Sunil Jain: Agriculture's future

RATIONAL EXEPCTATIONS

Now that Planning Commission Member Abhijit Sen is all set to submit his report on whether futures trading causes agricultural prices to rise, you can expect the political class to start protesting against 'speculators' all over again. When prices rose in January-February last year, it was this protest which got the government to ban futures trading in rice, wheat, urad and tur.

There is, however, little to show that, when the market functions well, futures cause prices to rise. By definition, futures prices are the spot price plus the interest and storage costs of the commodity. To understand why, assume the spot price of wheat is X and, by entering into contracts to buy it at 1.3X a month from now, speculators drive up prices. But if there is no real reason (like a global or local crop failure) for spot prices to rise, others will rush to enter into "sell" contracts "" after all, they can buy at lower spot rates, and make a killing at the higher futures sell-price. In which case, the futures prices will collapse.

There are exceptions. If the speculator trying to push prices is very large, others ranged against him may not stand a chance "" this doesn't hold since commodity trading rules don't allow individuals to take positions above a certain size. Commodity exchange NCDEX, for instance, does not allow members to take positions greater than, given India's wheat production, 0.04 per cent of output "" for individual clients of these broker-members, the positions are a smaller fraction. These limits get even smaller as the expiry date of the contract gets closer. When wheat futures were banned last year, the NCDEX had 302 members holding positions on behalf of 995 clients!

The more serious exception is speculators manipulating the spot market. They first buy up the wheat stocks in the spot market, and then enter into high-priced futures contracts. Once the contracts mature and you make your money, sell the wheat stocks! This is called 'burying the corpse' in jargon. Price rigging in 2006 took this form in some cases but exchanges have now got wise to this and monitor spot prices as well.

But such rigging takes place in equity markets as well "" remember the 1-2-3 synchronised trades when buyers and sellers, at the count of three, entered fake buy and sell orders? The solution was not banning the equity market but finding ways to improve surveillance.

Indeed, for the most part of the period when futures have been blamed, the price rise was a result of a poor crop. Wheat spot prices began rising in December 2005 on expectations of a poor crop and rising global prices (global surpluses fell 4 million tonnes in 2005-06 and by 26 million tonnes in 2006-07, which is why the official procurement prices were raised by 11% in 2005-06 and 21% in 2006-07). After that, spot and future prices mirrored events on the ground "" in March-April 2006 prices fell with open market sales and the crop coming in; prices rose thereafter and fell in Dec 2006 (with 210,000 tonnes of imports). Ironically, wheat prices began falling even before the ban in February last year. Interestingly, the futures (see charts) indicated as much "" prices falling till May 2007 and then rising. In the case of urad and tur a similar story can be told. Yet, the government goes and bans the instrument that indicates exactly what future prices will be! Interestingly, an NCDEX study shows commodities traded on the exchange contributed 0.3% of the 6.7% price rise (Feb 3, 2006 to Feb 3, 2007) while those of commodities not traded was 0.83%!

The importance of futures goes beyond this. An AC Nielsen survey found, for instance, that farmers near NCDEX terminals were more aware of prevailing prices (spot and future) and so got better returns by holding on to their crop (see "Empowering Farmers," 7-6-07). Indeed, and that's probably the subject of another column, since futures (and options) markets allow farmers to lock in to higher prices, this is a far cheaper solution to the current procurement price method of farm support, which costs around Rs 10,000 crore today.