|Hedging the farm|
|Friday, 24 June 2011 00:00|
The timing is atrocious. At a time when the world is yet to get over the aftershocks of the financial crisis where derivatives had such a large role to play, the World Bank is encouraging developing countries to use derivatives to insure against volatility in agricultural prices. But once you get over the initial shock, and stick to keeping the derivatives simple, the idea is worth exploring. The World Bank is not just talking in the air, it has put its money on the line. It has tied up with investment bank JP Morgan, each will put in $200 mn and this, the Bank says, will allow developing countries to buy $4 bn of price protection. In simple terms, farmers can now offer to sell $4 bn of their commodities at some date in the future. If the price falls below this, to say $3.5 bn, those entering into a contract with the farmers will have to make good the $4 bn. The cost of this insurance, as it were, will be a maximum of $400 mn according to the Bank. What if the price goes above $4bn? The important thing to keep in mind, of course, is that the farmers’ income is getting protected. But to address the specific situation, if a country allows ‘put’ options—India does not, as amendments to the Forward Contract Regulations Act of 1952 have been pending for over a decade—farmers can opt out of the contract.
Obviously the safeguards have to be in place, and that means a regulator which ensures contracts are understood by all parties concerned; the commodities in which this is to be allowed have to be very liquid—the fiasco with guar gum prices some years ago comes to mind; regulators in India have been thinking about these safeguards for many years and will obviously come up with more as further lacunae are exposed, but there’s no excuse for the refusal to experiment with ‘put’ and ‘call’ options (a ‘call’ is the opposite of a ‘put’ in the sense it is an option to buy, not sell, at a certain price). The other interesting issue relates to India’s policy of providing price support to farmers through the Minimum Support Price (MSP). While MSP guarantees price support to farmers through the Food Corporation of India’s (FCI) procurement, this is limited to 3-4 states. A system of ‘put’ and ‘call’ options, where the premium is paid by the government, would allow the government to extend price guarantees to farmers across the country, and at a fraction of the current cost. It is no one’s case, FCI shouldn’t have food buffers, but using options allows FCI to keep the buffers to the minimum while still supporting farmers.