Look Beyond Annual Contracts in Commodity Buying

The prices of key commodities (raw materials) such as milk, palm oil (for soaps), coffee and copra (for hair oil) have risen in the past one year with a volatility that will strain the margins of many FMCG firms. These companies need predictability in the flow of raw materials and stable prices to remain competitive. They have extensive exposure on the buying side but far less volatility on the selling side because terms and prices generally cannot be linked to the material price spread. MNCs in the FMCG segment have taken brand building, distribution, product innovation and marketing to a very sophisticated level while they have kept commodity sourcing (under volatile conditions) out of the strategic game plan. 

Before the economic crisis, raw material prices knew only one direction: upwards. Now the situation has changed. They go up and down in an irregular fashion and without any discernible pattern (for example, tomato and onions, which are raw material for ketchups). Traditional commodity management had relied extensively on procurement via strategic sourcing and this was primarily viewed as a means to lower raw material costs. Companies may also use financial hedges to smoothen price volatility, a practice that can actually inflate average cost due to the cost of the hedges. 

Some large Indian companies which started operations during the last ten years in the FMCG segment are more aligned to handle the volatility of prices. The centrepiece of the approach is the integration of procurement and sales activities to help manage the net exposure. 

The Indian FMCG sector has a market size in excess of 1.3 trillion. It has a strong MNC presence (P&G, Levers and Reckitt Benckiser) which is characterised by a well-established distribution network and intense competition. Most of these companies’ positioning are still based on consumer behaviour. The commodity price volatility has resulted this orientation to be relooked at. 

More often than not, an enterprise approach to managing raw material risk varies from ad- hoc to intuitive to unstructured approaches in a majority of the cases. This has resulted in managements often committing mistakes when it comes to managing commodity (raw material)risks or finding themselves uncertain and lost when it comes to building resilient business strategies around the sourcing models. Moreover, with the exception of sugar and wheat, none of the commodities that are consumed by the FMCG sector can be hedged on the futures. That too with the sword of ‘sudden contract bans’ hanging on the head. 

On the flip side, successful enterprises of India today have adopted a more structured approach that encourages their management’s confidence in an integrated trading model. Facing increasing commodity volatility, companies must move away from rigid and fixed systems. Annual contracts are no longer appropriate or up-to-date with the currently volatile raw material cost. In a dynamic cost environment, market prices instead of annual contracts will allow companies to quickly and accurately assess the price opportunities and adapt prices accordingly.

Published in The Economic Times

Commodities are in the blood for a few communities

Commodity markets are routinely regarded as fundamental economic institutions and the long-standing and quite varied ethnic and linguistic perspectives on traders are often overlooked.

In market yards, one often encounters enquiries about one’s community and the place of origin after the initial introduction. Further, on exploring the softer dimensions of trade, one can observe a subtle ‘in-group’ favouritism. It seems to point towards a tacit understanding or norms about how to treat members from the same community.

Traditional trading communities in India have been dominated by Aggarwals and Guptas of the north, Chettiars and Nadars of the south, Gujarati Jains and Baniyas, Muslim Khojas and Memon in the West and Marwaris all over India. People from these trading communities are not only seen to be very good at getting the best deal in negotiations but are also known to honour a contract since they know the importance of business more than any professional in the trade. 

The commodity market exists on the cusp of informal sectors of society and regulated markets. In many countries around the world, specific subgroups of the population carry a reputation for being particularly adept at running commodity trading. For example, the Jews in the bullion trade.

While a large number of communities are part of the market, one can always find trading traditions in India finding its roots in the practices of the Baniya and Vaishya communities. The predominance of a community can also be observed in a particular geography. One should not be surprised to see a large number of Kutchies (from Gujarat) trading pepper in the heartland of Cochin’s Jewish Town. They are a vibrant community which has managed to assimilate fully with the local culture while retaining its identity. The ethnic and linguistic identity continues to determine the basis of trade, albeit in a different way. Commodity traders also operate in mutually interactive community networks with ethnic, religious, family or linguistic ties with an opportunistic concentration towards profit. In this respect, the trading habits of Indians are not very different from those of Chinese and Arab traders. The Nadars are expert traders mainly located in south India. In Calicut, they have a belief that whatever they earn in Calicut is spent their itself. This is expressed in their saying in Tamil: Kallikkottai kaashu Kallai paalam thaandaathu(money earned in Calicut will not cross Kallai bridge.) It may not always be the case.

