Futures of food in India

According to news reports, senior Congress leaders want a stop to futures trading in certain commodities like wheat to address the rise in their prices. This isn’t the first time the futures market has been blamed for the rise in commodity prices. But is there any truth behind this claim?

On the face of it, it looks like the national commodity futures exchanges have little to do with the price increases. After all, the open interest in these exchanges peaks at only about 5% of total production for most commodities.

On the NCDEX, the largest exchange for agri-commodities, total open interest for all wheat contracts stood at 0.37 million tonnes, or 0.5% of India’s annual production of wheat. In the case of chana, where the action has recently picked up since it’s a rabi crop, open interest stood at 0.28 million tonnes or 5% of annual production.

Even if the entire open interest was held by manipulators, it wouldn’t normally affect prices by a large extent. Defenders of national commodity futures exchanges say that the rise in price levels is actually caused by a shortfall in production and also because of shift in consumption patterns.

In 2004-05, for instance, actual production of wheat fell by 5% to 68.64 million tonnes from 72.15 million tonnes the previous year. Government estimates put wheat production at 71.54 million tonnes for 2005-06, but market sources say the actual production would be more or less in line with FY05 levels, since estimates given by the government have been off-mark in the past. It also needs to be noted that production of wheat and pulses has stagnated since the late 1990s, although demand has grown due to the increase in population and a shift in consumption pattern favouring pulses, thanks to rising income levels.

But, although the main reasons for the increase in prices of wheat and pulses currently may be a shortfall in supply and an increase in demand, one can not rule out the possibility that even the national commodity exchanges may have a role to play. Experts point out that there’s a flaw with the contract design of quite a few commodities trading on these exchanges. Futures contracts are available for trading across the year on the national exchanges, even at times when there may not be active price discovery in the spot market. This especially happens in the case of seasonal crops, where active spot market trading happens mainly around the time of harvesting. With no fair spot price as a benchmark, futures prices are then open to manipulation, as NCDEX discovered with its urad futures contracts expiring in January and February this year.

NCDEX settles outstanding contracts based on average spot prices around the time of expiry, based on a poll of market participants conducted by an independent agency. Some urad traders took advantage of the fact that there wasn’t active spot market trading since the middle of January, by taking long positions in the futures market and then providing high prices for urad in the poll that was conducted. This led to a sharp jump of about 20% in prices of urad futures in a short period between the 15th and 19th of January. With little stock available in the wholesale market (mandis), traders were certain that they wouldn’t be forced to take delivery by sellers (physical settlement happens at the behest of sellers in the commodity futures market). This trend was repeated in February.

One of the solutions being proposed is to have compulsory physical settlement, since that would curb manipulation. But since the supply of many commodities is limited, there could be a short squeeze due to compulsory physical settlement. True, there are client-level and member-level position limits in place to avoid such practices, but that’s no guarantee that traders wouldn’t collude and try to manipulate prices.

It makes more sense to ensure that futures contracts aren’t available for trading when there’s no active spot market trading. This would plug an existing opportunity to manipulate prices.

Contributed by Mobis Philipose