Impact of Future Trading on Indian Agriculture

Dr Gursharan Singh Kainth
Director
GAD Institute of Development Studies
14-Preet Avenue, Majitha Road
PO Naushera, Amritsar-143008

Agricultural commodity futures are market based instruments for managing risks and orderly establishment of efficient agricultural markets. These are used to hedge commodity price risks. They also serve as a low cost, highly efficient and transparent mechanism for discovery of prices in the future by providing a forum for exchange of information about supply and demand commodities. The hedging and price discovery function of the future markets promote more efficient production, storage, marketing and agro-processing operations and help in improving overall agricultural marketing performance. Commodity trading is just one step in solving the complex Indian agriculture problems. Interestingly the concept of future trading started from Farming when a French Wine Merchant started locking prices for his wine produce even before his grapes were ready. Future trading in commodities refers to a situation in which traders and hoarders buy out the produce cheaply and then raise price by creating false scarcity with the consumers eventually having to foot the bill. Commodities are being traded on in this profit gate manner because stock and shares have failed to deliver. But because of this speculation, the consumer pays more. One must recognize that trading in future thrives on scarcity which has to be created artificially. Such institutions neither benefit the producers nor the consumers. The former sells on the basis of actual but the later pays not only the price he should but also a premium on it that results from speculative price increases.
Although formalized future trading in agricultural commodities has been in place since 1918-19, the future trading in commodity through commodity exchanges came to its own very recently. But the trade was mostly in the form of forward contracts. Moreover, the derivative trading is completely backed by the estimated physical availability. Traders in India had such a sensitive informal estimation system that they kept a fairly reliable tab on the production situation on the traded commodities with respect to area under crops, weather conditions, rainfall, temperature and natural calamities. And the availability has remained the deciding factor in the volume and performance of the commodity future markets. Since agriculture cannot be stored for a long time, the future transactions are restricted by the production cycles and consumption pattern projections over these cycles. Hence the future multiplier cannot go very high.
Future trading in India was introduced as a part of the financial liberalization policy, which has been pursued since 1992. Being the last mile in the road of financial liberalization, after all the other segments such a banking, capital markets, insurance, NBFCs and so on were opened up; the logical corollary was to extend the same to the commodity sphere. Although India has a long history of trade in commodity derivatives, this sector remained underdeveloped due to government intervention in many commodity markets to control prices. The production, supply and distribution of many agricultural commodities are still governed by the states. Free trade in many agricultural commodities is restricted under the Essential Commodities Act (ECA)-1955 and Agriculture Produce Marketing Committees Act (APMC) of various states. The forward and futures Contracts till April 2003, was limited to only a few commodities items under the Forward Contracts Regulation Act (FCRA)-1952. However, in 2003 Government of India removed all restrictions on commodities which could be traded on commodity exchanges. At present 25 commodity exchanges are in operation in India carrying out futures trading in as many as 81 commodity items. Most of these exchanges are regional and commodity specific. National Multi Commodity Exchange (NMCE) status has been accorded to four commodity exchanges, namely, National Mutli Commodity Exchange (NMCE) Ahmedabad, National Board of Trade (NBOT), Indore, National Commodity Derivative Exchange (NCDEX) Mumbai and Multi Commodity Exchange (MCX) Mumbai during 2003. These exchanges have excellent financial backing, demutualised ownership structure and more transparent electronic trading system. The Forward Markets Commission (FMC) established under FCRA-1952 is the agency which regulates commodity derivatives trading in India in the same way as SEBI does for securities markets.
The response of the market has been quite remarkable as seen by the enthusiasm shown in the commodity segments. The challenge has really been to take the benefits to the farmer’s level so that they can gain from futures trading. In some areas farmers are gradually getting aware of futures prices which are disseminated through exchanges. This is an important step before direct participation which is the final goal.
