[Shuchi Agrawal is a research fellow in the Corporate Law and Financial Regulation team at Vidhi Centre for Legal Policy]
On 27 October 2023, the Securities and Exchange Board of India (“SEBI”) extended the ban on futures trading in seven agricultural commodities for a year, that is, until 20 December 2024. Wheat, paddy (non-basmati), chana, mustard seeds, soya bean, crude palm oil and moong are covered under this ban. This extension of the prohibition of futures trading in the aforementioned items has come despite much resistance from the National Commodity and Derivatives Exchange (“NCDEX”) and the cabinet secretariat. Prior to this extension, several representations were made to highlight the severely adverse effects that such a step would have on the entire financial ecosystem, including the potential shutting down of the exchange.
The ban on commodities futures trading in these items was initially introduced in 2021, with the aim of combating rising inflation. The seven banned commodities constituted more than 70% of the traded volumes in the Indian agri-commodities futures market prior to the ban. Hence, the prohibition on their trading had a disastrous impact on the futures market. In fact, the daily turnover of NCDEX declined from approximately INR 2,000 crores to INR 300-400 crores due to this measure.
Subsequently, the ban was extended for a year in 2022 even though the decision was criticized heavily by market participants as well as the exchange. The recent extension means that the ban will continue for a third consecutive year. At this stage, it has become imperative to examine the soundness of the policy and gauge whether it has made any progress towards its stated objectives. Through this post, I will attempt to analyze the aims that this policy intended to achieve, the effectiveness of this policy in attaining these objectives and the potential way forward.
Agriculture in India and Futures Trading
India is primarily an agrarian economy and ranks second in farm production in the world. Nonetheless, the agriculture sector is highly vulnerable to volatility in prices because the commodities involved are seasonal products and perishable in nature. Fluctuations in the prices of agricultural products are a serious concern, but they have historically been dealt with in a reactionary manner by Indian authorities. Imposing restrictions on exports or purchasing products at the minimum support price (“MSP”) are some of the interventions frequently applied by the authorities to stabilize prices. However, commodity futures contracts (“CFCs”) offer a myriad of benefits for the agricultural sector in India, and may help manage these price-related concerns.
A CFC is an agreement to transact a specific amount of a particular commodity for a pre-determined price at a future date. Primarily, most participants in the futures markets are commodities producers or consumers who use CFCs to hedge their risks and maximize their profits. These contracts work as insurance against price changes, as they allow the contracting parties to fix a future price and hence combat price volatility. However, there is another set of market participants who wish to speculate on the trade and make gains from the changes in the prices of the commodities.
CFCs are an effective method of price risk hedging and protect farmers against fluctuations in prices by assuring them a fixed value for agricultural produce. In the context of the ban, a vegetable oil brokerage firm recently commented on how the absence of CFCs has created a dire need for a hedging mechanism to navigate the ongoing global market disturbance.
Additionally, CFCs enable price discovery. The futures market operates on the basis of interactions between buyers and sellers who take into account multiple factors while determining the future price, including global supply-demand conditions, supply chain bottlenecks and geopolitical issues.
Moreover, commodity exchanges also calculate and report spot prices of commodities even if CFCs have been suspended. However, without a futures market, the spot prices published by exchanges lose their relevance and significantly degrade the market’s ability to indicate a credible price. Hence, CFCs are integral to the price discovery process in India. This is the reason why farmers went on a protest against SEBI in Mumbai following the ban and termed the ban “anti-farmer.”
Is the Ban a Good Policy Measure?
Despite all the benefits of CFCs with respect to the agriculture sector, SEBI has banned them in a bid to contain inflation. The rising prices of agriculture products are a major problem for the authorities and can cause much socio-political and economic disturbance. The rationale behind the ban seems to be founded on the belief that the speculators who engage in the futures market may artificially drive up the prices of these commodities and cause physical hoarding of these items, in the hope for a greater future price. Such events may theoretically lead to inflation. However, in practice this has not been the case.
In April 2008, the Abhijit Sen Committee published its report on the impact of futures trading on agricultural commodity prices. According to the committee, there was no evidence to suggest any effect in the volatility of spot prices due to futures trading. However, the authorities did not agree with the committee and imposed a ban on the futures trading of chickpea and potato. Nevertheless, the market prices of both these items increased.
Following this, in 2010, the Reserve Bank of India (“RBI”) also studied the effects of futures trading on the prices of agricultural products between 2004-09. Their finding was in line with the Abhijit Sen Committee Report that there is no evidence to support a relationship between spot and futures prices.
Thus, the policy of banning futures trading with respect to the seven commodities is not backed by any empirical research. The policy has, however, caused tremendous upheaval in the futures market and has placed farmers and other market participants in a disadvantageous position by denying them a trusted mechanism of price hedging and a process for price discovery.
Therefore, the policy that is intended to regulate the prices of agricultural commodities impedes the development of a futures market which may actually help increase stability in the prices. Consequently, the policy seems to be ill-conceived, and harmful to the financial markets and the farmers. Furthermore, the ban has already been in place for a few years now and has not been able to prevent inflation in the prices of agricultural products.
Conclusion and the Way Forward
The problem of inflation, especially with respect to agricultural goods, is serious and requires effective policy measures. It disrupts daily life and threatens food security. However, a ban is perhaps not the best suited response to the issue.
Policy proposals like the imposition of a ban tend to have the appeal of being a silver-bullet, but are generally ill-suited to producing any long-term solutions. If such measures are adopted by the authorities without a deliberative and slow process, then this prompts the private sector to view the authorities as a regulatory risk. Furthermore, interference by the authorities in an attempt to engage in price control is often unsuccessful as it disturbs the adjustment process.
In its 2010 study, the RBI had found that commodity prices in India are influenced considerably by drivers of price changes such as the demand-supply gap, dependence on imports and international movements. Therefore, any attempt to manage inflation must be focused on these factors. In addition, the authorities should adopt a more favorable view of futures trading in agri-commodities and leverage it to achieve their goals. It has been argued that the Indian agricultural sector suffers from cycles of booms and busts because the authorities have disrupted the forces of stabilization, including futures trading, warehousing and international trade. As has been argued previously in this post, CFCs assist in price discovery and insure a price for the commodities. This can also help reduce reliance on MSPs and hence, benefit the authorities. Relevantly, the CEO of NCDEX has also suggested that options trading must be explored as a complementary tool to MSP. Thus, the authorities need to reconsider their stance towards futures trading in agri-commodities and instead explore their benefits.
– Shuchi Agrawal