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Making the Speculators Pay (a Little)

Decoding India’s Commodity Futures Transaction Tax

by KAVALJIT SINGH

On 28th February 2013, India’s Finance Minister P Chidambaram proposed a transaction tax on the commodity futures trading under the direct tax provisions in the Union Budget 2013-14. The commodity transaction tax (CTT) would be levied at 0.01 percent (Rs.10 for transaction worth Rs.100000). The CTT would be levied only on non-agricultural commodities futures contracts (e.g., gold, copper and oil) traded in the Indian markets. While the agricultural futures contracts would be exempted from CTT. The tax will be payable by the seller of futures contract.

The Finance Minister’s rationale for introducing a CTT is to bring commodity market on par with the securities market where a securities transaction tax is levied. In his Budget speech, Chidambaram stated, “There is no distinction between derivative trading in the securities market and derivative trading in the commodities market, only the underlying asset is different. It is time to introduce CTT in a limited way. Hence, I propose to levy CTT on non-agricultural commodities futures contracts at the same rate as on equity futures, that is at 0.01 percent of the price of the trade. Trading in commodity derivatives will not be considered as a ‘speculative transaction’ and CTT shall be allowed as deduction if the income from such transaction forms part of business income.”[1]

The proposed CTT would come into effect once the Finance Bill is passed by Parliament. After acquiring the assent from President, the government would issue a notification to make the tax operational. This entire process could be completed by May 2013.

India is the second country in the world to introduce a tax on commodity futures trading. In 1993, Taiwan imposed a transaction tax of 0.05 percent on the value of the commodity futures contract.

A Second Attempt

It is not the first time that the government has proposed a commodity transaction tax. In the Budget 2008-09 too, a CTT of 0.017 percent (much higher than the current tax proposal) was proposed. However, due to strong apprehensions expressed by the Prime Minister’s Economic Advisory Council coupled with intense corporate lobbying, the CTT proposal was not implemented and subsequently withdrawn in the next Budget.

It remains to be seen whether the current proposal of levying a CTT would be implemented at all given the intense lobbying by commodity exchanges, traders and their lobby groups against the tax. Just weeks before the Budget, a multi-million rupee advertisement campaign against the CTT was launched by the Associated Chambers of Commerce and Industry of India (ASSOCHAM), Commodity Participants Associations of India and other business lobby groups to ward off any attempt to introduce such a tax. Such lobby groups propagated misleading views through full page advertisements in national dailies and conferences to influence policymakers and public at large against the commodity transaction tax.

The Revenue Potential

During 2011-12, the total size of commodity futures market was Rs.181261 bn (US$3420 bn), registering a compound annual growth rate of 40 percent since its inception in 2003. Futures trade in non-agricultural commodities accounted for nearly 88 percent of the total turnover on Indian commodity exchanges during this period. The futures trading in bullion (gold, silver and platinum contracts) alone accounted for 56 percent of the total market turnover.

Based on the current trading value of non-agricultural commodities in the Indian exchanges, a back-of-the-envelope calculation suggests that the proposed CTT (at 0.01 percent) could fetch Rs.15950 million ($300 million) to cash-starved exchequer every year. This is a substantial amount in the present times when tax revenues are under severe pressure and the government’s attempts to reduce fiscal deficit through other measures are not yielding positive results.

The revenue raised through CTT could be utilized in several ways. Since New Delhi is too much worried over the current fiscal situation, it could use a part of this tax revenue to reduce the fiscal deficit.

Equally importantly, a portion of proceeds of commodity transaction tax should be utilized to enhance the regulatory and supervisory capacities of the Forward Markets Commission (FMC – regulatory authority) which is grossly understaffed and underfunded. The FMC is unable to perform its tasks effectively given the lack of financial and human resources. To carry out effective market surveillance activities, FMC needs better technological tools as well as professionals with domain specialisation. The FMC is unable to recruit talented professionals due to its low remuneration policy. Most of its staff is drawn on the deputation from various government departments.

A part of proceeds could also be deployed to install ticker boards at local markets and post offices across the country displaying commodity futures prices. This would help farmers and producers to access information on a real-time basis in their local languages and benefit from the futures price movement.

Tracking Money Flows

Apart from revenue potential, there are several other justifications for the adoption of a commodity transaction tax in India.

The CTT would enable authorities to track transactions and manipulative activities that undermine market integrity. Currently, large information gaps exist and a centralized database of money flows is almost nonexistent. With the implementation of CTT, the government would be better equipped to track the inflows and outflows of money into the commodity derivatives markets. This could be particularly valuable to the Indian tax authorities as there are no effective mechanisms at place to track the flow of illicit money that it finding its way into the commodity futures markets. The audit trail is considered to be a key factor behind the prevailing opposition against the proposed tax.

Fair and Efficient Revenue Collection

Another key benefit of the CTT lies in its progressive outlook. The CTT would only affect speculators and non-commercial players who often use high-frequency trading to transact a large number of commodity futures contracts at very fast speeds. In contrast, a sales tax is generally considered to be regressive because it disproportionately burdens the poor people.