There is a possibility that different ethnic groups might disproportionally adopt commodity trading not because of a comparative advantage in that occupation but because of differential access to other opportunities (or lack thereof) for the group. At times, these trading communities pay for protection and market access and have found conducive freedom to trade. Whenever the protection becomes too expensive, they usually have the leeway for moving elsewhere (for example, Assam and Bihar).

Approaches to commodity markets have often focussed on the formal properties of transaction systems as frameworks for organising behaviour. However, within wider ethnographic contexts characterised not only by economic exchanges, ‘community arenas’ act as nodes of information flow. The transfer of trust is crucial to minimise transaction costs in a market that is characterised by moving commodities over long distances and delayed payment (seller’s credit).

Sometimes, the specificity of the market environment equally facilitates the use of ethnicity for commercial purposes such as the delimitation of market niches. 

Published in The Economic Times

There can’t be a bigger farce than tendering

Commodities worth billions of dollar are transacted all over the world through tenders, which look transparent yet remain citadels of corruption. There cannot be a bigger farce in the transaction economy than a tendering process in the 21st century.

From presidents of various countries to a peon of a government department, everyone knows that the tender system is corrupt, farce and irrelevant. Then why are we continuing with such a system? The system of tendering has gratified the greed of so many powerful and influential persons all over the world (including international multilateral institutions) that an alternative transaction mechanism of commodities and services has not been allowed to emerge.

In times of crisis, government has encouraged import tenders (for pulses and edible oil) through public sector undertakings. While the process has remained transparent, the collusive practices of the supplier have caused price bids to remain at a high level. Army procurement, crude procurement by oil companies, state civil supplies, Commonwealth Games and NHAI all work under a tender system, which has become useless over the years. Not only crores of rupees are lost by way of suboptimal price discovery, the corrupt goes scot-free while honest officials (at times) gets embroiled in false charges. Transnational companies in commodity-rich African countries have developed it into an art form where tender processes are always followed but spirit is suffocated.

The objective of any transaction is to achieve the best price at that point of time. However, the tender process has focussed more on the objectives of accountability (in the spending of public money) and transparency (in the steps of the decision-making processes). A best available price in the real world cannot be ascertained. If the best price cannot be ascertained, then the loss to the exchequer cannot also be conclusively proven. Government procurement is often carried out by the process of tendering. Commodities do not work on a fixed price and therefore the 1991-92 case of palmolein oil import in Kerala was a game of oneupmanship to score a political point rather than addressing a fundamental issue.

The guidelines of the Central Vigilance Commission (CVC) on the tendering process make an interesting reading. It says “as post-tender negotiations could often be a source of corruption, it is directed that there should be no post-tender negotiations with L-1, except in certain exceptional situations.” Nothing wrong except that the guideline forgets that the cornerstone of price discovery is the interactions that take place between sellers and buyers.

In actual life, an inadequate knowledge of the available commodities or services is made up for by the experience with the persons or firms supplying them are one of the most important facts which enable one to solve the immediate problems. The function of competition is here to teach who will serve well: which company and which supplier. Thus tender conditions are often made to suit those who are actually known. On the other side, these companies will ensure that the pre-bid conditions are also made to suit their own interest.

Gigabytes of guidelines have been written on corrupt, coercive and collusive practices in the tendering process and its prevention. Generally, trustees (officials) of the tendering process have tried to ensure the process is followed in letter and the fundamentals of price discovery are conveniently ignored. This has caused corruption to multiply but can never be proven. In recent times, this outmoded method of transaction has been improved by E-tendering and E-auction. Though the change in the bidding process has improved, some of the transparency issues and the methodology of transaction remain irrelevant. Simple corruption has also given way to E-corruption. 

