The Indian Economy Blog

July 18, 2007

Wheat Procurement And Derivatives Markets

Filed under: Agriculture,Capital markets,Regulatory reforms — Karthik @ 9:28 am

So the government has done it again. After managing to procure only about 11 million tons out of the targeted 15 million tons from our farmers, the government has gone ahead and imported about half a million tons from the international market at a much higher price. A process which, in its entirety, ends up raising a large number of questions.

According to a front page article in the Business Standard last Wednesday, the effective cost of procuring wheat domestically works out to about Rs. 11000 per ton, while the price that the government has paid by buying wheat abroad has worked out to about Rs. 13600 per ton, all inclusive. When you see this kind of a price difference between domestic procurement and imports, it is only natural to question the logic of import. Couldn’t the government, through better fixing of domestic prices, have obtained the wheat at an overall lower rate? Should we have needed to import wheat at all, when domestic production has actually gone up?

The basic problem lies in the initial round of domestic procurement. Clearly, for the target that the Food Corporation of India (FCI) set for itself, the prices offered were way too low, and a large number of farmers ended up selling their wheat in the open market. The question we need to ask here is could the FCI have done better? Would the presence of certain indicators have helped to set a better price?

Now, setting this kind of a minimum support price is no child’s play, and therefore I’m not surprised that the FCI has gone wrong in that. Wheat prices depend upon a large number of factors – a few of them would be rainfall levels in India, rainfall levels in other wheat-growing regions such as Argentina or the US, probability of pest attacks in different areas, the list is endless. And if you look at the list of factors, one thing that might strike you is that a large number of them (including all those that I have mentioned) have a very large degree of variability.

To put it in short, it is not something that any single person could solve, be it a sarkari babu at FCI or a top-class investment banker in a top global investment bank. It requires way too much knowledge and prediction skills, and there is a good chance of going horribly wrong.

However, there is one thing that the i-banker might to here – he will take the help of people! Not just one or two, but millions. The banker will harness the wisdom of crowds, the views of a large number of people. He will effectively ask a thousand people about their opinions on wheat prices a year hence. They will include people from all walks of life – other bankers, farmers, traders, wholesalers, and even some people who have nothing to do with wheat apart from consuming it. And take into account all their opinions, weighted by their “market power”.

Now, the question is if there is an easy way to do that. Thinking about it, if we have efficient futures and options market, it is. The futures price tells us what the market (or you may call it the mob, or the crowd) thinks the price will be on that day. This, combined with option prices would give us an idea of the expected volatility. The two markets together help us hedge our bets, and obtain a cap on the amount we might have to pay out for the wheat, while making sure we get the required amount.

Unfortunately we currently don’t have this “luxury” in India. Futures markets in wheat and rice have been suspended, for they “encourage speculators and drive up inflation”. Nehru had banned options on commodities, and the situation remains. There are no domestic indicators which can help the FCI determine this all-important number, and it is forced to rely upon the variation in spot prices. Of course, you do have international prices, but using them is not that straightforward, for there are issues such as “grade”/quality, overheads, exchange rate fluctuations and the like.

The presence of futures and options markets might have also helped in the situation where the government wasn’t able to procure enough from the farmers. For instance they could have helped the government decide whether to buy from the domestic market or float tenders abroad. They could’ve helped the government figure out how much to buy from the overseas market. The longer term of them could even help the government decide whether they could delay procurement by a season.

And it might be pertinent to mention here that the Minimum Support Price is nothing but an open put option that the government writes. Any farmer who is willing to supply a specific quantity of wheat can bring it to the procurement center on the appointed date, and the government will buy it at the notified price. This is an option that is written a few months in advance of the strike date, and has no option premium. It is only fair that the farmer has to option to strike similar options with other parties at higher rates, even if he were to have to pay a premium for it.

11 Comments »

  1. The “value” of 1 kg of wheat or rice does not change today, tomorrow, next year or after 10 years, the amount of work one can do after eating 1 kg wheat will be the same. The value of the currency notes printed by RBI with asset base of only Rs.5 Crore http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/54435.pdf keep changing every minute!

