Improving Competitiveness in Agri-commodity Markets – Part 3: Recommendations for Policy and Market Framework

This post is the concluding part of the three-part series on the competitiveness of agri-commodity markets in India.

How can policy enable competitive agri-commodity markets thereby also improving the conditions and incentives for farmers and others? Once again, we use the three key fundamentals as a guideline:

1. Access to Credit: As compared to a target of INR 575,000 crore credit for the agriculture sector, only INR 308,025 crore was disbursed to the farming sector (as on 31st October 2012)¹. Not only is the quantum insufficient to meet the needs of the farmers, but also the credit arrives too late in the cycle (whether at the pre-harvest, harvest, or post-harvest stage), and the repayment schedules can be inflexible or too short and not accommodating of the length of the cycle. Policy reforms should be put in place to encourage and expand lending at each of the three stages of the cycle.
2. Hedging of risks: The government at both the state and national level should incentivize the usage of hedging measures by both the farmer and others in the value chain, whether it be by promoting the use of micro-insurance products, giving farmers access to commodity derivatives or keeping transaction costs low for risk hedgers in commodity markets (OTC, spot, futures, and derivatives). As an illustration, the proposed CTT would increase transaction costs for traders and key risk hedgers that purchase commodity futures. This could constrain trading volumes, which in turn would hamper liquidity and price discovery and result in inefficient risk hedging, all of which would affect parties exposed to the commodity – farmers, traders, and wholesalers. A lot of commodities underlying traded futures contracts that are classified as industrial commodities are often used by farmers for price discovery (price of sugar as a proxy for sugarcane price). A drop in the underlying volumes of these contracts could harm hedgers as well as farmers who use these contracts to price their produce.
3. Price discovery: Having in place established and widespread commodity exchanges that deal in not only spot but also futures and derivatives will, as explained earlier in the post, enhance fair and transparent pricing of agricultural produce. Towards that, the government should encourage the setting up of exchanges whether physical or virtual, and allot a public sector body to regulate such markets. Apart from exchanges, direct markets can also be encouraged on a smaller scale, such as Rythu bazaar cooperative model, the ITC e-choupal model. This will require a dedicated awareness campaign that will reach out into the rural hinterland and educate the farmers about the options available to them. Suitable amendment of the Food Safety Standards Act and/or the promulgation of laws to standardize quality at a wholesale level may be required to protect the players in the agri-commodity market at a wholesale level. Besides this, policies that promote the linkages between spot and futures market and thereby aid price discovery in a fair, transparent and reliable manner will go a long way.

Some more steps towards Competitive and Sustainable Commodity Markets: Addressing Current Challenges in Regulation and Governance

The main goals of a commodity exchange are to provide a platform for risk hedging and price discovery. Both these are important aspects of the agricultural cycle affecting all stakeholders. We review the existing landscape of commodity exchanges (NCDEX, MCX, NSEL, NSPOT) to identify the issues that hamstring the agri-commodities market.

Strong linkages between the exchange and warehouse regulators: If the commodity exchange is to honour contracts based on physical delivery of commodities, it must ensure that the warehouse meets minimum standards of quality, security, climate control, staffing, waterproofing, et cetera. This is particularly important as warehouse receipts can be used to raise financing for the warehouse itself to expand or invest in facilities such as pest control, fumigation, fireproofing, and standardized weighing equipment. The Warehouse Development and Regulatory Authority can act as a third party verifier of scientific warehousing standards and issue receipts that are treated as negotiable instruments and accepted by the Indian government and banks. In order to register with the WDRA, the warehouse must comply with strict rules on the terms of storage and construction and make penal provisions for stock shortfalls from the amount on the receipts. The 350 warehouses across the country that are registered with WDRA are subject to regular inspections by empanelled agencies. Although WDRA has been in existence since 2010, most of the warehouses in employ under the current exchanges –NSEL, NCDEX, MCX, NSPOT- are not registered with WDRA. In light of the NSEL debacle, it has been reported that the FMC is considering a proposal for compulsory registration of all warehouses used by spot and futures exchanges with the WDRA. Such a move would be a positive step for the market. Registration would also incentivize warehouse operators to improve the quality of their construction and facilities and therefore reduce wastage in the long run.

Price linkage to external markets: Since commodities are traded globally, it would make sense to start thinking about linkages of the Indian commodity exchanges with global markets. If there is a bumper corn harvest in West Africa that drives global corn prices down, the Indian farmer should be aware of these global movements. Removing the barriers to market information will ensure more transparency and information symmetry and lead to a more efficient exchange particularly in commodities where linkages with the global markets are increasing.

Price distortion caused by the government being a large player in markets for those commodities under MSP: Since the government is a key high-volume buyer of the commodities under the MSP umbrella at pre-fixed prices, it will invariably cause price distortion. More efficiency in procurement, storage and stock management by the Government may in turn minimize the degree of distortion in the market.

Need to differentiate between industry crops and food crops: Policy makers should understand the distinction in the impact measurement of movements in prices for industry crops and food crops. A supply shock in rice will directly affect the consumer who will have to pay much higher prices for his daily staple. However, a similar magnitude of supply shock in guar, which is an input into many different processed food and non-food products and for which there exist alternatives, will not affect the end-customer to the same extent in the same window of time. This distinction has implications for product design and policymaking (for example, applying the Essential Commodities Act differently to industry vs. food crops). In the context of commodity exchanges, the distinction could come into play in the pricing of derivatives, in hedging measures, as well as transaction costs.

FCRA Act: It has been nearly a year since the Cabinet approved the Forwards Contracts Regulation Amendment Bill and it awaits passage by the Parliament. Passing this bill will ensure a boost to the commodity exchange industry through introduction of new products like options and new generation commodity derivatives to expand risk management opportunities beyond the usual futures and forward instruments, and will provide more autonomy and accountability in the operations of the FMC (the regulator of forwards markets). An analysis of the NSEL crisis currently unfolding may reiterate the urgent need to pass this bill for empowered supervision of this important component of agri-commodity markets.

Even if the FCRA Act is passed, still needs a few more tweaks for FMC: FMC currently reports to Ministry of Consumer Affairs while all other financial market regulators are under the Ministry of Finance. In order to serve as an effective regulator of commodity markets, it should be independent and supervised by the more relevant Ministry of Finance and held accountable for its critical supervisory activities.

A better business model for exchanges in line with the top global commodity exchanges: Across the world, commodity exchanges use turnover fee based on volume rather than value. This encourages exchanges to push for higher volumes of contracts which in turn enables better price discovery – the primary aim of such an exchange. Further such a revenue model would avoid any conflict of interest as the exchange would be indifferent to the direction of price movements.

Correction: FMC has now come under the purview of Ministry of Finance since early September. Thanks to Mr. Ramesh for pointing it out in the comments section.
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1 – Farmer’s Access To Agricultural Credit – Department of Agriculture And Cooperation, GoI