Sunil Jain: Helping McKinsey fix FCI

RATIONAL EXPECTATIONS

The government's decision to appoint McKinsey & Company to help fix the Food Corporation of India's (FCI's) problems has led to howls of protest from not just the left crowd but also from others.

All make essentially the same point, that there is little wiggle room in the FCI's operations with the government mandating the costs of most things including, if you please, the commission payable to arhatiyas who help FCI procure grain.

Besides, almost anything that can be done at the FCI has been suggested by various studies already, from the BICP in 1989 to ex-food secretary Arun Sinha a couple of months ago.

So how's McKinsey to fix the FCI?

Clearly it's up to them to justify their massive fees (reportedly Rs 5 crore as compared to a mere Rs 1 lakh for Sinha), but one very promising solution involves "put" and "call" options.

Today, on commodity exchanges like the NCDEX, for instance, farmers can enter into a contract to sell their produce at a future date (say Rs 2,000 per quintal of cotton on January 15, 2005, for instance) but the problem arises if the ruling price on January 15 is above Rs 2,000.

If it's Rs 2,100, the farmer will lose by selling at Rs 2,000. The solution is a "put" option, which allows the farmer the right to sell the cotton at 2,000 if the ruling spot price on January 15 is below or equal to this, but gives him the freedom to sell in the spot market if it is above Rs 2,000.

Sadly, however, "put" and "call" options are not allowed by the law--an amendment to the Forward Contract Regulations Act (FCRA) of 1952 has been pending since 1998. (A "call" is the opposite of a "put", in the sense it is an option, not a commitment, to buy at a certain price and date.)

While this will virtually eliminate the downside price risk for the farmer (of course he will have to pay for the "put" option, a figure that's roughly around 6"�7 per cent of the cost of his output), how will this help fix the FCI's problems and how will it reduce the need for the FCI to buy foodgrain at the government-mandated minimum support price (MSP)?

Since the MSP is required as market prices are often low, the question is: How do you get someone to agree to buy cotton (on January 15, to continue with our example) at Rs 2,000 if the market price is expected to be lower, at Rs 1,900 say?

It appears there's a well-developed model for this (the Black-Scholes model got a Nobel in economics for this a decade ago) which takes into account interest rates, price volatility, the time period for which the contract is valid, and so on.

So, if the spot price of cotton is Rs 2,000 and you want to buy a "put" option to be able to sell at Rs 2,100 six months from today, the "put" premium will be Rs 142 (that's a 6.8 per cent cost) but if you want to buy a "put" at Rs 2,300, the "put" will cost Rs 302 or 13.1 per cent. The higher the "put" price, the higher the premium.

What NCDEX chief P H Ravikumar is advocating is that this premia be paid by the government, after which the FCI can dramatically cut its procurement operations to just around 10"�12 million tonnes for buffer-stocking and a few million more for the PDS, and make huge savings on transportation and storage costs.

According to Ravikumar, the food subsidy bill could be cut by half, or around Rs 14,000 crore, as a result. The biggest advantage of course is that while the FCI procures grain from just 2"�3 states right now, the new system will provide income support to farmers all over the country and at a fraction of the cost.

If the FCI is to offer price support for all 73 million tonnes of wheat produced in the country, based on the current MSP of Rs 640 a quintal, it has to be prepared to shell out Rs 46,720 crore, apart from another 30"�40 per cent for procurement and storage costs. The "put" method, by contrast, will reduce this cost to just Rs 4,000"�5,000 crore.

It would of course be foolhardy to expect the entire MSP"�FCI system to simply switch over to the "put""�"call" system overnight, and the NCDEX is planning several pilot projects, including one for soyabean in Madhya Pradesh and cotton in Gujarat and Andhra Pradesh to examine the practical issues that come up.

There is also the issue of excess speculation that needs to be dealt with. While the NCDEX insists there was no unbridled speculation in the recent flare-up in guarseed prices, it is now in the process of coming up with market-wide caps to ensure the ratio of the commodity traded has a sensible relationship with its total availability, for instance.

Finally, for the system to work, there have to be enough buyers (or "calls") to offer to buy the farmers' output, that is enough private players to replace the FCI. Today, however, if a farmer buys a "put" and stores his grain in a godown, borrowing against this is not considered agriculture-lending and so costs more.

Indeed, even banks and mutual/pension funds are not allowed to invest in the commodities market even though such investment gives better risk-adjusted returns.

While the new system will take time to become foolproof, the costs of the old system, in terms of the losses to the FCI and the concentration of benefits in just 2"�3 states, are too high to be allowed to continue.

suniljain@business-standard.com