The opponents cannot ignore the fact that the CTT would be a more efficient revenue source than other taxes. The CTT would be collected by the commodity futures exchanges from the brokers and passed on to the exchequer, thereby enabling the authorities to raise revenue in a neat, transparent and efficient manner.

Will CTT Trigger a Sharp Fall in Futures Trading?

The opponents fear that the proposed tax would lead to a drastic fall in the futures trading volumes. In the initial few weeks, trading volumes in some non-agricultural commodities futures may witness a 5-10 percent decline but given the huge profit opportunities and risk appetite among the trading community, a small levy of 0.01 percent would be quickly absorbed and trading volumes will witness a sharp rebound.

If the trading volumes remain subdued over the next six months, the key factors responsible for the decline would be the adverse price developments in the overseas commodity markets and weak domestic market sentiments. In such an eventuality, the Finance Minister could revisit the transaction tax rate and take other appropriate steps in consultation with the FMC.

However, the proposed tax is unlikely to hit genuine hedgers – consisting of producers, processors and consumers of the underlying commodity – due to their limited participation in the Indian commodity derivatives markets. A small increase in the transaction costs due to CTT would not lead genuine hedgers to flee since they primarily use futures markets for ‘price risk management’ purposes. On the contrary, such market participants may welcome a CTT if it enhances market stability and integrity.

Furthermore, the government is keen to allow banks, mutual funds, insurance companies and institutional investors to trade directly in the Indian commodity derivatives markets. The government is also considering the introduction of new products like commodity options. Both these developments will pave the way for rapid growth in commodity derivatives trading in the coming days.

In 2004, a similar apprehension was expressed when a securities transaction tax (STT) was introduced in the Indian stock markets. At that time, market players had predicted that the introduction of STT would bring Indian stock markets to a standstill and would dry up liquidity. [2] Since its implementation, all apprehensions related to STT have proved erroneous. The introduction of STT had no negative impact on the securities markets which have witnessed tremendous growth in both cash and derivatives segments in the past seven years. At present, the daily turnover in the equity cash segment is around $4 billion while the daily turnover in the derivatives segment is around $30 billion.

Since its introduction, the STT has undergone substantial modification depending on market conditions. During the fiscal year 2011-12, the government’s revenue from STT was Rs.56560 million ($1.06 billion). Even though the STT rates have been drastically reduced in the current Budget proposal, the government aims to raise Rs.67200 million ($1.26 billion) from it in the next fiscal year (2013-14).

Will CTT Promote Illegal ‘Dabba’ Trading?

The opponents fear that the imposition of CTT would shift as much as 90 percent of futures trading ($2705 bn) from commodity exchanges to illegal platform (popularly called ‘Dabba’ trading). “Almost all the business will be lost and trading will shift to Dabba,”[3] argues Venkat Chary, Chairman of Multi Commodity Exchange – country’s largest commodity exchange with a market share of 86 percent of the Indian commodity futures market.

Dabba trading – similar to bucket shops in the US in the 1920s – is a parallel market operating in India without any rules and regulatory oversight. The brokers and speculators illegally place bets on commodities (mostly gold and silver) without paying any fees and settle their transactions in cash outside the exchanges. Since transactions and client details are not reported, Dabba trading is one of the major contributors of unaccounted illicit money in the Indian economy.

But it would be wrong to assume that a tax of 0.01 percent would alone shift futures trading worth $3000 billion to Dabba trading. The opponents need to recognize that Dabba trading in commodity futures has mushroomed across the country over the past ten years in the absence of any transaction tax.

The market observers believe that commodity exchanges have often used the bogey of Dabba trading to advance their self-interest rather than taking action against brokers who indulge in it. There are numerous factors that encourage the growth of Dabba trading in commodity futures and are beyond the scope of this paper.  However, a part of solution lies in better policing and policying to break the nexus between commodity brokers, traders and criminals. The FMC needs more punitive powers to act against commodity brokers and traders involved in such malpractices.

Another widespread fear that the CTT would lead to migration of futures markets to offshore markets is grossly exaggerated. No international exchange can trade in Indian commodity futures contracts without a license from domestic exchanges and approval from concerned regulatory authorities.

The Murky World of India’s Commodity Futures Markets

Over the years, we have witnessed that excessive speculative trading by big players more often than not degenerates into market manipulation. Despite some recent initiatives by FMC, the Indian commodity futures markets remain a fertile ground for price manipulation by rogue traders. As a result, futures markets are unable to perform two primary functions – price discovery and hedging – in a fair, transparent and orderly manner.

The speculators overwhelmingly dominate trading in non-agriculture commodity futures. To illustrate, not a single barrel of crude oil was delivered out of 730 million tonnes crude oil futures contracts (worth Rs.24633 bn/$464 bn) traded at MCX during 2011-12. “Trading in oil and gas futures is almost wholly by pure speculators rather than government-owned oil and gas companies. Ditto is the case with gold and silver. In other words, all these contracts are being traded for the pure kick of making a bet,”[4] says Nidhi Nath Srinivas, Commodities Editor of The Economic Times.

