By Tofik Shaikh, MBA Capital Markets, NMIMS
RBI surprised the markets by revising its monetary policy earlier than expected. It repeated its move later in the same month on June 27th,but this time, reverse repo rate was increased by 50 basis points. Undoubtedly, RBI has opted for the best possible recourse to contain inflation. Interestingly, in last couple of years inflation has become one of the most searched words on internet. Even a layman ends up asking what the inflation rate is. Of course, it is spiraling high and he ends up abusing government for doing nothing and acting in the hands of rich traders. This sentiment generates panic, and clamor for ‘banning future trade’ in essential commodities surreptitiously emanates from this chaotic situation.
Government does understand that these allegations are more of a popularity appeal than anything else and in the past it had appointed an expert committee, which comprised Prof. AbhijitSen, member of planning commission, peasant leader and MP,Sharad Joshi, IIM-Ahmadabad professor (and independent director on the board of the National Multi-Commodity Exchange of India),SiddharthSinha, IIM-B director PrakashApte, and FMC acting chairman Kewal Ram to study the impact of future trading on prices of essential commodities. The committee submitted its report in 2008. (Source-Ministry of Consumer affairs, Government of India)
Its recommendations can be summarized as follows
1. The Committee has been unable to determine any conclusive causal relationship in view of the short time period during which futures markets have functioned and the complexities that arise are because a large number of variables impact spot prices.
2. Futures markets have the potential to bring about better price stability in medium to long term although the literature on futures markets itself is rather divided on the subject of price variability. Indian data analyzed in this report does not show any clear evidence of either reduced or increased volatility of spot prices due to futures trading.
Inspite of this verdict by expert committee, govt. buckled under populastic pressure and indulged in a myopic measure of commodity banning. Trading in urad, tur was suspended in Jan 2007, rice future tarding was banned in 2008,and in May 2009 when sugar prices were soaring high govt. banned sugar future trading too. But it has been found that banning future commodity trading has made no difference to upward surge in prices of these commodities.
Another argument against future trading is that they induce speculation and hence encourage volatility. If we look at the commodity price index for last 10 years,we can see the upward trend in commodity price index but it is the culmination of many positive factors such as comparatively good monsoon between 2003-2007, implementation of sixth pay commission recommnendations, UPA govt. flagship programme MNREGA,etc. These factors contributed to increase in purchasing power of the rural as well as urban people. Government has also increased the minimum support price(MSP) for commodities like tur, moong,urad,etc. (Refer the table below). It clearly indicates a rise of 40-50% increase in MSP prices of these commoditites over corresponding prices in 2007-08. The sudden spike in inflation after Feb 2007 is a result of drastically changing global scenario as well as bad monsoon that followed, which disrupted the demand-supply equation. Even the expert panel committee said that they could not find any substantial correlation between future commodity trading and volatility.
A report by NCAER-CMR shows the growing Net National Product of the country. It prompted KaushikBasu, Chief Economic Advisor to GOI, to say that even poor strata is benefitting from the growth, which is stimulating consumption and escalating the demand. Note that lower quintile is growing at an average rate of 6.7%. (Business Standard, August 16, 2010).
Inflation at retail level:
One important aspect of inflation, which has generally been neglected, is price discrepancy at wholesale and retail level. G. Chandrasekhar of The Hindu Group has come up with an analysis in which he claims that wholesale market is quick to react to changes in market conditions but retail market is reluctant to do so. Following example is quoted from his analysis-
At Rs 45 a kg, imported yellow pea is the cheapest pulse on the kirana shop shelf. Its landed cost is Rs 16 a kg (Rs 16,000 a tonne) and processing adds another Rs 6 a kg (Rs 6,000/tonne). Yet, by the time it reaches the shelf of your neighborhood kirana shop or the supermarket, the price is double the wholesale rate. In fact retailers act very selectively. When prices go up, they raise the prices at retail level but when prices in wholesale market go down they refuse to lower the prices and enjoy a margin of about 20-30% without adding any considerable value. This food chain has too many intermediaries which make market more inefficient, inflation more lethargic and benefits of higher prices are rarely percolated to the farmers. This grey area can be removed if private players are brought in. FDI in retail will play a major role in price discovery at retail level as big players can enter the market leading to more competition and hence more efficiently.
Farmers and future commodity trading
It is widely presumed by farmers that they will have to sell their farm output at whatever price available in market through local brokers (aratya). No wonder that very few of them are interested in knowing the prices. This is grey area and lot of improvisation can be done here. Some measures like disseminating future prices through commercial banks and post offices have been taken but, as I have already mentioned, the produce is mainly sold at local level so this price may not reach farmers. There is a dying need of creating awareness about future commodity trading and making people partners in this success story. If a farmer gets an idea about probable price in the market when the farm produce will be ready, he can plan accordingly. Thus, depending upon his capacity and expectations, he can decide to sell or hold on. Here comes the real patchy area. Where are the warehouses? Building warehousing facilities as well as financial services will be a stepping stone to farmers success. Private sector has a very important role to play here.
A NEW ‘OPTION’ TO FARMERS
Options can also be introduced as they require less financial commitment and also they are comparatively safer option. Even Sen committee has suggessted an introduction of simple options.Widespread awareness and training progarams are required for that.Government will be introducing a bill amending the Forward Contracts Regulation Act of 1952 very soon which also talks about introduction of options. Governmentis serious about this as Mr B. C. Khatua, chairman of FMC, has been given one year extension to ensure the smooth implementation of the bill. At international level, Rabobank in Uganda, Nicaragua and Tanzania sold options of coffee to farmers at a low premium. It helped farmers to save huge lending fee. Also, banks offered them credit when they realised that future value of their collateral is assured. There is no doubt that why this experiment cannot be replicated in India. An initiative taken by MCX SX is worth mentioning here.
MCX has successfully conducted a project in which they managed the flow of price information and helped farmers in Surendranagar district of Gujarat to recover right price. Farmers from five villages in various groups represented by members, members in turn formed the Farmers federation that dealt with brokers and other players. The schematic flow is reproduced here-
In Nov 2007, cotton market prices were expected to fall owing to the high domestic production. Farmers Federation took position accordingly. But a huge export demand from China, US and other countries, started pushing the cotton prices northwards. This opposing trend encouraged farmers to look in futures contracts at higher prices and hold on the stock in anticipation of price rise in spot i.e. physical markets. Farmers’ Federation took position for 26 contracts of Kapas futures on MCX. The average price for short positions was Rs 471.35, whereas, the average price for long positions was Rs 495.08. The deficit in mark-to-market margin was Rs 123,480.The average price realization of focus group farmers this year was Rs 2531/quintal which isaround 5.9% more than their average price realization of Rs 2399/quintal last year.
Conclusion:
Futures trading in commodities helps to discover the fair price, it also allows better risk management through hedging. In the long run, competition will lead to more efficiency among domestic producers. But there is a difference between future commodity market and physical spot market which widens the price gap at these two levels. It is imperative to improve physical spot market by developing rural communication, transport and storage infrastructure. Private players in retail sector can play a defining role here as that will make prices at retail level more responsive to the changes in wholesale market as they are expected to build the required infrasctructure.
This treatise makes it clear that price volatilty in agricultural commodities is not a direct function of future trading, hence, instead of playing to the gallery by banning these trades, Govt. must focus on making farmers a beneficiary in the trade by encouraging participation in future trading.
About The Author
Tofik Shaikh is a 1st year MBA student at NMIMS, Mumbai. He has completed his B. Tech in Surface Coating Technology at UICT, Mumbai and can be reached at tofik111@gmail.com