Though the progress has been satisfactory, the absence of integration with the disparate spot market is a challenge to overcome. Importantly, in any venture especially as complex as commodities, there would always be problems in terms of misconceptions, absence of market integration, efficient price discovery and so on. In the capital market, spot market developed before the derivatives market which made the things easier. In the commodity space, the derivatives have come before the so called integrated spot market. The route is different and probably difficult but a start has to be made some time. Hence no time is premature on the innovation map.
It is the job of FMC to adjust key points to ensure that markets run smoothly. Future market is a boon to the farmers. It gives farmers advance knowledge of prices to expect at harvest. It provides an iron clad guarantee that farmers will get that price. Under the prevailing scenario, Commission for Agricultural Costs and Prices (CACP) recommends Minimum Support Prices (MSP) with no guarantee that farmers will get that price. Generally, MSP acts as the maximum price that is paid to farmers. The operation of MSP is like a zero premium option. The government instead of playing its role as the buyer of last resort at the MSP has become the sole player to the disadvantage of the producer sellers. Open-ended purchase could continue to be made at MSP as floor price, exchanges should be able to offer market based options at strike prices higher than the MSP. Farmers should be encouraged to participate in these put options for which FCI can be the options writer. Simple options may be allowed for some times to attain maturity and operations and regulations and farmers attain adequate understanding of the market and of technique to use them. Be able to offer market based options at strike prices higher than MSP. Hoarding is an illegal practice like gambling. But in future markets upper and lower limit is well defined.
The Budget 2008-09 apart from an incidence of 12 per cent service tax and 2 per cent education cess, slapped Rs. 17 per lakh for commodities trading and 6 per cent as exchange levy. Budget fails to meet the expectations of participants in the commodity future markets as the needed reforms facilitating the growth of commodity markets have been avoided. Introduction of Commodity Transaction Tax (CTT) on line with Securities Transaction Tax (STT) is a negative move for the commodity market when market is still evolving seeking larger participants and volumes. When STT was introduced in the securities market it was allowed to set off losses against profit from similar business. Moreover, the long and short term capital gains benefits extended to securities market has not been extended to commodities trading. On the other hand, the decision is significant in the wake of commodities markets regulator to institutionalize the development of market mechanism, support institutions capacity building and development of strong forward and backward linkages between market, producers, traders and consumers and the Forward Markets Commission receiving more autonomy to deal efficiently with the challenges facing the commodities futures markets with the approval of Forward Contracts (Regulation) Act, and Foreign Direct Investment (FCI)/ Foreign Institutional Investors’ (FII) Investments in commodities sector.
It showed an increased interest of the government in expanding the commodity futures markets in line with the equity markets. It also underlined the fact that investing in commodities was now an accepted investment avenue like in the developing countries. It will also increase tax compliance by default because the tax will be levied at the time of trading itself. Traders and hedgers of international commodities will also be able to hedge their currency risks. It is a moot point that whether the forex markets will be under the commodity future regulatory framework as in most of the western countries.
Securities markets are eight times larger than the commodities market and hence the levy is premature. The functioning of securities markets is different from that of commodities markets. Commodities markets are global asset class and trade flowed to the most efficient markets that bore the least cost of trading. The users are very sensitive to transaction cost up to fourth decimal place. Commodity markets are still in the nascent stage (4years old) and a fraction of the size (1/5th) of the securities markets. The irony is that the budget get refers to options which were still to be introduced in the commodity markets. Under the situation, one an expect business to migrate from regulated exchanges to illegal trading or global exchanges to the extent allowed by the central bank and unofficial local markets. Introduction of CTT will shoo away investors and will also impact intra day volumes. Liquidity may come under pressure. It’s difficult to bear triple whammy of ST, CTT and non-availability of benefits of trading normal business. These costs will also distort our price vis-à-vis the global prices as the impact cost of trading will increase.
Furthermore, the trading in equity derivative is constructed as business activity and the relative profit/loss as business income. However, trading in commodities derivatives is treated as speculative activity and accordingly treated as tax. It would increase the cost of trading by at least four times. While big hedgers and arbitrageurs may be able to off set CTT against their net business profit, small investors and punters will see their gains dwindling. CTT needs to be brought down; otherwise, it will drive away participants from the market and distort the price discovery mechanism. CTT, as and when imposed, should be earmarked exclusively for development of the required physical market infrastructure and farmers’ access to it.