Published in the Economic Times

Trade-based money laundering on the rise

The term ‘money laundering’ is said to have originated from mafia ownership of Laundromats in the US. Gangsters there were earning huge sums in cash by extortion, prostitution, gambling and bootleg liquor. They needed to show a legitimate source for these monies. 

Money launderers now resort to the use of apparently legitimate commercial transactions to camouflage their laundering activities. There has been an increasing amount of interest of late in commodity trade-based money laundering. Deception is the heart of money laundering. This is being increasingly used to move the cash proceeds through a process by which the transactions appear very genuine. 

Commodity trade-based money laundering has been growing as an alternative remittance system that allows illegal and unaccounted money with an opportunity to earn and move the proceeds disguised as legitimate trade. Increasingly, the domestic commodity trade is being used for bribing politically exposed persons (PEP) and government officials. 

In India, sometimes the task is achieved by purchasing commodities (above the market price - ‘placement’) from a so-called genuine supplier (often a conduit of PEP or relatives of officials), transferring them to another entity where the commodity is sold (‘layering’) and the proceeds are remitted to the intended recipient (‘integration’). The large companies (with bigger reputation and brands) sometimes use the channels to oblige the powerful. Since the size is often small compared to other genuine transactions, this never gets discovered. 

Trade flow volumes have increased significantly as a result of globalisation. An Exchangebased transaction in India is also showing double digit growth. Such large trade flows and paper trade growth provide ample channel, through which transactions can be obscured due to the presence of complex transactional structures and co-mingling of illicit funds with the cash flows of a legitimate business. 

Global trade is used by larger criminal and terrorist organizations to move value around the world through complex and sometimes confusing documentation that is frequently associated with legitimate trade transactions. The illicit trades are often blended in with legitimate ones, which make them difficult to single out and the source of their funding hard to trace. The scope and prevalence of the practice is tough to determine with any precision, but it is clearly on the rise. Values have moved through this process by false-invoicing, over invoicing and under-invoicing commodities that are transacted in the domestic market (no more restricted to imported or exported commodities). 

Relaxed oversights by domestic authorities along with weak procedures to inspect goods and register legal entities provide sufficient opportunity for such activities. Moreover, inadequate information technology systems and lack of adequate coordination and cooperation between regulators often lead to misuse by the launderers. 

As money laundering methods become complex and sophisticated, it is necessary that agencies, authorities, investigators and prosecutors alike should equip themselves with the evolving knowledge of money laundering typologies. Instead of just issuing instructions to abide by PMLA (Prevention of Money Laundering Act, 2002), the regulators must equip themselves with the market-based forensic knowledge of such activities. 

Investigations have shown that one of the most effective ways to identify instances of trade-based money laundering is through trade data for anomalies that would only be apparent by examining both sides of a trade transaction. Sometimes commodities being traded do not match the business involved and on other occasions, false reporting provides adequate indicators of trade-based money laundering. 

Published in The Economic Times

More time needed to clear confusion on warehouse receipts

Two terminologies — commodities demat and negotiable warehouse receipt — in the commodities market has created more confusion in the last seven years than in any participatory facilitation. 

The jargons have led the market to a state of confusion because these are perceived more as “insurance policies” underwritten by an exchange and the warehouseman (as applicable) for the users rather than instruments of facilitation. 

Brokers and investors are confused about “commodity demat” as they often draw a parallel to the seamless stock market functioning. In case of commodity demat, the mere act of recordkeeping in the electronic form has not conferred the qualifications of “security” on the commodity. The statute of “security” to the demat commodity has remained elusive under the Depository Act. Therefore, the funding of a demat commodity has conferred an inferior legal protection on the lender when compared to the demat funding of stocks. 