    Even well educated people find it difficult to fathom the vagaries of inflation, it is commendable that Indian farmers have understood the situation within couple of years and reduced production, it is obvious farmers will reduce food production further if they are not paid “inflation adjusted” price.

    Currency inflation is “stealing of wealth” by the currency issuers and those close to them from “real producers of wealth”.

    Rate of inflation is the rate at which the “wealth transfer” or “the rich gets richer” phenomenon inherent in redemption-less fiat currency system happens.

    Redemption-less fiat currency system is equivalent to slavery!

    Comment by General — July 18, 2007 @ 5:26 pm

  2. Just being a bit of devil’s advocate.. ” Any farmer who is willing to supply a specific quantity of wheat can bring it to the procurement center on the appointed date, and the government will buy it at the notified price ” — Wouldnt it encourage middlemen ? .. How many of the farmers would understand the nuances of hedging and futures ?

    Comment by Ajith — July 19, 2007 @ 2:07 pm

  3. @ajith,

    fair point you have raised. i’m not sure how the thing of MSP works now. but yeah, education of farmers is an extremely imoprtant thing. and hedging and futures isn’t as complicated as some people like to make it sound. you don’t need to teach the farmer Black-Scholes. just some basic fundase will do.

    Comment by Karthik — July 19, 2007 @ 10:32 pm

  4. focus on what’s real – why worry about the middlemen? middlemen look for price mismatches and earn the margin between low price of purchase from farmers to high price of sales to the eating market. if there is free competition amongst (read “lots of”) middlemen, their margins are going to be wafer-thin. i don’t get what the connection is between middlemen and farmer’s not understanding derivatives.

    which is any case is a piece of politically instigated flight of imagination. there are large unofficial derivatives markets in india with volumes far higher than the volumes on the official exchange have ever seen. the farmers use these markets happily ’cause it’s unwatched by the government who they believe are the biggest scamsters around.

    can’t figure how the farmer gets stuck with this image of being a moron who gets taken for a ride on anything coming out of a market.

    Comment by mango man — July 20, 2007 @ 7:58 am

  5. @mango man –

    Well, I’m not sure of much of finance funda like you..I’m putting this point for my learning.. Assuming that the futures & derivatives markets exist.. All will go well if the farmer makes rational & logical decisions based on his estimates or the estimates guided to him…But how often would an illiterate populace make such decisions ? And in a nation like India, whats the guarantee that someone will honour the futures prices he has pledged to a farmer ? And that too in the rural areas where there is practically little governance ..Wouldn’t such circumstances give more space to middlemen who’ll end up duping the farmer?

    Now, over the cut-throat competitions among middle-men…Often what happens in rural areas in the absence of govt is that there is a big clout of a local procurer..He kind of runs a monopoly over the entire system of purchasing / selling in the absence of agencies like FCI .. I’m not saying that FCI does a good job always..Often they too collude with local sellers to underquote the prices.. To be fair to the FCI and the similar govt agencies ( civil supplies corporation controlled ones) atleast in my home state – kerala, they do the minimum pricing systems decently enough so as to ensure a consistent return to farmers , which is actually very crucial for the farmers than having a speculative market of possibly higher returns..

    The inherent assumption that everyone involved in futures/options market will honour the rates that they have pledged, is often a faulty one when it comes to interiors of India , where ppl with enough clout don’t honour even the price they have pledged 4 hours before or so… The current MSP system might be an economically incorrect way, but then it actually provides a bit of social security to the lower-strata of the society..

    ( PS:- This might seem to be a kind of communist – sided view, but actually its a view from someone who has seen a bit of troubles faced by a few vegetable farmers over the pricing of their products )

    Ajith

    Comment by Ajith — July 20, 2007 @ 10:53 pm

  6. Ajith

    Re your point about “the other party not honoring their contracts”

    A futures and options market is normally set up with a central clearing-house which ensures that all obligations are honored.

    http://en.wikipedia.org/wiki/CBOE

    Re the “illiterate” populace

    If the members of this iliterate populace can decide what to grow and harvest, what makes you think they can’t learn how to sell their products in the future? All they’re doing is locking in their selling price so they’re insulated on that front, and can focus on farming.

