India Fools Itself With Wheat, Rice Futures Ban by Andy Mukherjee of Bloomberg

India's political class has perfected its response to bad news: Shoot the messenger and do something contrary to what's needed to set matters aright.  A case in point occurred last week, as wheat and rice futures dared to warn the government of an inflationary shortage in food production.  At the government's behest, the market regulator summarily banned new contracts in both commodities on Feb. 27.

Wheat and rice together account for almost 4 percent of the benchmark price index. Farm produce has no doubt played a part in India's inflation headache. Food-price inflation in India stands at 11 percent now, almost double the 6 percent pace a year ago. Even so, holding futures trading responsible for the spiraling prices is illogical and betrays a profound misunderstanding of the economic facts of life. Take wheat. Last year saw the biggest decline in the commodity's production globally in 10 years. Naturally, prices skyrocketed everywhere, including in India, the world's second- biggest consumer of the grain after China. India's fledgling futures markets anticipated the price escalation. As far back as August 2005, the futures contracts on the four-year-old Multi Commodity Exchange were signaling that a demand-supply imbalance was building.

The Indian government was complacent. Its own wheat stocks, which are used to supply the grain to fair-price shops, were a comfortable 14.5 million metric tons in July.

Prices, Politics

By October 2005, they had declined to 10 million tons. It was the first time in 10 years that the buffer stock had dipped below the level that's considered safe. Yet, it was only in February 2006 that the government first decided to import wheat. By then, it was too late.

Wholesale wheat prices in India rose 54 percent between early April and the middle of November. The government's communist backers jumped at this chance and demanded an end to speculation. Farm Minister Sharad Pawar said on Feb. 21 that trading in futures is not responsible for the increase in prices; it's the gap between supply and demand that caused prices to rise. And yet, ``If all constituents demand a ban in futures trading, we will have to succumb to their demand,'' he said. ``I don't know for how long I will be able to resist.'' A week later he wilted.

Helpful Speculation

Far from being the root cause of spiraling grain prices, speculators may have prepared the ground for a correction. Encouraged by an optimistic outlook for prices, farmers in India planted more wheat starting October. Now, when they are barely two weeks away from the harvest, the regulator has pulled the trigger.

Following the futures ban, wholesale prices may slide from their current level of about 10,400 rupees ($235) a ton. This is a big blow to the farmers who, with their backs against the wall, are feeding 1.1 billion people. Indian planters are struggling to cope with rising costs of fertilizers, seeds, credit and labor; individual land holdings are shrinking with division of property in each generation. Productivity gains, such as those from high-yielding seeds developed in the 1960s, have hit a plateau. The futures ban will destroy a process of price discovery that is crucial if farmers are to have some control over their earnings.

Untamed Prices

Inflation now is at 6 percent. This needs to be brought down because a rate above 5 percent may hurt economic growth, according to central bank Deputy Governor Rakesh Mohan. It is, however, not certain if the ban on futures trading will do much to tame retail prices. Consumers pay twice as much for wheat as wholesale traders, a clear sign that the real problem is not speculation but a creaky supply chain. The government, the biggest buyer of wheat in the country, will benefit from the ban.

Last year, officials in at least one Indian state were giving away free gun licenses to induce farmers to sell their wheat. Even then, the farmers were reluctant because private buyers such as Cargill Inc. and ITC Ltd., which had correctly read the emerging shortage, were offering a better price on the open market. The government now will be able to procure the commodity from farmers at a pre-announced price of 7,500 rupees a ton, or 28 percent below the prevailing market rate. The gain to the government from this usurpation may be transient.

Collateral Damage

If wheat becomes unprofitable, farmers will shift acreage to some other crop next year and the grain deficit will worsen, hurting consumers. Besides, if farmers can't boost their incomes, how will they help the government meet its goal of food security? The country is likely to import 3 million tons of wheat in the year ending March 2008, according to the Foreign Agricultural Service at the U.S. Embassy in New Delhi. Export of wheat has been banned. In the event of a steep decline in domestic prices, there isn't a lot that Indian farmers can do other than to accept the price the government pays them. This is economic repression.

What's totally out of kilter in Indian wheat is the spot price, which is determined in some 7,000 fragmented, inefficient bazaar-style markets where the farmer is at a perennial disadvantage to the buyer's agent. Derivatives, if they had been allowed the room to grow, would have eventually brought a semblance of order to the chaos; prices that better reflect demand and supply would have emerged.

Instead, wheat and rice futures will now be counted as collateral damage in India's war against inflation.

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