04 July 2017 09:37:57 IST

Where MSP falls short

Procurement support is essential to make it a trustworthy signal to farmers

It is an irony that farming remains the livelihood of more than half of our population, yet there is no other profession that provides a low return, accounting for about 15 per cent of India’s GDP.

The profitability of farming is largely associated with prices that are fixed by the buyers and not the producers.

Against this context, here is an attempt to examine the sufficiency and relevance of one of the oldest tools used by policymakers — Minimum Support Price (MSP) — to send price signals to the farmers.

In the absence of prior signals, the unorganised community of farmers always grew what fetched them best prices based on their memory of the last season and as such action became viral, it had always inevitably crash-landed markets.

With lack of infrastructure to support by way of procurement, MSP largely remains an indicative price for about 22 agricultural products. Backing up MSP with procurement support is essential to make it a trustworthy signal to the farmers. Given that food products constitute about 46 per cent weight in the consumer price index, a complete transformation of the ‘agricultural commodities value chain’ and the markets is the need of the hour.

‘Options’ a viable option?

What is needed more is not only enabling farmers to take sowing decisions with advance price signals but also enabling them to lock in the prices they see in the markets through simple instruments such as ‘options’ wherein a ‘sell’ decision can be undertaken by way of buying a ‘put’ option on an exchange platform paying a small premium that will give the farmer the right, but not the obligation, to sell at a pre-decided price on the exchange platform. This insurance-like feature of options is precisely what MSP intends to achieve.

The foremost advantage of farmers in using options is in the form of lower cost, which is the cost of ‘premium’.

The commodity options trading model as outlined, wherein the options have futures contracts as the underlying and devolve into futures positions on expiry, will help farmers to engage in delivery through the Options route which would have otherwise remained a ‘financial hedge’.

Compared with commodity futures, the hassles of daily maintenance margins and exit and entry out of a position to reflect new fundamentals does not arise in the case of options. If they intend to deliver, they can carry their positions till the expiry of the options contract as the strike prices at which puts that were bought were lower than the current prices — called ‘in-the money’ options which if not opted otherwise on expiry would get compulsorily converted into a sell position in the underlying futures contract with a need to maintain margins only for a few days, till the produce is delivered on the exchange platform on expiry of the futures.

For those farmers who are not adequately funded, it might be a challenge given the underlying commodity’s value and market volatility, as the quantum of margins may tend to be large. Adequate hand-holding of farmers at the time of options expiry and devolvement into the underlying would make options a successful instrument.

As the lot size of the options would be reflecting the respective futures contracts, small farmers would still need institutional arrangements such as aggregation by financial institutions equipped with appropriate portfolio management and price advisory skillsets.

Additionally, to the markets, the prevailing option strike prices and the premiums for the same would provide a nuanced indication of participant price expectations along with the movements in the underlying futures market. With robust derivative markets, a dynamic global trade policy that embeds signals from it can save the markets from price fluctuations arising out of rigid fundamentals as in a ‘Closed Economy’. Further, the procurement parastatals that back up MSP should also be encouraged to hedge their stocks to make MSP a cost-effective support mechanism.

(The writers are, respectively, Head, Research and Senior Analyst at Multi Commodity Exchange of India. The article first appeared in The Hindu BusinessLine.)