Banning commodity futures trading

Mobis Philipose and Pooja Meswani have an excellent article in Business World (link, but use this permalink) on the banning of futures trading on urad and tur (announced on 23 Jan and effective from 24 Jan). Ila Patnaik wrote about this in Indian Express a short while ago. For a sense of how one politician sees it, there was a fascinating piece in Business Standard by Deepender Singh Hooda (a Congress MP), where he takes support from Steve Levitt and the World Bank in saying there should be a ban on commodity futures trading:

Steven D Levitt's Freakonomics establishes an unconventional premise: if morality represents how we would like the world to work, then economics represents how it actually works. The crusade to promote futures trading in the name of the farmers interest began in India after the 1993 Kabra committees cautious recommendations, and gained momentum in 1998 with a World Bank-funded grant directed at reforming exchanges. Later, all the caution was thrown to the winds in the NDA budget of 2002-03, when the then FM announced expansion of futures and forward trading to cover all agricultural commodities.

Since 2002-03 we've seen unrestricted entry of speculative capital in futures trade in agricultural commodities. The total value of commodities futures traded in 2002-03 was Rs 100,000 crore, which increased to about Rs 22,00,000 crore in 2005-06. The farmers haven't gained through this, consumers have had to pay a lot more. Only middlemen and traders have benefitted.

Theoretically, such markets provide farmers, traders and processors a mechanism for hedging their risks and improving price discovery in their forward planning decisions. The classic application helps a farmer who is planting in November to know the price at which his produce will be sold at Baisakhi so that he may incur appropriate farming input costs.

While this agro-liberal utopia would work if we had a "perfectly free market" for our agro-products, that is neither true at the moment nor desirable. A free market would have: (1) No government intervention in setting procurement price floors (we have a strong MSP regime); (2) No or little governmental procurement at a pre-determined fixed prices (we have a substantial PDS); (3) Physical spot markets should not lag much behind the futures markets; (4) Government interventions should not restrict the normal flow of commodities (like between states), and so on.

Indeed, even a World Bank and UNCTAD study (Managing Price Risks in India's Liberalised Agriculture: Can Futures Markets Help?) had concluded that futures trading for commodities such as sugar, non-basmati rice and wheat are "non-viable" in India unless some of the market ground rules are changed.

Take the case of maize in Andhra where the MSP was announced at Rs 540 last season. The maximum reported price that farmers could secure was about Rs 600 whereas the futures trade was at around Rs 850. The early announcement of MSP here had increased the expectations of farmers who were happy to pre-sell their produce at a marginally higher price than the MSP to the middlemen who built their stocks under a pre-fabricated illusion of a negative supply-demand gap, which in turn led to higher prices for reselling and for consumers. The story on wheat is all too well known. Last year we saw big private companies cornering huge wheat stockpiles in the name of helping farmers get good prices (slightly above the MSP), and then prices hitting the end consumers hard (much above the MSP), and finally we ended up paying foreign traders up to Rs 400 more per quintal than what we paid to Indian farmers. The Haryana chief minister recently apprised the prime minister of an expected record-high wheat production this Baisakhi. Our farmers have responded astoundingly well to the demand pressures through their grit and toil. But even as you read this, the Cargills of the world are again securing their wheat stockpiles on account of forward trading while the Food Corporation of India's PDS stocks are awaiting the spring spot market MSP procurement. The bumper crop expectation should point to mild inflation for our consumers in the months ahead. But I'm afraid we should expect the opposite this summer, as the futures of our farmers and consumers have been forward traded already!

The "freakonomical" moral of the story: lets get rid of the current futures trading model for the essential commodities that have a propensity for undesirable exploitation in the current restricted agro-market reality and think of another model of forward trading thats suitable to the Indian MSP-PDS agro-regime that actually helps our farmer.

Steve Levitt should be proud that he has mind share amongst MPs in India!

Business Standard did an editorial today refuting Mr. Hooda:

Deepender Singh Hooda recently argued in a Business Standard debate that a genuine free market for the underlying commodity is a pre-condition for futures trading. He argues that since such a genuine free market is neither desirable nor prevalent, commodity futures trading should be banned. He is wrong, and this can be shown in two ways.

Proof by existence: crude oil. There is a powerful cartel (the Organisation of Petroleum Exporting Countries) which exerts the mighty energies of many governments in manipulating crude oil prices. Opec interferes with the global crude oil market far more effectively than the Government of India is able to do with most commodities. Yet, that has not changed even slightly the case for futures trading in crude oil. Energy futures trading at NYMEX (in New York) and IPE (in London) is highly successful. Every Indian firm which buys or sells crude oil suffers from risk owing to fluctuations of global crude oil prices, and it ought to be doing futures and options trading on NYMEX or IPE in order to manage this risk.

If someone plans to buy wheat at a future date, he suffers from price risk because the price of wheat is not certain. This fact holds regardless of why the price of wheat might change. It might respond to genuine market forces, or it might be responding to the manipulation of a government. The reasons do not matter; the fact remains that if a buyer of wheat is unsure of the wheat price next month, he is better off obtaining a locked-in price for a wheat purchase next month. This holds regardless of whether the wheat spot market is a genuine free market or not. It might be argued that someone operating in a futures market could exploit control of an imperfect or thin spot market, but that would be a fit case for the market regulator to get into.

Similarly, a speculator forecasts the price of wheat or crude oil next month. Whether the spot market is a vibrant free market, or it is vibrantly manipulated by a government, the fact remains that if a speculator predicts that the price will go up and adopts a buy position, and then the price does go up, the speculator makes a profit. The arithmetic of futures trading works whether the spot market is genuine or manipulated by a government.

The deeper reason why futures trading is extremely important lies in a strategic sense of Indian agriculture. Where is India going on the terrible distortions of the agricultural sector? Is India ever going to move away from the knee-jerk responses of hurting milk farmers one day by banning milk export, and then trying to set up a minimum support price for milk because milk farmers are unhappy? If India is going to make progress towards a well-functioning agricultural sector, then there is no question that futures trading belongs in it. Futures trading is as much a part of modern agriculture as fertilisers, drip irrigation and bio-technology.

Mr Hooda is not alone in his views. The political and bureaucratic establishment that deals with agriculture is deeply steeped in the mindset of a government that prevents agricultural markets from functioning. For this reason -- if not for any other -- the regulation of commodity futures trading needs to be moved to the Ministry of Finance, merging it with all organised financial trading, as is the case with all other mature market economies.