India Markets close in 6 hrs 6 mins

Beyond MSP! Protecting farmers’ income through market mechanism

By Harsh K Bhanwala & Sunil Kumar

Indian farmers face several risks-production, weather, quality, market, and so on. While crop production is often seasonal and regional, consumption is round the year and across the country. So market prices of agriculture commodities tend to be volatile. To provide remunerative prices to farmers, the government announces MSP for 23 crops.

For arriving at the MSP, the CACP undertakes an annual exercise examining the cost of production of select crops, overall demand-supply, domestic and international prices, inter-crop price parity, terms of trade between agri and non-agri sectors, and so on. The rationale behind MSP is the assurance of a minimum price that ensures a farmer recovers his cost of production and receives a reasonable return on investment. MSP acts as a sort of a guarantee that farmers will not be allowed to suffer losses if crop prices fall below the specified minimum price.

Limitations: MSP not backed by a robust procurement policy and associated logistics is not likely to succeed, especially in the context of our production-centric approach. In the case of rice and wheat, grain mono-cropping and open-ended procurement at support price in Punjab, Haryana and UP are leading to disastrous environmental impacts. Soil health has deteriorated and the water table has gone down to alarmingly low levels.

Indeed, an ecological disaster is waiting to happen. The financial burden emanating from MSP also cannot be ignored, given the rise it has seen over the years. The total food subsidy (Rs 2,000 crore in 1987-88) increased to Rs 72,823 crore in 2011-12. The food subsidy budget for FY17 was Rs 1.34 lakh crore, of which Rs 1.03 lakh crore was to be routed through FCI to intended beneficiaries. Can commodity derivative markets offer solutions that can be a credit alternative to MSPs?

For deciding which crop to sow, farmers need information on current price, market arrival related information and forecasting of market trends. Along with the information of the spot market, the forward and futures market prices are also required to be disseminated to farmers. They need to be trained in taking appropriate signals from the forward and futures prices.

Crop sowing decisions can thus be taken by farmers based on prevailing spot market price/futures price, and crop panning can be done based on signals transmitted from market through futures prices. As regards perishable crops like onion, potato, vegetables, fruits, etc, price spikes and glut situations can be avoided by strengthening production clusters, developing distributed warehousing facilities, putting in place agri-logistics arrangements like cooling and processing facilities, transportation, etc.

Remunerative prices: In a developed commodities derivatives market, there could be several market-based instruments that can serve as an efficient alternative to MSP. These could be options, forwards and futures. These instruments rely on market prices rather than administrative prices, thus shifting risks to viable financial markets that are better able and willing to take risks. Of these instruments, commodity options could serve as the best alternative to the current price support system.

Actually, MSP works as option contract. If price were to fall below the specified MSP, the government has the obligation to purchase from farmers at MSP. At the same time, the farmer is under no obligation to sell to the government if the price stays above MSP. In the event, the farmer is free to sell in the open market at a price higher than MSP.

There are two type of options-call option and put option. Buyers of "put" option have the right but not the obligation to sell, or make a delivery, at a predetermined price and date. Therefore, put option could be used by farmers as it empowers them with the right to sell at predetermined prices without any obligation to sell for the same. If a farmer buys a put option of a commodity he produces, he locks in his profit by paying a premium. Here, this premium could be partially or fully subsidised by the government. In case prices fall after harvest, the farmer gets the predetermined price of his produce, and if prices rise after the harvest, he can sell in the open market to realise higher prices of produce.

Although commodity futures are available with Indian commodity exchanges where farmers can theoretically sell futures on various agricultural commodities to "lock in" their price, there are two drawbacks. Firstly, selling through futures means depositing margins for farmers as sellers of futures, and secondly giving up on any further rise in the price of their produce. Though buying a put option 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 for the put buyer, who could be a farmer, is the original premium posted. The benefit of the upside is preserved for the put buyer.

There are several benefits of facilitating remunerative price (on the lines of MSP) to farmers/FPOs as well as to the government using the option approach. Firstly, the price gets locked-in by farmers as put options act as an insurance and the risk from price fall is mitigated, while at the same time retaining unlimited potential for upside gains in case of price rise.

Secondly, for the government, the cost of subsidising option premium would be a fraction of total procurement and administrative cost. This will result in huge cost savings for the exchequer and reduction in administrative efforts.

Thirdly, all transaction details and trails can be transparently recorded ensuring efficient utilisation of public resources. And finally, the risk of price fall is transferred to counter-party through the exchange platform by paying a small premium, and due to lower cost, reach can be widened to benefit more farmers than what is being covered under MSP.