There is no evidence futures markets distort prices
Given that it figured in a report of a group of chief ministers headed by Narendra Modi on controlling inflation, many are expecting a ban on futures trading in essential commodities. If this happens, Modi will be following a UPA tradition of ill-conceived bans which achieved nothing. Vegetable prices rose 41% in FY14 and alone accounted for around a ninth of WPI inflation for the year. But there is no futures trading in vegetables—prices rose due to a huge supply shortage. Rice WPI rose 16.6% despite, after the February 2007 ban, there being no futures trading in it—there is no shortage of rice, the 30.5-million-tonne FCI stock is the real problem as it lowers market availability. Equally high inflation was seen in pulses like moong (22.4%), masar (15.3%) and urad (10.1%), none of which are traded in futures markets. Wheat is traded, and that saw a 9.4% WPI hike in FY14, but given the volumes traded are such a small fraction of stocks, the impact would be minimal—once again, the 30.5 million tonnes of FCI stocks are to blame.
Look at any previous inflation episode, and the story is of the futures markets signalling a problem, not creating it. In 2007, the futures market signalled a large wheat shortfall and, it later turned out, India had to import wheat—wheat futures were banned but, given the problem was the wheat shortage, this didn’t help. The same thing happened in 2009 when sugar prices kept rising after the ban on futures—it turned out, supplies were so low, India had to import sugar. Governments that ban futures essentially don’t understand how they work. If wheat is sold in the spot market at R15 a kg and Trader A wants to drive prices up to R30, he has to place buy orders at that price for delivery, say a month from now. In that situation, every other trader will buy wheat at R15 today and store it to deliver to Trader A on the given date—that’s the only way spot prices can rise to R30. Imagine how deep Trader A’s pockets have to be to buy all the wheat sold—the moment he stops buying, spot prices will stop rising. Since such manipulation is easier in commodities with small floating stock, commodity regulators allow very small trading limits for individual traders.
Not allowing futures and options has another consequence—it prevents farmers from knowing where markets are headed. Indeed, were ‘options’ to be allowed, farmers would be able to contract to sell their produce at a fixed price at harvest time and, if the spot prices were higher at that time, pay a certain penalty and simply exit the contract—in other words, they stabilise farm income. Banning futures and options are not just bad economics, they are also anti-farmer.