By Rakesh Gupta and Di Mo    Source: Global Times    Published: 2015-10-13

Following the continued success of market models in China - especially the stock markets and, more recently, the commodities markets - President Xi Jinping announced the introduction of an emissions trading scheme during his visit to the US last month. This trading system will be based on a cap and trade mechanism, which is widely regarded as the best mechanism for reducing emissions.

While most people in China have a reasonable understanding of how the stock markets work, the general investing public is less aware of the introduction of commodity markets (or exchanges) in China. Several commodities exchanges were set up in the early 1990s with the objective of providing derivative contracts to hedge risk in the commodity markets. This was especially attractive for producers (e.g. farmers) and traders who were importing or exporting commodities, because it allowed them to hedge the risk of future changes in commodity prices and currency exchange rates affecting international traders.

Commodity exchanges in China were later reorganized into three main commodity derivatives exchanges: the Shanghai, Zhengzhou and Dalian commodity exchanges. Most commodities are represented on these exchanges via futures contracts that expire at a fixed time in the future. After twenty years of development, Chinese commodity futures are now playing an important role in global commodity markets. Recent drops in commodity prices may have been influenced by China`s economic slowdown and the cooling of demand for commodities.

In theory, the value of derivative prices depends on the spot prices of the underlying commodities, and the flow of information should be bilateral. In the global economic environment, there is a strong link between commodity futures in China and the commodity futures traded in US markets. Although the Chinese commodity futures market doesn`t allow international trading, Chinese investors can trade globally to hedge price risks in commodities. China`s commodity markets are, however, subject to government intervention, which may create a moral hazard for market participants and encourage the development of parallel unofficial commodities markets.

When the Chinese government believes the prices of commodities to be either too low or too high, it interferes in the spot market. However, if futures prices are much higher than the government-mandated spot prices, market participants may choose to trade outside the market, thus giving rise to an unofficial market (a black or gray market) in the affected commodities.

The general understanding that the government will intervene and support prices gives rise to an implicit guarantee for market participants, exonerating them from having to individually assess risk in the market. This simultaneously creates potential for the development of an unofficial market for any commodities that are improperly priced in the spot market due to government control.

Thus far, stock markets and commodity markets (especially derivative markets) seem to be functioning well in China. However, these markets have been exposed to interventions and significant moral hazards. As markets grow and expand, it is vital that the government and policymakers refrain from unnecessary and excessive interventions and let market forces determine price levels. We understand that the decisions policymakers make may not be well-liked by the public at times, but they may be important to the effective re-allocation of resources in a free market model.

The authors are researchers with Griffith Business School at Griffith University in Australia. Rakesh Gupta is also a visiting fellow with the Chongyang Institute of Financial Studies at Renmin University of China.