There is an uncomfortable link between volatile food prices and poverty, with the countries that have endemic poverty ironically witnessing the steepest rise in food prices. For a large democracy like India, food price increases are an unacceptable political-economic proposition. So the government has been using all the tools at its disposal to rein in this monster, whose rein has survived two consecutive years of good monsoons. But the cost of controlling food prices, and the collateral damage that control measures cause, leaves one wondering whether the solution is worse than the problem!
To manage food price volatility, the government purchases foodgrains from farmers at remunerative MSPs (on a cost plus basis), then transports and stores them at government warehouses, finally releasing them to consumers at low prices through designated sale outlets. This gargantuan task has not only proved to be costly for the exchequer but also an inefficient means of reaching out to those with limited access to foodgrains. Yet, the taxpayer continues to shell out a food subsidy of about R60,000 crore to maintain this system. At the same time, without sufficient storage capacity, the government does permit the farmer to benefit from exports of commodities such as sugar and cotton. Thus, in its attempt at maintaining remunerative prices for farmers and affordable prices for consumers, the government has ended up satisfying neither, while contributing to the fiscal burden through subsidisation?which, in turn, feeds into demand-led inflation.
While food inflation can be sustainably mitigated by addressing the supply side problems, there are cheaper and more effective market-based avenues available to address the issue from the demand side too. Exchange-traded commodity derivatives can play a paramount role here, as they have done in many other countries. It is well-established that agricultural price volatility leads to uncertainty, which forces stakeholders in every link of the food value chain to demand a premium for the risk they handle. This culminates in a high price that the consumer ends up paying while the intermediaries sap much of the value. By lowering this uncertainty and providing a platform for discovering future referenceable prices, exchange-traded commodity derivatives help manage price risk through a market that is transparent, participative and well-regulated.
The beneficial role of exchange-traded commodity derivatives in lowering volatility through transparency and their ability to correct distributional problems has been endorsed by multilateral agencies including the World Bank. Last week, the World Bank announced that, along with JP Morgan, it would provide up to an initial $200 million (leverage for products worth $4 billion) to protect farmers and consumers from volatile food prices in developing countries, through hedging instruments. Recognising the importance of protecting multiple stakeholders from price volatility, the communiqu? from the Bank commented that, ?While price risk management products are routinely used in agriculture in developed countries, hedging instruments cannot be obtained directly by smaller emerging market producers and consumers because of high upfront costs and margin requirements. Furthermore, many financial institutions in emerging markets are not yet experienced with these risk management services, and do not offer them to local clients.? This applies to India too, as products like options are not yet available in our commodity derivative markets.
By allowing commodity futures in India, our policymakers have gone halfway in experimenting with the commodity derivatives market and ushering in its benefits to its stakeholders?especially farmers. The benefits include both direct benefits of price risk management through hedging and indirect benefits of future price discovery, which helps improve production choices and identify optimum timing for sales. But the legal framework within which our commodity derivatives market functions is archaic, namely the Forward Contracts (Regulation) Act, 1952, or FCRA.
Enacted against the backdrop of wartime shortages, it has not been amended over the six decades of its existence. Consequently, appropriate products for more effective risk management?such as options, which are proven cost-effective tools for farmers and risk-averse traders?are not permitted. Passing an amended bill would not only allow producers and other stakeholders of the agricultural commodities ecosystem to cost-effectively manage their risks, but would also make government production support obligations more market-oriented and cost-effective, besides contributing to smoother global market integration. A vibrant options market and the government?s participation in it will not only move the burden of storage from the public to the private sector (thereby increasing efficiency), it would also send effective signals about producer costs into the markets. This would pave the way to a smooth roadmap for market-oriented agricultural production and processing systems.
A major factor contributing to the suspicion of the commodity derivatives market is the rather na?ve perception that this market leads to inflation. Yet, independent researches, cross-country evidence and a committee set up by the government itself could not prove the causality between inflation and commodity derivatives. The World Bank announcement earmarking financial and intellectual resources to bring the benefits of this market to stakeholders in developing countries could have come at no better time. Will the government try and get a share of these resources on offer to propagate acceptance of commodity derivatives? Or, will it let this opportunity too pass by? No prizes for guessing.
The author is Senior Economist with the International Crops Research Institute for Semi Arid Tropics. Views are personal