A farmer in Kerala's Idukki district said "FM means Farmers' Messiah" immediately after Palaniappan Chidambaram presented this United Progressive Alliance government's last full Union Budget on February 29. Definitely, PC has won over the hearts of millions of farmers across the country with his Budget proposal to waive off Rs 60,000 crore (Rs 600 billion) worth agriculture loans this year.
However, PC's soft approach to the farmers was not visible when it came to the commodities market one of the major factors for the development of agriculture sector in any country. While announcing lots of populist measures in his 'dream Budget', Chidambaram quoted from Indira Gandhi's book: "The more one does, the more one attempts, the more one is capable of doing." This was indeed a precursor to what was to follow as the nation eagerly listened to his speech.
He created a 'first' when he went beyond the recommendations of the R Radhakrishna Committee on Agriculture Indebtedness and announced a massive agricultural loan waiver of Rs 60,000 crore. Even as experts were debating pros and cons of the waiver, came the first-ever announcement in the history of commodity markets anywhere in the world the introduction of Commodity Transaction Tax and this, coupled with service tax imposed on commodity exchanges, was a blow to the nascent commodity Futures industry in the country.
A shocked commodities market was quick to respond. They disputed P Chidambaram's statement that "transactions in commodity Futures have come of age". With one shot the finance minister raised the transaction cost in commodity futures by over 800 per cent. Majority of the volumes in commodity exchanges is created by speculators and arbitrageurs.
With the imposition of CTT, there is no incentive for such people to operate. Hence, the price discovery function, hedging and volumes will not happen in our commodity exchanges, a cross section of commodity players told Commodity Market. Among the first to react to the CTT proposal on Budget day was Jignesh Shah, managing director of Multi-Commodity Exchange of India.
The commodities markets are global assets and trade flows to most efficient markets which have least cost of trading. With the addition of commodities trading tax, Indian market will become unusable for risk management.
"The Budget has added an incidence of 12 per cent service charge and Rs 17 per lakh for commodities trading which will increase the cost by more than 800 per cent. This taxation was introduced in securities market with attendant benefit of long-term capital gains and allowing Futures income loss to be treated as normal business income loss," Jignesh Shah said.
Market regulator Forward Markets Commission also came out with its strong opposition to CTT within 48 hours of the Budget presentation. "CTT will have an adverse impact on the Futures markets. It would virtually kill the growth story of 23 commodity exchanges in the country," B C Khatua, chairman of FMC, said.
Later, he told Commodity Market that CTT was unique and it has not been imposed on any Futures market anywhere in the world. "We have already conveyed our concerns to the finance ministry and agriculture ministry. We still stick to the stand that it is harmful for the growth of India's nascent Futures market in the country," Khatua said.
How CTT will work?
At present commodity trading attracts the following charges: brokerage (0.03 per cent), service tax (12 per cent of brokerage), education cess (3 per cent on service tax), stamp duty (Re 1 per lakh), exchange levy of 0.004 per cent of turnover.
From April 1 onwards, the additional burden to be created are: service tax of 12 per cent on exchange levy, educational cess at 3 per cent of service tax, and a CTT of 0.017 per cent on turnover (Rs 17 per lakh). In addition to this, a buyer of Futures needs to shell out a CTT of 0.125 per cent.
CTT and its impact
Even as reactions continue to pour in against CTT, its real impact will be felt only from April 1 when the new tax comes into effect. With transaction cost rising, it will pave the way for trading in illegal exchanges, according to Biren Vakil, managing director of Paradigm Commodity Advisors, Ahmedabad. At present, RBI regulations permit individuals to invest in securities and derivatives upto $200,000 a year.
That apart, CTT will also lead to illegal trading from India even in overseas exchanges. In fact some of the overseas futures markets are open to investments by foreigners
"The exchanges will see a major drop in volumes this year by as much as 70 per cent. The difference between bid and ask will be widening," S Venkat Raghavan, CEO of Altos Advisor Services Pvt Ltd, Chennai, said. He felt that if the FM refuses to reverse his CTT proposal, he could at least think of introducing different slabs of CTT based on turnover instead of a flat rate proposed now.
"The FM sees CTT as a revenue-raising exercise. He hopes to raise Rs 10,000 crore of revenue this year from CTT. In my view, imposing the tax at this stage when commodity Futures is poised for a take-off will only hamper the market development and dampen its enthusiasm," said Kailash Gupta, managing director of National Multi Commodity Exchange, Ahmedabad.
There are many who feel that with the CTT, the positive impact of many of the progressive initiatives, including granting autonomy to FMC, introduction of options, allowing FDI into commodity exchanges and participation of FIIs, has been derailed.
What will be the short-term, medium and long-term impact of CTT on commodity Futures? Based on interactions with leading commodity players, exchanges and market regulator, Commodity Market has found out that:
- Volumes in commodity exchanges will fall dramatically.
