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Improving Competitiveness in Agri-Commodity Markets – Part 1: Understanding the Markets

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The Indian farmer might earn only INR 30 a day, but there are many of him. According to the 2001 census, the Indian agriculture sector employs about 60 percent of the population, of which farmers comprise 119 million (the rest are agricultural non-owner labourers). Yet agriculture contributes only 14 percent to total GDP (2011-12, as per Ministry of Agriculture statistics), and has seen stagnating growth at around 3-3.5 percent over the last five years (compared with 7-8 percent national GDP over the same period, according to Ministry of Agriculture statistics). This is a big community that continues to remain entrenched in economic immobility. There has been a lot of informed discussion at the academic and policymaker level on how to revive the agricultural sector via policy and external stimuli such as subsidies. This series explores issues core to improving competitiveness in agri-commodity markets and presents them from the perspective of the needs of the Indian farmer.

Part 1 of the series outlines a few factors that would enhance competitiveness in these markets
Part 2 sets down a background of legislation and policy framework in the sector
Part 3 lists out our recommendations to improve the policy and market framework and will follow in a subsequent blog post.

The Need for Competitive Markets

The agricultural cycle can be divided for the purpose of our analysis into pre-harvest activities, harvesting, and post-harvest activities.

  • The pre-harvest activity entails seeding/planting, pruning, irrigation, disease/pest control.
  • Harvesting will entail the use of seasonal/temporary labour and or/machines to reap the harvest
  • Post-harvesting will require the use of transportation, warehousing and storage, and getting a good price for the produce.

Pre-harvest needs:

The farmer’s requirements include access to credit so that the farmer may finance the seed and fertilizer purchase, the labour required, the irrigation needs and insurance or other hedging measures to protect against adverse weather or rainfall patterns or plant disease etc.

A specific challenge at the pre-harvest stage is the lack of access to suitable financial products both in terms of credit as well as insurance. This may force farmers to obtain pre-harvest financing from ‘middleman’ to whom they are forced to sell their produce – leaving them in a weak bargaining position. Further the lack of access to insurance and hedging products such as micro-insurance, weather insurance or crop yield products may weaken their overall financial position, leaving them exposed to risks they are not best equipped to deal with (weather, price-volatility, crop demand-supply dynamics at harvest time).

Harvest needs:

The lack of access to financial services could equally manifest at the harvest stage if the farmer needs to finance the hiring of labour and machinery.

Post-harvest needs:

Significant linkages with agri-commodity markets truly begin at the post-harvest stage when the farmer may have a range of requirements including: credit, adequate and well-located infrastructure for transportation, warehousing, direct low cost access to wholesale markets without depending upon middlemen, ability to source price information in a timely manner.

At this stage there are many challenges faced by the farmer:

  • Insufficient access to finance at the post-harvest stage, forcing farmers to resort to middlemen to finance transportation/warehousing as well as to find buyers and determine wholesale prices.
  • Inadequate infrastructure for warehouse and storage of crops can result in high crop wastage.
  • Most warehouse and storage facilities are distantly located from the rural farmlands, resulting in a high price and opportunity cost for the farmer in terms of time taken for transporting his crop. Poor roads may complicate this further.
  • Inability of farmers to access updated commodity price information due to poor awareness and understanding or information asymmetry.
  • Inability of farmers to directly access markets, due to limited reach of private wholesale markets or MSP mandis has increased dependence upon middlemen to handle the agricultural commodities and fix a wholesale buyer and the price themselves, leaving the farmer with little say in the price he gets after paying commission fees.

To summarize, there are three fundamental issues:

1) Access to credit: at all stages of the cycle to enable the farmer to move away from dependency on middlemen and towards self-reliant price discovery.

2) Hedging of risks: need to hedge against not only adverse weather and sub-optimal crop yield (via insurance and weather derivatives), but also against price shocks. A farmer who grows a crop is long that commodity the day he sows the seed. Not having access to hedging mechanisms forces the farmer into a speculative position on the commodity. His returns now depend upon how the prices of the commodity behave at harvest time. An increase in the underlying commodity price will leave him richer. A drop in the commodity prices may leave him with barely enough to cover the costs of input and labour. Access to commodity futures and options will give the farmer a choice to hedge and move away from his current position of “speculator by default”. While futures contracts exist on some commodities, the size of the contract is too prohibitive for the small farmer. Mechanisms would need to be put in place to provide farmers access to futures hedging by way of aggregation by an intermediary.

While today farmers can theoretically sell futures on various agricultural products to “lock in” a price, there are two drawbacks. Firstly, it means depositing margins for farmers as sellers of futures, and secondly giving up on rise in the price of their produce. While futures based hedging would benefit farmers, having commodity options would enable farmers to hedge their long positions while retaining the price upside, an upside thus far only available to traders and aggregators. Buyers of “put” options have the right but not the obligation to sell, or make a delivery, at a pre-determined price and date. Basic, standardized commodity options are increasingly traded on exchanges globally and often have liquid secondary markets. Since buying a put option is being bearish on the underlying commodity, even though it is similar to selling a future, it involves no margin to be posted, and the only loss that accrues if the underlying commodity’s price increases, is the original premium posted. The benefit of the upside is preserved for the put buyer. In short, a well-designed agricultural commodity options market could completely replace the MSP system.

