Wheat Procurement And Derivatives Markets

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.

Cross posted on the Indian Economy Blog. Usual rules for replying to comments apply.

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