- Jobbers, arbitragers, day traders will be badly hit.
- No major problems for brokerage houses doing long-term business for clients.
- With volumes and speculation falling, it will affect price discovery mechanism, a vital function of Futures markets.
- Business will move to lower transaction cost exchanges abroad, subject to RBI constraints.
- Development of Indian Futures market will be curtailed.
- Impact of service tax on commodity exchange transactions not to have a substantial effect and will be absorbed by the system.
- CTT applies to only online trading, hence business could move to regional exchanges.
The government was, however, bound to introduce CTT because of its potential to generate revenue to the exchequer and create an audit trail. Right now it could generate only Rs 800-cr a year based on the present turnover in commodity exchanges, according to Giby Mathew, director, JRG Securities. He added that as a political decision it shows the government's increasing interest in expanding the commodity Futures markets in line with the equity markets.
The government views this as a good income source because worldwide turnover in commodities market is exceeding the equities market. If it could have implemented in such a way that Commodity Transaction Tax could be set off against income tax liability instead of treating it as a speculative transaction the burden on the commodity players could be set off. Ultimately the increased transaction costs will have to be born by the clients of broking houses.
If implemented in its present form, CTT could be akin to imposing a 55 percent tax on jobbers and hedgers. The Union Budget also lacks clarity on realization of central excise on turnover in commodity exchanges, Mathew added. In some states, it is collected by brokers and passed on to the government, some others don't.
Even sub brokers like Narottam Patel in Rajkot doubted whether the Finance Minister did sufficient homework regarding transaction costs and tax burden in commodity futures exchanges world wide before announcing CTT in the budget.
"This could well mean that the business could go to overseas futures exchanges," he said. Right now Reserve Bank of India rules permit an individual to invest upto $200,000 (Rs 80 lakh) annually in commodity exchanges abroad and for a family of four- the limit is $800,000. Those who are not exercising this option so far may opt for this facility.
What prompted P Chidambaram to introduce CTT was the huge success of Securities Transaction Tax in equities. When STT was imposed on securities transaction, the benefit of tax was given to different classes of investors in lieu of STT, like long-term capital gains tax was exempted and short-term capital gains were taxed at a concessional rate of 10 per cent in place of 30 per cent and in case of business income STT was made adjustable against the tax liability and the profits from derivative securities transaction was declared to be business profit and not speculative, D K Agarwal, chairman and managing director of SMC Comtrade Ltd, Delhi, said.
"But while introducing CTT this logic of giving concession is not followed which is highly illogical and against the spirit of the STT. On one hand government is mulling to allow banks, Mutual Funds, FIs and FIIs to enter commodities market and on the other if CTT is imposed the increased impact cost would act as disincentive for these players to trade in Indian commodity exchanges," Agarwal told Commodity Market.
Jayant Manglik, head, commodities, at Religare Commodities Ltd feels that the FM should bring down CTT to Rs 50 per crore on selling side along with the attendant benefits of flat short-term capital gains tax at 15 per cent as also treating commodity Futures trading losses as business income loss. Having CTT at current level will only harm the commodities Futures industry and lead to de-growth, he told Commodity Market.
Where CTT hurts
Obviously, modeled on STT, the new commodity tax will not affect physical deliveries, only those derivative settlements settled in cash. Right now, majority of the trades do not end up in delivery and is settled in cash. As in STT, CTT is intended to create an audit trail in order to prevent tax evasion. Once a trail is established through CTT, it would help Income-Tax department to check general tax evasion.
Major commodity players have already submitted their memorandum to Union agriculture minister Sharad Pawar and Chidambaram. However, there is no indication that the CTT proposal will be rolled back. As of now, the depression set in due to the Budget proposal still continues and all the players are keeping their fingers crossed.
Ashok Jain, director, Contact India Commodities, Mumbai, said the focus of the government should be on growing the commodity market volumes in the next few years by allowing broader participation at the earliest possible.
"Larger volumes on exchanges should ideally result in reduced cost of transaction for exchanges. The government should look at sharing the transaction charges as levied by exchanges in the ratio it deems fit. This will not only keep the transaction costs under check, it will also result in better compliance and easy administration."
There are those who point out that equities market reacted unfavourably when Securities Transaction Tax was imposed for the first time. However, STT was introduced after equities market had attained a maturity and stature on par with global markets after implementing several reforms and strengthening of Sebi. Through the Union Budget for 2008-09, Chidambaram has proved Indira Gandhi's saying to be true. The more he tries, the more he creates several 'firsts' in his Budget.
How to beat FM on CTT
Just after Chidambaram announced the Commodity Transaction Tax and service tax for commodity exchanges, the commodity players were up in arms.