    Comment by Prashant — July 21, 2007 @ 5:03 am

  7. The VERY concept of federal procurement through FCI as part of Food subsidies to help maintain MSP (minimum support price) is a big drainer on economy and is ill-conceived, out-of-date approach.

    LET ME TELL WHY?

    1) You are wasting lot of federal tax money of these subsidies when they can be used to bring more productivity gains in rice and wheat.

    To give Everyone some context and background, India is literally in FAMINE in 1960′s before Norman Borlaug from Rockefeller Foundation’s Wheat Research in mexico truckloaded 18k Tonnes hybrid-wheat-seeds to india to help india get through these famine conditions. MS Swaminadhan is the conduit for this. India’s wheat production (and Per Acre Harvest) TRIPLED by 1974 (10 yrs) directly as result of these hybrid seeds and has never faced a famine since.

    The same story again in RICE can be traced back to IRRI in philippenes (again IRRI is sponsored by Rockefeller foundation) whose IR8 seed helped us get terrific yields that kicked off green revolution in india to make us self-reliant in rice for the last 3 decades.

    We are at another juncture where rice/wheat acreage is dropping, productivity gains are flat and even coming down in some areas, water being drawn from 300-400ft under through submersibles at most places, severe flooding and arid conditions as a result of unpredictable weather conditons in the last 10 yrs and predictions that it will continue happening and gets intense in the coming decades….

    what all these tell us? Federal Agencies should spend these DAMN RUPEES on attacking these problem domains through visionary approaches than wasting money on futile subsidies. IF IRRI in philppenes can do these things for us with thier paltry budget of 30 Million USD, why aren’t (india) we showing any results in terms of arid/flood-resistant strains of rice and wheat? It a SHAME on us (1 and every 1 billion of us). ..and we all should be indebted to rockefeller foundation for thier magnanimous vision. Rockefeller is a ruthless business-man whose oil monopoly in US (Standard Oil) has been split into 4-5 companies (Exxon, Chevron, Conoco..)…But his foundation contributed more than what govt’s of china and india (with 2 billion people) did to farming.

    ..had 9 more reasons why this whole procurement drama is just a public stunt by short-sighted political agenda that’s being nurtured on and on by all parties during all these decades. But, i would fill up almost 5-6 pages just on this subject. don’t want to swamp this blog.

    Marketplace is smart and savvy enough to tackle the pricing isssues for the harvest..let the fderal govt. spend all the time, money and effort on providing a sustaibale farming life-cycle to farmers and stop bluffing all of us into an illusion that it’s providing price-protection for farming community.

    May god bless all these political big-wigs with self-realization on the purpose of thier leadership and necessity of bigger vision!

    Comment by Krishna Moturi — July 29, 2007 @ 10:15 am

  8. @Krishna Moturi

    Today Farmers are at the bottom of the economy because they accept paper currency, if they stop accepting paper currency and exchange Wheat/Rice only for “goods and services” then the whole equation will change. Farmers will become masters of Indian economy like they were in past 5000+ years upto 1970 when food levy system forced them to accept paper currency and pushed them to the present suicide situation.

    Comment by GP — July 29, 2007 @ 1:21 pm

  9. Krishna, that is one thorough insight backed with historic perspective!
    Could we get the remainder of your analysis on this subject posted?

    Comment by Amar V — July 29, 2007 @ 8:31 pm

  10. [...] INDIA: Wheat Imports and Derivatives: [...]

    Pingback by Agenda & Objectives: « Siva Moturi’s Economic Policy Critique Blog — August 1, 2007 @ 2:38 am

  11. I want to know the birth place of M S Swaminadhan.

    Comment by rafeeq — June 25, 2008 @ 6:10 pm

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