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Derivatives can end government distortion of agricultural prices

Agriculture commodity options will enable farmers get a minimum price for produce, while retaining any upside
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First Published: Tue, Nov 20 2012. 04 40 PM IST
In short, agricultural commodity options can completely replace the MSP system, and push for the liberalization of the suffocatingly over-regulated agriculture sector.  Photo: Ramesh Pathania/Mint
In short, agricultural commodity options can completely replace the MSP system, and push for the liberalization of the suffocatingly over-regulated agriculture sector. Photo: Ramesh Pathania/Mint
On 4 October, the cabinet finally approved the Forward Contract Regulation Act (Amendment) Bill, or FCRA. This amendment, along with the weakening of Agricultural Produce Marketing Committee Act (APMC) in many states—thanks largely to the initiative of the National Democratic Alliance (NDA) government that ruled India between 1999 and 2004—and the recent push towards more foreign direct Investment (FDI) in retail by the United Progressive Alliance (UPA) government could catalyze another Green Revolution in India.
How can changes in an obscure Act regarding derivatives be so impactful? For that we first need to understand what minimum support prices (MSPs) in our agricultural system are, and how damaging they have been.
Minimim support prices, that are set by the government are those at which it is ready to buy the produce of farmers. MSPs are effectively a price insurance scheme, as opposed to insurance that would guarantee uptake of a farmer’s output and protect the farmer from, say, drought or bad weather. Because the MSP system fixes prices, the prices of some crops compared with other crops, and prices within the agriculture sector as a whole compared with other sectors, are artificially raised.
Actual insurance involves a premium charged based on statistical analysis and the need to make an accounting profit over the long term, but the government does not follow these considerations.
Competitive electoral politics has ensured that MSPs are increasingly set above expected market-clearing prices that can be discerned by looking at prices globally; and MSPs become the de facto prices. Moreover, vote bank politics ensures that rice and wheat are subsidized much more than other crops, further distorting agricultural markets and exacerbating regional inequalities and nutrition indicators. Protein-rich pulses, along with cash crops, often get the raw deal under the MSP system. Ramesh Chand, writing in Economic and Political Weekly, has noted that the intervention of the Commission on Agricultural Costs and Prices (CACP) which determines MSPs “led to accumulation of a huge grain stock, ironically by diverting cereals from consumption to government warehouses”.
Basic economics tell us that the government’s involvement in pricing inevitably causes misallocation of resources and leads to the entire economic pie becoming smaller. But efficiency alone is not (and should not) be the imperative here; equally important is equity, especially in a developing nation such as India. Focusing on efficiency alone would come across as being ignorant of the environment and no political party can be seen to be taking that line, especially when billionaires get rich off crony socialism and not much is written about efficiency then. There is indeed a need to understand the insecurity a farmer could feel in a market with unpredictable, volatile prices. But if properly and sufficiently liberalized, private insurance can ameliorate this problem. While weather or quantity insurance would need the law of large numbers for actuarial assumptions to play out and would also need a buy-in from a substantial segment of India’s massive agriculture sector constituency to work effectively, price insurance is even easier to provide for through commodity derivatives such as futures, forwards and options.
In a forward contract, a buyer promises to take a delivery of the underlying commodity on a fixed date at the currently agreed price, thus ensuring a fixed price, assuming that neither side reneges on the contract. When the same forward contract is transacted through exchanges which have margin requirements, guarantees, and other provisions it is often called a “futures” contract. These forwards and futures, once purchased, do not have to be held till the delivery date but instead can generally be sold. The futures markets tend to be more liquid and transparent—while still providing greater anonymity—and after the financial crash of 2008 there has been a global regulatory push towards having more exchange-traded derivatives rather than “over-the-counter” (OTC) ones.
Buyers of “put” options, on the other hand, have the right but not the obligation to sell, or make a delivery, at a pre-determined price and date. Basic, standardized commodity options are also increasingly traded on exchanges globally and often have liquid secondary markets. In India, while we have slowly allowed stock and currency options, commodity options on our exchanges and in most OTC trades as well are still banned. This has been harmful because while farmers can theoretically sell futures on various agricultural products to “lock in” a price, there are two drawbacks. Firstly, it means depositing margins for farmers as sellers of futures, and secondly giving up on any sudden rise in the price of their produce. Since buying a put option (the opposite type of option is called a “call”) is being bearish on the underlying commodity, even though it is similar to selling a future, it involves no margin to be posted, and the only loss that accrues if the underlying commodity’s price increases for the put buyer, who could be a farmer, is the original premium posted. The benefit of the upside is preserved for the put buyer.
In short, agricultural commodity options can completely replace the MSP system, and push for the liberalization of the suffocatingly over-regulated agriculture sector. APMC laws need to be further reformed, if not repealed. FDI in all related areas need to be encouraged and electricity and fertilizer subsidies need to be cut. It would be best to redirect subsidies to irrigation and warehousing projects. With reduced risk thanks to commodity options, there will also be less of a need to keep crop inventories as buffer stocks. Farmers will be able to increase their incomes rather than forcefully smoothing production for consumption. Moreover, by not coercing farmers to sub-optimally diversify into different crops and different plots, agricultural productivity would increase and more land could be reforested, providing significant cumulative environmental benefits.
The Abhijit Sen committee report on commodity futures correctly defends the expanded use of commodity derivatives: “Literature on the subject emphasizes that such markets help in price discovery, provide price risk management and also bring about spatial and temporal integration of markets...‘Options in goods’ are hedge instrument suitable for farmers needs...assessment should be made of the possibility of agencies implementing MSP including FCI (Food Corporation of India) acting as the writer of options in agriculture commodities. This could reduce the cost of operations and incentivise market operations... Farmers should be encouraged to participate in these put options for which FCI can be the options writer.” These are all eminently sensible suggestions, and the FCRA amendment cleared by the cabinet now needs to be passed by Parliament.
Rajeev Mantri is director of GPSK Investment Group and Harsh Gupta is a Hong Kong-based co-author of an upcoming book on financial derivatives.
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First Published: Tue, Nov 20 2012. 04 40 PM IST
More Topics: derivatives | agriculture | MSP | cabinet | NDA |