They said this is unjust and unfair. It will kill the fledgling futures market. Remember how he justified the Fringe Benefit Tax and Minimum Alternative Tax some years back. Perhaps the FM's Harvard training helps in all these efforts. You just can't blame the FM. After all, his job is to raise resources and as pragmatic citizens it is our duty to use expert advice to avoid them. Can the markets beat the FM? That would require creative thinking on the lines of 'what could be' as opposed to 'what is'.
For example, Futures bourse TOCOM can think of opening up their market to Indian commodity players. If indeed their transaction tax is lower, they will be able to attract more business. TOCOM could also become colourful if our chana, nutmeg, chillies and khandsari are added to its tradeable Futures.
Why should TOCOM ignore the Indian market of Rs 30 lakh crore (Rs 3 trillion), the business that is supposedly happening through our commodity markets. So what will happen to our MCX, NCDEX and NMCE? How can they wriggle out of this crisis? Actually, they also need not close down. They can go to greener pastures. Perhaps they can open their subsidiaries in Tokyo, Malaysia, China, Vietnam or elsewhere provided they are allowed to.
Just as Indian, US and European companies started to move towards safer industrial destinations such as China when conditions were not friendly back home, could there be a exodus of Indian commodity business to overseas markets? Again why should such countries forego a wonderful opportunity of tapping into Indian commodity business. As in stock markets, the ratio of retail players to institutional players in commodity markets is also low.
To tap this segment, dedicated mutual funds capable of overseas investment and transactions would crop up. At present, even if arguments against CTT are genuine and convincing they still can't do much if, in the worst case, Chidambaram refuses to revoke his decision. The argument that commodity market growth has been stagnant last year shows that CTT alone is not the culprit.
As they say every crisis creates an opportunity. It is for the global players in commodity markets to examine whether they can creatively respond to the crisis created by the CTT. In the globalised era it is just not capital and goods that need to move freely across boundaries, markets also can. For an investor it matters little whether he puts his money in MCX or TOCOM or Shanghai Futures as far as transaction costs are lower and returns are good. So, exchanges also need not worry whether they make money in their origins or overseas. Will our FM earn more by way of foreign participation in commodity exchanges than through the ill-timed Commodity Transaction Tax?
In January, the Union government came up with an important announcement regarding permitting 49 per cent Foreign Direct Investment in commodity exchanges. Of this, 26 per cent is FDI while 23 per cent is foreign institutional investment (FII).
A single investor can invest only up to five per cent in an entity. This landmark decision was necessitated because of the enormous funds required for the development of Futures market in the country. According to an estimate, huge investments worth around Rs 15,000-20,000 crore (Rs 150-200 billion) are required over the next five years for developing warehouses, grading facilities, market yards and electronic trading platforms.
No sooner the decision was announced the New York Stock Exchange, Goldman Sachs, Merryl Lynch, Citigroup among other majors picked up stakes in our major commodity bourses like MCX and NCDEX. However, Reserve Bank of India regulations do not permit Indians to invest in commodity exchanges or do commodity trading except for a class of importers and exporters who have exposures to relevant commodities.
But many countries have benefited out of opening up of their bourses to foreign trading. Countries like Britain, USA and Singapore have reaped considerable economic benefit from foreign participation in their Futures markets.
According to T V Somanthan's (World Bank) book 'Derivatives', participation in Futures markets has the potential to act as a substantial 'invisible earner' of foreign exchange. "First, assume that foreign participants have, on an average, an aggregate open position (long and short) on Indian Futures markets worth Rs 100x million. This must be accompanied by margin monies of say Rs 10x million.
This sum of Rs 10x million in foreign exchange will permanently remain in India. If world market interest rates are 10 per cent per annum, the annual foreign exchange earnings would be Rs x million.
Secondly, transactions of foreign participants will be carried out through Indian brokers. The brokerage charges, paid in foreign exchange, are invisible earning, besides benefiting the broking community.
Thirdly, Futures contracts are subject to stamp duties, levied by government and other charges levied by the associations.
These amounts would also accrue in foreign exchange. Again, transaction of funds to and from India would involve banking transaction costs, representing yet another foreign exchange earning.
Finally, foreign participation would promote employment in the financial services sector, and help alleviate the country's burden of high educated unemployment'.
However, the model is not so rosy and perfect as it seems. Foreign investors may manipulate the market, move in and out of short and long positions and create volatility. And such foreign transactions should be permitted only if potential benefits outweigh drawbacks.
Somanathan says that the world-wide derivatives explosion of the 1980s and 1990s owed much to the prevailing atmosphere of strong free market policies followed by governments in the United Kingdom and USA and lifting of various controls.
A growing trend in world Futures markets is the fierce competition between different Futures exchanges. The benefit of this is improved convenience and lower cost. In strictly regulated commodity trading environments, there is pressure to ease regulations because they fear loss of business to other countries.What the commodity players and economists want to stress upon is the fact that even without CTT, on a global scale there is competition among Futures exchanges to gain business. CTT will make it even more un-competitive for the Indian commodity exchanges.