On the other hand, a warehouse receipt (WHR) is not negotiable under the common law. A WHR is an instrument issued by a warehouseman, reciting receipt of certain goods therein described and evidencing the contract between the parties along with the details of warehousing. What is being envisaged (however, not yet grasped) under the WDRA Act, 2007, is to confer on the document in a certain way the same sort of limited and peculiar negotiability which is possessed by a bill of lading. 

A WHR can only be an evidence to the title of the goods and not a promise to pay while a “negotiable instrument” means paper evidencing a debt ultimately reducible to money and not calling for the delivery of other property. 

The law regarding the document of title is trying to borrow the feature of negotiability from the law of negotiable instruments but it must always be remembered that the two classes of instruments — negotiable instruments on one hand and documents of title on the other — must in certain respects be different and be governed as they are today by entirely different bodies of law. 

The negotiable instrument is a promise to pay or an order to pay money while a document of title calls for delivery by a bailee (warehouseman) of certain particular goods. It is better to keep this thought in mind that a warehouse receipt is a document of title not a negotiable instrument and that there is a separate body of law governing each. 

If at all, WHR becomes negotiable, it will pass greater freedom from hand to hand chiefly by the reason of the fact that the transferee thereof does not need to notify the bailee (warehouseman) of his acquisition of title while a transferee of an assignable document of title (WHR) acquires no rights against the bailee except by giving notice.

By assigning negotiability on WHR will not provide the document with a status of “negotiable instrument” but can be referred as a “negotiable document of title”. It is going to take a while before the cloud of confusion is removed and we see a clear blue sky on the commodity horizon in India. 

People asking questions lost in confusion,

Well I tell them there’s no problem, Only solutions,

I’m just sitting here watching the wheels go round and round,

I really love to watch them roll, No longer riding on the merry-go-round, 

— John Lennon’s ‘Watching the Wheels’ 

Published in The Economic Times

Corporates’ farm land buy a cause of serious concern

When missionaries came to Africa,

They had the Bible and we had the land

They said, “Let us pray” We closed our eyes.

When we opened them

We had the Bible and they had the land.

 — Bishop Desmond Tutu

AGRICULTURAL land around the world has become a new magnet for speculative financial flows. ‘Efficiency, wastage reduction and supply chain bottlenecks’ have become latest gospels to grab land. Soaring farmland values have generated new investment vehicles and increased participation in existing vehicles by institutional investors.

With food prices rising again, interest in farmland is on the rise. The private investors believe the trend will continue, given that the world needs to increase food production by 70% by 2050 to feed a rising and wealthier population.

The influx of financial investment into agricultural land is global. A few years back, agrifood giant Louis Dreyfus Commodities raised $65 million for Aclyx Agro Ltd, its vehicle established to buy, operate and sell land in Latin America (chiefly Brazil). The influx gained notoriety after an attempt in 2008 by South Korea’s Daewoo Logistics to secure a large chunk of land in Madagascar for a very low price and vague promises of investment.

In India, land banks are also being created. Driven by the huge opportunities, Indian corporations too are aggressively expanding into the agriculture and retail sector (both with the ultimate objective of land bank). In a few states, pitch for APMC land by a few corporates has already been made in the name of “modernization”.

The cause for concern is that this is happening without a proper regulatory framework and lack of comprehensive understanding of the likely impact on agriculture in general. Agriculture, land use, real estate, tax and labour policies and laws are being changed to facilitate the entry and growth of big corporate agencies into agriculture and retail.

Under the financial imperatives, firms in the food processing and agricultural service sector have essentially become bundle of assets to be deployed or redeployed depending on the short-run rates of returns that can be earned. Investors in the food processing and agricultural services sectors are now demanding rates of return equal to those obtainable in global financial and stock markets at the rates unthinkable even a decade ago. In the absence of a high operating margin, the land valuation game is being played.

Agricultural service sector has already moved into the “high cost” trajectory. Prices of agricultural products are in a long-term upward trend due to factors like increasing land cost and high input cost (e.g. fertilizer price driven by crude). It is likely to go up even further, with further pumping of private funds into agriculture, food processing industry, warehousing and agriculture infrastructure. Productivity continues to grow but wages no longer keep pace with profits and productivity. Focus has shifted from increasing productivity to deployment and distribution.

