Market Options Complementing MSP

The Government of India uses the Minimum Support Price (MSP) to as a security against loss to the farmers as also to procure food grains for public distribution. But the MSP is at the same time a heavy drain  to the exchequer and to reduce this burden as also for the greater benefit of the farmers, Niraj Shukla advocates use several market-based instruments viz., options, forwards and futures of commodity options as the best alternative to the current price support system.

The Minimum support price (MSP) is a form of market intervention by the Government to save the farmers from distress sales and to procure food grains for public distribution. While Commission of Agricultural Costs & Prices (CACP) is responsible for recommending MSP to incentivize the farmers to raise productivity and increase the production in line with the emerging demand patterns in the country, Food Corporation of India (FCI) acts as nodal agency for procurement. CACP considers factors such as the cost of production, change in input prices, market price trends, demand and supply and a reasonable margin for farmers while recommending MSP. Though MSP protects the interest of farmers, it comes with a heavy price to the exchequer. The food subsidy budget for FY17 was Rs1.34 lakh crore, of which Rs1.03 lakh crore was to be routed through FCI to the intended beneficiaries.

MSPs are usually announced at the beginning of the sowing season and this helps farmers make informed decision on the crops they must plant. FCI along with State agencies, establishes purchase centers for procuring food grain under the price support scheme at locations decided by the state government with the aim of maximising purchases. Each year, the FCI purchases roughly 15 to 20 per cent of India’s wheat output and 12 to 15 per cent of its paddy output.

In a developed commodities derivatives market, there could be several market-based instruments viz., options, forwards and futures that rely on market prices rather than administrative prices thus shifting risks to viable financial markets which are better equipped and willing to take risks. Out of these instruments, commodity options could be used as the best alternative to the current price support system. Using this instrument, the government could easily shift their risks to commodity market participants who are more capable. Under this, the government can procure the strategic requirement at MSP and the purchases above this strategic requirement can be accomplished by selling put options to the farmers.

If the prices of the underlying commodity fall below MSP (reflecting strike price in commodity options), farmers or option buyers will sell their produce to government procuring agencies such as FCI at strike price i.e., MSP. However, the procuring agency will face a price risk which can then be hedged using exchange traded derivatives. But if the market price is above the strike price, farmers will choose to sell directly in the open market and the only loss will be the premium paid by the farmers which can be subsidized by the Government in pursuit of its social goals.

The government’s liability in the maintenance of MSP then becomes a contingent liability, rather than a committed one, as Government agencies are bound to purchase only when the market prices of the commodities fall below the MSP. Being contingent liabilities, it can be expected that not all will become due at the same time (assuming that MSP is implemented across a number of commodities). This could lead to immense savings in the purchase process, interest, storage and insurance costs.

Additionally, the government could sell call options in the open market for the unencumbered stock in warehouses, thereby gathering additional premium and hence revenue for its market operations. A call option is simply the right to buy a commodity in future at a price fixed today. In case the call options are exercised then the government agencies have adequate stock to be able to make deliveries. This gives the ability to stabilize prices in the event of a price surge due to shortages. This ability to buy and sell options would effectively make the government agencies involved insurers of the food marketplace, which is the role they play today through direct purchase and sales rather than via options.

Progressive farmers/farmers collectives can directly use the options contracts to hedge their produce. The farmers, as an options buyer, are not required to pay margin and M2M, instead they have to pay a onetime fee/premium upfront to the writer (option seller). The premium paid by them can further be subsidized partially or completely by the government. This will provide them with a derivatives market based instrument that would help them get the benefit of price protection in case the prices fall below their cost of production and also derive the benefit of any rise in the price. Options would enable farmers to lock in future revenues thereby assuring the lenders that these revenues will cover repayment of the loan that in turn could improve the terms of commodity financing to farmers. Moreover, banks/financial institutions with commodity exposure would also be able hedge their risk at the exchange and transfer the benefit to farmers in terms of more competent lending rates.

The author is Senior Economist at NCDEX. Views expressed are personal.