In the Indian futures markets, the price discovery function is largely limited to agricultural commodities. “The prices of gold, silver, crude oil and natural gas are discovered on the exchanges in London, Dubai and New York. Their contracts in India simply mirror the trends in the overseas markets. In fact, if you ignore the currency fluctuation, you will discover perfect co-relation between NYMEX (New York Mercantile Exchange) and MCX prices. So whether trading volumes rise or fall in Mumbai make no difference to the price discovery overseas,” [5] Srinivas adds.

The Guar Futures Trading Scandal

The recent guar trading fiasco reveals how commodity exchanges are acting like casinos for speculators, moving away from their avowed objectives of price discovery and price risk management in an efficient and orderly manner. [6] A speculative buying frenzy (coupled with market manipulation through circular trading) caused unusual price hike in guar futures contracts during October 2011-March 2012. Guar seed and guar gum prices surged 900 percent in the futures markets during this period. There is no denying that strong export demand for guar products pushed up prices initially but a 900 percent price increase cannot be attributed solely to this factor.

In a well orcherested game, big players in the futures markets in collusion with spot market traders managed to hoard a sizeable portion of physical stocks and thereby created an artificial shortage in the spot markets. Savvy speculators managed to circumvent new regulations on positions limits and margins imposed by FMC. Moreover, the guar farmers did not benefit from price hike because they had sold their produce several weeks before prices began spiraling upward in the futures markets. When the new regulatory measures failed to rein in rampant speculative trading, the FMC announced the suspension of futures trading in guar futures contracts in March 2012. After the suspension of trading in futures contracts, the guar prices witnessed a sharp decline in the spot markets.

Speculators Shifting to Agricultural Commodities?

The measure to exempt agricultural commodities from CTT is ostensibly designed to encourage the participation of farmers in the futures markets. However, the unintended consequences of this move could be wide ranging as speculators may shift focus to narrow agricultural commodities (such as cardamom, methna oil and mustard seed) which are more susceptible to price manipulation due to limited domestic production and non-availability of precise and timely data.

As pointed out by G Chandrasekhar, Commodities Editor of The Hindu Businessline, “A blanket exemption could have been avoided. Exemption ought to have been restricted to really essential food crops and products (with high weightage in the consumer price index) such as wheat, sugar, soyabean oil, chana and similar items.” [7]

CTT is not a Panacea

Despite numerous potential benefits, a levy of 0.01 percent alone cannot fix the myriad problems plaguing the Indian commodity futures markets. The CTT should not be viewed as a substitute for effective regulation of futures markets.

If CTT is used in conjunction with other measures (such as strengthening the regulatory and supervisory capacities of FMC, segregating hedgers and non-commercial traders, and encouraging greater participation of farmers and hedgers) it does offer an attractive mechanism to reform the Indian commodity derivatives markets. Hence, the CTT should be part of policy measures to ensure that commodity futures markets function in a fair and orderly manner.

Once implemented, the government needs to constantly monitor and fine-tune the commodity transaction tax in response to rapidly changing market conditions.

In the larger interest of macro economy, the economic and developmental gains of taxing speculative transactions in the commodity futures markets outweigh the private gains of speculators and day traders.

Kavaljit Singh works with Madhyam, a policy research institute based in New Delhi (www.madhyam.org.in).

Notes and References

1 Budget Speech by P Chidambaram, Minister of Finance, Lok Sabha, February 28, 2013. Available at:http://indiabudget.nic.in/bspeecha.asp.

2 For a detailed analysis of securities transaction tax in India, see Kavaljit Singh, Tax Financial Speculation: The Case for a Securities Transaction Tax in India, ASED-PIRC Briefing Paper, February 2001; Kavaljit Singh, “Equitable Equity: India Introduces Securities Transaction Tax,” Mainstream, July 24, 2004; and Kavaljit Singh, “Securities Transaction Tax Disproves All Fears,” October 10, 2004. The papers are available at www.madhyam.org.in.

3 Quoted in “Bourses fear 90% Shift to Dabba Trade,” The Hindu Businessline, February 12, 2013. Available at:http://www.thehindubusinessline.com/markets/commodities/article2885703.ece.

4 Nidhi Nath Srinivas, “Transaction Tax on Big Boys No Big Deal,” The Economic Times, February 4, 2013. Available at: http://blogs.economictimes.indiatimes.com/something-fresh/entry/transaction-tax-on-big-boys-no-big-deal.

5 Ibid.

6 For a detailed account on guar futures trading scandal, see Kavaljit Singh, “Excessive Speculation and Market Manipulation: The Guar Futures Trading Fiasco,” Madhyam Briefing Paper # 8, September 2012. Available at: http://www.madhyam.org.in/admin/tender/Madhyam%20BP%208.pdf.

7 G Chandrasekhar, “Chidambaram has Done a Balancing Act,” The Hindu Businessline, February 28, 2013. Available at: http://www.thehindubusinessline.com/opinion/columns/g-chandrashekhar/chidambaram-has-done-a-balancing-act/article4462663.ece.