Renowned economist Abhijit Sen, who passed away recently, was known for his passion for ensuring the welfare of farmers by giving remunerative prices. So, when he was asked to study the extent of the impact of future trading on agricultural commodity prices as the head of an expert committee in 2007, many were not sure what the gentle professor would recommend. However, the committee’s verdict was clear: Evidence available did not provide any conclusive evidence about whether there was a causal relationship between futures trading and rise in prices of agricultural commodities.
Conventional wisdom says the report should have been enough to stop any government or regulator from considering further ban on futures contracts, which is essentially a promise to buy or sell something at a pre-set price on a later date. It lets buyers lock in future supplies at a known rate, and sellers get a fix on their proceeds, thus spreading trades across the year, unlike the spot market.
But India has taken a unique route—derivatives on several commodities have been banned/suspended as many as 19 times in the last two decades, with some facing multiple suspensions. The latest was the year-long futures trading ban on seven agri-commodities on December 20, 2021.
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In the past, Sebi had banned futures trade in a single commodity, but banning seven commodity futures at one go was unprecedented and devoid of any logic, except pandering to populism keeping in mind the never-ending elections.
We are at the brink of a new marketing or arrival season of kharif crop in two months. So it may be a good time to lift the ban once and for all. Volatility in commodity markets is a global phenomenon that has intensified during the pandemic on account of supply-chain hurdles and geopolitical tensions. Regulators around the world recognised this disruption and supported the physical market participants with approvals for tools to hedge their risks.
While no contract has been suspended in the commodities derivatives market anywhere in the world in the last two decades, the Indian markets faced just the opposite—suspension of derivative commodity contracts, thereby leaving the value chain with no cover
A September report by NCDEX says the suspension of futures contracts in the past have not resulted in the desired impact of controlling the prices. At best, there have been minor corrections in the short term. For example, chana futures contracts were suspended on July 28, 2016, attributing the price rise to futures. But the upward trend in chana continued even after suspension, and prices rose to Rs 12,000 per quintal compared to Rs 8,000 per quintal at the time of suspension.
Similar trends were witnessed in urad and tur even earlier. Prices fell in the short term, but started moving up later on account of strong fundamental factors. Besides, other commodities, such as sugar, potato, etc, have continued to remain sensitive though they were never under futures trading.
Suspension from futures market is often justified on the grounds of speculative activity emanating from trade in the futures market. However, an independent study by Nidhi Aggarwal, Tirtha Chatterjee and Karan Sehgal found there is no relationship between the two. The study found no role of futures market trading on price changes, nor did it find any empirical evidence of the impact of suspension of trade on price behaviour in the period after suspension. Rather, before the suspension, the futures market had a dominant share of 64% in uncovering the true price of mustard seed. This role ceased because of the ban.
One of the biggest ironies is that such a ban adversely affects the target group it is intended to protect. For example, price discovery. When a derivatives contract is suspended, it leads to the absence of a pan-India, integrated price discovery mechanism. When a commodity is traded in the futures market, its price discovery is efficient, and the demand-supply relationship automatically sets in for a longer time-frame. So, suspending of contracts is like shooting the messenger.
NCDEX has rightly pointed out that frequent bans lead to the opportunity of becoming a price setter being lost. Many countries have developed themselves as price setters for different commodities. A recent addition in this is China that has seen a major boom in the commodities market in the last 15 years. It has also become the price benchmark for many major commodities such as iron ore, eggs, polymers, etc.
Despite being the largest producer and consumer of many agricultural commodities, India has not been able to become a price setter. The lack of a robust derivatives trading thus compels domestic players to refer to prices in the international markets such as CBOT, ICE, etc, which impacts domestic price discovery. One example of this is the sugar contract wherein market participants have to refer to ICE sugar contract.
The government is also promoting farmer producer organisations (FPOs), so that they can use their collective might to get better terms in the market. Many FPOs have begun utilising the exchange platform for the benefit of farmer members.
However, such suspensions can erode the confidence of the farmers in the market mechanism and will force FPOs and their farmers to go back to mercy of middlemen in physical mandis. In the absence of derivatives contracts, it is safe to construe that there is 100% speculation in the physical market as there is no means available for participants to hedge, leading to a huge amount of risk on account of price volatility and consequent business loss.
A ban on futures trading shows lack of faith in market mechanisms, whereas the government’s stated policy has been to let the market play its rightful role in sorting out the farm sector’s assorted problems. An uncertain policy, fluctuating between bans and incentives, should give way to functional commodity futures and options. The earlier it is, the better.