Agriculture incomes in India are volatile because of a number of unforeseen factors, such as weather, disease/pest infestations and/or market conditions. With 65 per cent of the population dependent on agriculture, it is essential to manage both production and price risks. The government has responded by encouraging the setting up of modern exchanges, with daily mark-to-market margins, a trade guarantee fund, back-end computerisation, on-line trading and demutualising of new exchanges.
However, to realise the benefits from such initiatives, the bulk of farmers, who are small and marginal, require access to finance immediately after harvest, though they possess limited collateral to obtain bank funding. Physical collateral such as land and agricultural implements are of little value in mitigating a financier’s risks as the collateral is difficult to enforce and has a low resale value.
Agriculture is a seasonal business with high price uncertainty. During harvest, prices drop due to excess supply. But, if the harvest is lower than expected, the prices rise. Hedging against price fluctuation is possible through derivative contracts such as commodity futures, fixed price forward sales or purchase of put options.
With commodity futures, the farmer agrees to sell the commodity at a pre-determined price and date. While a fixed price forward sale agreement is possibly the simplest price hedging strategy, it is difficult to find the right counter-party unless the size of the expected crop is reasonably well known, prices are satisfactory and buyers have enough confidence in the seller to commit on a forward basis.
Since there are several variables, such contracts are better implemented with a put option for the farmer or a call option for the buyer. In India, proposals to allow options in commodities and provide for registration of brokers by suitably amending the Forward Contracts (Regulation) Act have been pending in Parliament for over five years.
Warehouse receipt financing
Small farmers need liquidity urgently and the crop is inevitably sold to traders/village-level aggregators immediately after harvest. The buyers hold the stock through the harvest season till prices rise. If farmers are enabled to hold their crop beyond harvest, this price benefit could accrue to them. Farmers face two major problems — lumpy cash flows and non-availability of intermediate finance.
Warehouse receipt finance, which can be used to extend the sales period beyond harvest season and secure collateral for obtaining finance, can play an important role in smoothening farmers’ incomes by providing liquidity at times when cash-flows dry out.
The concept of warehouse receipt financing is not new in India. Banks have been extending these facilities to large aggregators, traders and bulk farmers, ignoring small and marginal farmers. Extending cheaper credit to small/marginal farmers is easily done through warehouse receipt financing if banks purchase suitable hedges on the price of commodities, assuming only a minimal credit risk.
In warehouse receipts financing, producers deposit goods of a certain quality, quantity and grade in accredited warehouses and receive a receipt for it. Since these receipts are now accepted as negotiable instruments (under the Warehouse Development and Regulation Act 2007), they can be traded, sold, swapped and used as collateral to support borrowing or accepted for delivery against a derivative instrument such as futures contract. This facilitates access to finance.
For the receipts to work effectively, it is essential to ensure infrastructure, and grading and collateral management systems which guarantee the quality and quantity of stored commodities. This will provide comfort to farmers — to store their produce, as well as to banks — to accept warehouse receipts as secure collateral to finance farmers.
Trading units on national-level commodity exchanges are large, preventing small and marginal farmers from participating individually; they depend on local mandis/middlemen. Also, the rather small number of delivery centres and the price difference across physical markets limit farmers from participating in trading.
There is a need to increase the reach, provide the services of an assayer and reduce transportation costs. Setting up local access to commodity exchanges and end-buyers, allowing them the kind of price discovery offered by national exchanges, and convenience of access, is a possible solution.
An example of a local exchange is the Agricultural Terminal Markets Network Enterprise, which works with castor farmers, allowing them to trade at local branches across Kadi Taluka, 65 km from Ahmedabad.
Small and marginal farmers are also inconvenienced by the inter-bank settlement time, preventing exchanges from making instantaneous payments to traders. Price discovery between international and domestic commodity markets can improve by allowing banks to offer commodity solutions as an intermediary between international counterparties and smaller Indian companies.
While domestic exchanges currently offer over 50 commodities across various segments, the number of contracts listed on the exchange for agricultural commodities continues to be low. As the number of listed contracts increases, price discovery will improve.
This article first appeared in The Hindu Business Line.