Why we want to have our own commodity futures market.
An efficient commodity futures market provides producers and consumers not only with correct price signals but also with tools for managing price risk, contributing to the efficient allocation of resources. Mainland China has seen rapid growth in its commodity futures market in recent years, with turnover increasing by more than 300% since 1999. The range of commodity futures products traded has also been expanding. However, recent research by the HKMA suggests that there remains considerable room for improvement in the Mainland's commodity futures market in terms of its price-discovery and risk-transfer functions. Such improvement can only be achieved by increasing the market's breadth and depth, in order words, by further increasing the types of commodity futures products traded and expanding the base of market participants, so that prices on the futures exchanges better reflect changes in demand-and-supply conditions arising from economic activities both within and outside the country.
I believe there are two key considerations in making the functioning and development of the commodity futures market more effective. First, it is important to strike the correct balance between market regulation and market development. From the perspective of Hong Kong's free-market environment, the regulations imposed on the commodity futures market on the Mainland seem somewhat conservative. There are more restrictions on participation in the futures market, and especially on participation by speculators, who are largely institutional investors. Speculators play an important role in facilitating price discovery in a free market, although their speculative activities may sometimes cause market volatility. A market regulator would be happy to see the former but not the latter. Nonetheless, without the participation of speculators, in particular institutional investors, price discovery will not be efficient.
Secondly, the Mainland's commodity futures market is open only to domestic participants because of capital controls, and there is therefore no interaction between domestic and foreign market participants. As a result, the market prices produced by the Mainland's price-discovery mechanism often deviate from those in the international markets. Without adequate interaction, it is invariably the overseas markets that influence the local ones – and therefore local market prices – because the more mature commodity futures markets play a dominant role in the international price discovery of commodity products.
China has now become one of the world's largest producers and consumers of many commodities such as tin, steel, coal and rice, accounting for about one third of world consumption and output. But demand-and-supply conditions on the Mainland do not play a commensurate role in influencing international commodity price formation, let alone defining the rules of the game. This does not help the Mainland's commodity producers and consumers allocate resources effectively or manage risk arising from price volatility, and it is not in the overall interests of the country.
Some people might suggest that one way to increase the Mainland's influence on its commodity futures market is to allow the market participants on the Mainland to "go abroad". They think that China's pricing power can be raised by allowing some large market participants to enter the mature markets in the US and Europe. This is plausible in theory, but experience tells us that "going abroad" may not necessarily be a good thing. I am sure we can all recall recent cases of Mainland companies that have ended up suffering huge losses from trading futures in the international market.
While these cases mainly reflect lack of proper internal risk management and control, on the whole, I believe the effectiveness of the "going abroad" strategy in raising China's commodity pricing power in international markets will be constrained by a number of factors. First, the effectiveness of risk management may be hampered by the time difference. It is not easy for us to obtain the latest information on developments during the business hours of the US and Europe. More importantly, developments in our time zone may not always be accurately, promptly and comprehensively reflected in the US and European markets. As a result, changes in our demand-and-supply conditions may not be able to exert meaningful influence on futures prices. Secondly, our market participants may not fully understand the rules of the game in the overseas markets. Thirdly, different legal systems in different jurisdictions may result in legal risk. Fourthly, lack of familiarity with the overseas market environment may lead to various kinds of operational risk. Fifthly, participation in the US and European markets by our institutional and individual investors is limited because of the relatively high cost of trading. This is an obstacle to our local market conditions being fully reflected in the price discovery process.
There is a Cantonese saying, "the fierce tiger is inferior to the local worm", which essentially highlights the importance of home-court advantage. It is certainly good to "go abroad" to gain some experience, but we can greatly improve efficiency and risk management if we have our own "home court", in the shape of a commodity futures market located in our own time zone, in our own territory, in an environment that is familiar to us, and following rules of the game that we determine. The market will then be able to reflect significant developments in our time zone, and especially the demand-and-supply conditions in China. I will talk about Hong Kong's role in developing China's commodity futures market next week.
Joseph Yam
22 March 2007
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