanges to fail in their objectives of price discovery and resource allocation., the CII release said.  

Indian commodity derivative markets which are currently establishing their position on the global map to emerge as 'price setters' in Asian time zone will eventually become uncompetitive thereby resulting in shifting of the commodities futures trade to the unorganized platforms (also known as 'dabba trading' in local parlance) or to the global exchange platforms as commodities are global asset classes. It will eliminate our chances of being 'price setters' and we would always remain 'price takers' much to the disadvantage of the Indian economy. As the Indian economy opens up to currency transactions, the trades will have stronger potential to cross the borders than what has been estimated, leaving the prices of commodities that we consume to be largely determined by international markets, states the study by the confederation, the CII release went on to say.

Finally, if the increase in tax collection is the prime objective of the proposal, the study doubts whether imposition of CTT would facilitate the same. On the contrary, it may prove to be counterproductive for revenue collection due to the decline in trading volumes as has been estimated above, said the CII release.

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CTT will hit commodity derivatives market: CII