3) Price discovery: To ensure fairness and transparency of prices of agri-commodities, it is necessary to have an organized, competitive, liquid, and efficient market wherein market forces, and not the influence of middlemen, result in price discovery and full awareness of both buying and selling prices by the farmer and the consumer. Deep and wide futures markets are an effective means of enabling such price discovery – which goes beyond the local geography that serves as a reference for the farmer and could lead to better quality decision making by the farmer. The price of raw farm products such as sugarcane and natural rubber are derived from the futures price of processed end-commodities such as sugar and rubber. Availability of warehousing and storage with guaranteed standards will enable the farmer to hold stock for a potential upside. This is also a requirement for exchanges that operate on delivery based contracts. As we said earlier, the ability to hedge his long commodity position will better enable him to manage price risk.

At present, there is no uniform system of standards for measuring and certifying food quality and safety at the wholesale point of trade. It is observed in different studies that due to the lack in information integrity, the farmers are often paid less for their high quality agriculture produce and at the same time, retailers feel that they have paid more for lower quality food1. Additionally, the Food Safety Standards Act does not currently exempt the value chain up to the wholesale point from food quality and safety checks, thereby putting the exchange or transacting parties at risk if the underlying commodity of the contract or transaction is found to contravene the stringent quality standards as per the Act, leading to a possible repudiation of the contract.

The next post (Part 2) will explain more about the Food Safety Standards Act and other pieces of legislation and policy that are relevant for the study on competitive agri-commodity markets.

1 – Economic Inefficiencies in Farm-Market Linkages in Agriculture Value Chain in India: Problems and Solutions – Anshul Pachouri

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2 Responses

  1. A few points that you may want to reflect on in your approach to this subject.

    i) Access to credit

    Dependency of the middleman –

    Nothing prevents any organized sector entity, not just a bank, from providing credit and related facilities to small farmers. A host of issues relating to profitability does. The middleman there, thus performs a function and full spectrum services that no one is willing to do..with the accompanying risks that banks won’t touch.

    The size of the small producer is often too little to justify more than 1 middleman in a community.

    All the hoopla on “inclusive banking” effectively replaces the indigenous middleman with an organized sector middleman, who is still a virtual monopoly. Lead banks in districts attest to this.

    While govt tries to address this through “push” policies of credit targets, banks are necessarily constrained by prudence laws on banking.

    A via-media that works better is the self-help groups who can step up to agri-finance. However, these groups function where there is social cohesion – or the prevailing class iniquity overrides easy access to finance and groups don’t get formed. The interest rates aren’t much better than the “middleman” except the profits accrue partly to the farmers.

    How does one provide choice of formal institutions to a farmer that will reduce dependency? It won’t happen by replacing a monopoly provider with a monopoly provider.

    Maybe enabling the front end to be an agent for multiple banks may create the competition to drive costs and prices down. The agent can obtain a carrier fee for handling the transaction.

    Self reliant price-discovery

    A small producer (Indian farms are typically 1-2 acres, the big guys don’t have so many problems) of a perishable product has little staying power. Further, if its a commodity product he has very little say on prices – e g rice compared to vegetables.

    As a small producer, his costs of transacting are too high. He will sell cheap regardless of the mechanism available as long as he has to act as an independent player.

    Futures and Options etc

    Gold is the largest form of individual savings besides banks. Its a commodity too. No individual holder trades in gold or options or anything of that sort. In fact, educated urban citizens mostly don’t do this.

    While retaining or developing these options may serve the market for various reasons, its not going to help the farmer in practice. The small farmer.

    There are two aspects to this approach on agricultural commodities:

    i) How to bring in transparency and more organized sector entities into this business as opposed to opaque systems prevalent. This aspect has little to do with small farmers. It has more to do with what will excite large players from the organized sector. With banking interests and or investments interests – futures, options etc.

    ii) How to make earnings and finance etc a more predictable way of life for small farmers with scope to get the best prices for what they produce. Also make a risk-reward matrix available as their individual choice. To illustrate, as a small rice producer I may be happy to sell at a predetermined price that gives me reasonable income. As a producer of vegetables, I’d like to obtain better prices if my crop is of better quality. The former may warrant a contract arrangement that is “fair”. The latter woud entail providing enabling systems such as grading, more transparent price disovery etc. Ideally both should be available. The latter will entail more downstream investments that will take a longer period to turn profitable – not unlike any infrastructure service such as even telecom or power. High capex – gradual adoption etc. Its a big avenue for PPP structures. (added this so the “should” doesn’t stay in the realms of theory!).

    Hope this helps. .

  2. Hi Prasanna,

    Many thanks for your comment. We have actually addressed
    several of your points on price discovery and the benefit of futures/options to
    the farmer in the forthcoming Part 3 of the blog series.

    As to your other point on dependency on the middlemen, we are not
    trying to provide a solution on who should be the right mix of players in the
    front-end providing funding to small farmers, that would need exhaustive
    research and analysis beyond the scope of this blog series. Instead we are
    discussing how best to improve competition in agri-commodity markets and bring
    the small farmer into an important role in the chain so that he has other
    options beyond depending on the middleman.

    Please feel free to discuss in more detail with us once we
    have shared Part 3 and our concluding remarks.



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