Has the ban worked? Business Standard, 29th July 2007

Futures trading was banned in four commodities in the beginning of the year ostensibly because it was felt that they were responsible for higher inflation. Five months have passed since the ban was imposed and it is essential to assess the impact of this ban on prices and the market — more so because there is a Committee that is looking into aspects of futures trading to provide a clearer perspective.

The inflation impact has not really been positive. The moderation in inflation from the 6 per cent mark to the 4.3 per cent mark witnessed today has been more due to a higher base effect as well as the aftermath of the rabi crop, which was good this year. Also this is the time when inflation is typically lower than in the latter part of the year, when demand picks up across the board.

Therefore, we have seen the prices of wheat and urad decline to begin with as the rabi harvest came in the months of March, April and May . However, ironically this was indicated by the futures prices at the time of the ban. But in the case of wheat, the story did not really end because the government has still not managed to procure the 15 million tonne target set for the FCI.

Either the production estimates of wheat, which is supposed to be close to 75 million tonnes, is not right or the farmers have become savvy and are not interested in selling to the government at a price of Rs 850/quintal especially since the landed cost of wheat could be anywhere up to Rs 1,200 per quintal at a minimum price of $263/tonne. The wheat chaff has yet to settle down and imports have been reckoned for the second successive year.

Tur was the other commodity which was banned, and its price continues to increase in the market, as output has fallen short of the target as indicated by the ministry of agriculture. This was also what the futures prices had indicated in January. In case of urad, the futures prices were falling anyway due to the rabi arrival as well as the imports which come towards the end of the first quarter from Myanmar. Quite evidently, the important signals provided by the futures market were incorrectly interpreted which resulted in what was euphemistically termed as a delisting of these commodities.

The consequences on the market have been fairly harsh. Firstly, market participants are apprehensive of trading in agricultural commodities as there is fear that the same kind of restrictions may be imposed on other commodities as well, in which case moving out of the market on satisfactory terms would be difficult. Therefore, participation in trading in agricultural commodities has come down quite significantly by between 10-20 per cent.

Secondly, the volumes of future starting in agricultural commodities have also come down and the commodity market appears to be buoyant only in non-agricultural commodities. The share of agricultural commodities in total traded volumes fell from around 55 per cent in FY06 to 35 per cent in FY07 and has further declined to 29 per cent in the first quarter of FY08.

Thirdly, diminishing volumes as well as participation in the futures markets have also affected the liquidity of contracts on the exchanges. Liquidity is important because an efficient market means there are large volumes, which is the prerequisite for efficient price discovery which, in turn, implies lower impact cost. This process has been set in motion in the last three years and has been quite competently established in an array of commodity groups such as cereals, spices, pulses and oils and oilseeds.

Fourthly, the very purpose of having futures trading has been defeated as it was proposed that futures trading would bring the benefit of fair prices to farmers when this market was resurrected in 2002. However, with diminished interest in futures trading, this bridge would get that much farther. While it is true that farmers are not trading today on the exchanges, there is enough evidence to show that in certain pockets of the country, the community is making use of the prices.

It is true that farmers would take time to actually trade as there are a number of enabling provisions in the regulatory structure that need to be put in place before this can happen. But before this can be embarked upon, we need to have a liquid market for agricultural commodities. The drying up of liquidity would automatically make the market that much less efficient and keep the farmers away from this system. There is a view that vested interest groups, who have seen their oligopolistic power diminished with the advent of futures trading, have been constantly trying to present an incorrect picture which could have influenced the decision to ban the trading of futures in four essential commodities.

The last consequence of a thin agricultural futures market is that a very important tool for taking economic decisions would be lost. Futures prices have, in the last couple of years, indicated well that crop harvests and prudential regulation from the FMC have ensured that price deviations have by and large reflected the fundamentals. This tool can hence be used at a more practical level by the government for fixing the MSPs as they will provide the market view of things.

At a different level, the ban has also affected the global view of the country in an age where markets are being liberalised; India appears to be dragging its feat. However, it is heartening that there are a number of foreign investors who are still interested in taking equity stakes in commodity exchanges with an equal interest being shown in trading.

The delisting logically needs to be removed to restore the equilibrium though it would take time for the market to restore its faith. This would be a pragmatic decision.