Recently, the Forward Markets Commission imposed a ban future trading in four more agricultural products, namely, chana, Soya oil, rubber and potatoes as a part of the exercise to control inflation in the country leading to creation of negative sentiments. These four commodities taken together constitute one per cent point in the wholesale price index (WPI). Future trading in wheat, rice, tur and urad had already been suspended by the FMC. This put in doubt the capacity of the present FMC to be true guardian of the forward market. The politically touchy issue to ban of commodity future has been taken on the basis of pre conceived ideas though future trading had a very little or no impact on either spot prices or inflation and the ban would end up further harshening the interest of the farmers.
The existing future markets and contracts suggest that though the volume of futures trading has increased phenomenally, its ability to provide instruments of risk management has not grown correspondingly, rather has in fact quite poor due to high basic risk in most of contracts which keeps out potential hedgers and leads to greater dominance by speculators. This need to be addressed by both the exchanges and the regulators. Attracting speculators, arbitrageurs and other investors is no doubt important but that should not be the primary criterion while designing the contracts. The contracts designs should serve the objectives of risk management to farmers and other commercial use. Efficient functioning of futures markets pre-supposes the existence of efficient spot markets. Currently, physical spot markets have large numbers of infirmities. It will be difficult for the futures markets to function till these are removed. The operation of Model APMC Act by appropriate set of rules and regulations needs to be expedited.
Exchanges should act as self regulatory organizations capable of administering fair play, objectively and customer orientation. The proposed FC(R) Amendment Bill to upgrade the regulation and to improve the capabilities of the regulator need to be pursed vigorously. Commodity markets in India need structural changes for increasing depth and curbing of speculative activity. Banks, FIIs and other institutions should be permitted to trade in the commodity markets. National Commodity spot markets need significant legislative and administrative support for taking off. Banks, FIIs and other institutions should be permitted to trade in commodity markets. Commodity options need to be developed. The development of commodity market is a bit like how the media is shaping the development of policy/functioning the government. Its effectiveness will improve with the passage of time. All the players will have to work synergistically to achieve the objective of establishing an efficient and transparent agricultural market system in India in the greater interest of farming community for better price realization of their farm produce. The setting up of national electronic exchanges by the national commodity exchanges is an attempt to create a national integrated market. To promote integrated national market, central government should take active steps to bring inter state spot trade under the regulation of a central authority rather than leave it to highly scattered APMCs Entry 33 in the concurrent list of the 7th schedule of the constitution seems to provide such a jurisdiction.
There is an urgent need to educate farming communities on how to use the exchange to hedge their price risks. Moreover to opt for the modern mechanisms, consolidation has to happen in Indian agriculture. One cannot have successful market mechanism with 500 million people working on small farms of one acre land. Land ceilings need to be raised/removed and significant work has to be done to move the majority of the people from agriculture. Once the agriculture is trimmed and consolidated such modern trading mechanism will have greater impact. In addition organized retail industry can supplement futures indices in a great way. By having organized retail growing at a humongous rate, futures would be made by default MOUs where retailer giants cut deals with farmers much before sowing. Alternatively, like micro finance, micro trading can be have to reach out to small farmers.
There is need to have a strong and resilient agriculture sector attracting investment for raising production and productivity. Agriculture should be made a remunerative option. The vibrant agriculture markets including derivatives markets are the frontline institutions to provide early sign of future prospect of the sector. Vibrancy in these markets gives signal about commodities which deserves flow of investment. These markets deserve to be promoted for giving such signal. All the regulators operating within the commodity markets scope work in cohesion. Government should ensue that a closely coordinated structure is put in place to achieve this. Under the current situation it is better that farmers should shift to organic farming on the large areas. Globally, organic foods are in great demand under the changing life style. Organic seal implies no use of pesticides. Organic farming on isolated area is not feasible due to attack of pesticides which can be minimized by adopting organic farming on large areas.