While we don’t have the luxury of philosophizing about food, the bottleneck in food supply chain is the latest whipping boy of the government to be blamed for the price rise. Under the grab of the supply chain bottlenecks, large investments are likely to be approved in the coming months which will benefit a selected few with incentives (subsidies) and the land bank creation opportunities. First it was the floods of North and now it is the food price rise which is being cited as the reason for the need for increased investment.

While there is a need ‘it is only going to benefit a selected few with policy incentives. Mark Twain once said “buy land, they’re not making it any more” and it seems that corporate and private investors share his view. 

Published in The Economic Times

Latest surveillance systems a must to check price spikes

Every now and then, it is fashionable to talk of market manipulation and how some traders (hoarders in Indian context) have “rigged” the market to favour themselves and to fleece the average investor or consumer. 

We are now witnessing with a yo-yo like price movement in the precious metal market - a playback of crude spike of 2007 but this time it is silver. You are bound to hear of three types of talk: 

•We have consumed nearly all the silver in the world

•We continue to consume more than we mine 

•Never before have conditions like today ever existed 

Let’s break down a logical fallacy. If we assume that the presence of market manipulation in commodities makes it impossible to forecast price trends (or at least makes it impossible to follow basic trends through a reasoned strategy), we have to assume that dabbling in any commodity category is a waste of time and money and should be completely avoided. Why is this true? Any asset worth investing at any given time is under manipulation. That’s right: manipulation is actually a normal phenomenon without which a smooth-functioning, trending market environment would be impossible. 

Market manipulation is a practice in which people engage in activities which interfere with the normal operations of the market. Many nations have only a loose definition of market manipulation because it is sometimes difficult to point specific manipulative behaviors but people can still track manipulative activities and see the influence manipulation can have on the market. These practices are illegal in many regions of the world, although sometimes it can be difficult to distinguish between normal activities and market manipulation. 

This brings us to a basic question: if manipulation is normal and the regulator exists only in times of normalcy, do we actually need a commodity regulator? 

In its 36-year history, even a regulator like the US Commodity Futures Trading Commission (CFTC) has successfully prosecuted and won only one manipulation case in the commodities markets. In the past, CFTC had to prove that an individual intended to manipulate prices and evidence was often difficult to find through e-mails or phone calls. It also had to show that the person had the market power to move the price of a commodity and that the trader caused a price in the market that otherwise would not have occurred. 

The recently-passed Dodd Frank Act has changed some of these in the US. The CFTC will now only have to show that a trader acted in a manner which had the potential to disrupt the market, making it easier to prove the case. The Dodd-Frank Act also requires the CFTC to ban certain trading practices that include “banging the close” and “spoofing.” 

“Banging the close” refers to the practice of acquiring a substantial position leading up to the closing period, followed by offsetting the position before the end of trading for the purpose of attempting to manipulate prices. “Spoofing” is where a trader makes bids or offers but cancels them before execution (widely prevalent practice in India). 

In India, we do not have legislative support against price manipulators and the controlling systems are also not pro-active information-based. 

Market intelligence and price monitoring are being rigorously pursued in a large number of countries. Our systems are often police-like (with raids following a price rise). The monitoring systems are reactive rather than price surveillance-based. A transformation from a reactive to a surveillance-based system shall require efforts and commitment, both at the central and state levels. 

Internal compliance and surveillance teams of ministries should arm themselves with tools and metrics that are at least as rigorous as those used by technology-savvy regulators. Finding the appropriate mix of risk-based, price-based and activity-based screeners are essential. 

For Indian regulators, it may not reasonable and feasible to focus on every market and every trader every day. However a risk-based approach to price data screening can increase the likelihood that compliance and surveillance teams are alerted to potential issues and reduce the surprises of price manipulations. 

Published in The Economic Times