The government’s decision to suspend futures trading in sugar in response to the rising retail prices of the sweetener deserves to be welcomed. A complete ban imposed much earlier would have been even better. Indeed, it is high time to ban futures trading in all essential edible commodities and replace it with delivery-based forward trading. 


Inflation control is on top of the new Government’s agenda, and rightly so. Indeed, what is striking is the delay in stoppage of futures trading in this essential commodity. As far back as August/September 2008, it was clear that cane output would be sharply down, as would be sugar production. Sugar production in the current season (October 2008-September 2009) is sharply down from that in the previous season.


Estimates vary, but production in the current season is placed at 150 lakh tonnes, compared with 260 lakh tonnes in the last season. Even after taking into account carryover stocks of about 45 lakh tonnes, the domestic supply is likely to be very much short of the estimated consumption of 220 lakh tonnes. So, undoubtedly there is going to be a supply shortage and the government will have to make up the shortfall with imports.  


Yet it took the government several months to act. The initial response of official circles was plain refusal to recognise a production decline. The Government allowed exports to continue merrily with incentives, although it knew of the looming shortage. Although the food ministry had been steadily reducing its estimates of sugar production since October 2008, exports were banned as late as December. Then there was inordinate delay in allowing sugar imports, again despite solid evidence of a serious shortage.

Speculators took advantage of the demand-supply mismatch; sugar prices spurted from Rs 1500 a quintal in August 2008 to over Rs 2200 by March and Rs 2500 now. Storage controls and additional releases of free-sale quota hardly helped contain prices. Meanwhile, policy-makers turned a blind eye to continued speculative activity in the futures counter. Taking a cue from Indian market conditions, world sugar prices increased over 30 percent in the first three months of 2009, making imports expensive. A weak rupee added to the strain.

To make matters worse, sugar is in short supply not only in India but also in the international markets. According to International Sugar Organization (ISO), the global sugar market is expected to see a supply shortage of 7.5-7.8 million tonnes during 2008-09, far more acute than the previous estimate of 4.3 million tonnes.
 

Against this background, the suspension of futures trading in sugar has not come a day too soon. Yet the pro-speculation lobby has been quick to condemn it. “The move shows that the administration remains irrationally suspicious of market forces when it comes to agriculture, even when markets benefit farmers, a constituency whose support this government claims to have won… The ban on futures will not only hurt farmers, but also the food processing industry, particularly biscuit and confectionary manufacturers, a lot of whom operate in the small-scale sector and all of whom hedge against a rise in sugar prices in the markets,” pronounced an editorial in an economic daily.

These are specious arguments which would not stand a moment’s scrutiny. Although farmers are invariably mentioned in any discussion on futures trading in agricultural commodities, how many farmers do you find operating on the NCDEX or MCX? Of the millions of farmers in the country, how many would even be aware of (let alone be aggrieved by) the suspension of sugar futures? The reality is that futures trading matters only to a handful of speculators for whom it is one more avenue to make a fast buck.

Opponents of the ban argue that futures markets do not invent the price, they only help players discover it. A ban on futures trading, we are told, cannot change the fundamentals. Banning futures trading in wheat, rice, tur and urad did nothing to prevent their prices from rising. On other hand, there are hundreds of commodities which have seen a steep price rise although they are not traded on commodity exchanges.

The arguments sound convincing, and the data irrefutable. However, as everything else in the world, this too has another side. Theoretical arguments in support of futures trading assume that these markets are deep, transparent and efficient, that the underlying spot (cash) markets are homogenous and unified, that there are no information asymmetries among players and that transaction costs do not matter.

These assumptions, alas, do not hold in the real world. In reality, speculators have had a free run and captured the markets. There are also instances of established physical market players abandoning their traditional business and trying to make their fortune in paper trading.

The derivatives market proceeds from the cash market. And India’s cash markets, especially in agricultural goods, are notoriously fragmented, shallow, inefficient and heterogeneous. There are myriad constraints (physical and others) on movement of goods even inside the country, the government has a large role in fixing prices and hardly one-fourth of the market price of grains reaches the farmer, the rest being pocketed by transporters, middlemen and government agencies.

Add to this the imperfections of the commodity exchanges. While the cash market would require full payment, one could play large volumes in the futures market by paying just a fraction by way of margin. No wonder, punters saw commodity exchanges as just an extension of the stock exchanges and lost no time in seizing the opportunities provided by a shortage economy.

As a result, futures trading has vastly aggravated the consequences of demand-supply mismatches. It has enabled unscrupulous elements with deep pockets to locate shortages and drive prices far above the levels they would have achieved otherwise. It has magnified the effect of global shortages and imperfections in the local spot markets. Futures trading may not be the original villain, but is not an innocent scapegoat either. It is a willing accomplice.


What the sugar market needs is not futures trading, but delivery-based forward trading which will create a healthy environment for sellers (producers) and buyers (consumers) to take forward positions. In times of shortages, compulsory delivery will reduce if not eliminate the role of undesirable speculative capital.


In fact, this is true not only of sugar, but all agricultural commodities. It is high time to ban futures trading once and for all in all essential edible commodities and replace it with delivery-based forward trading. The delivery-based forward trading would go a long way in curbing anti-consumer and anti-farmer speculation while retaining freedom for genuine producers and consumers to hedge their positions as part of business risk management.


The pro-futures arguments originate from countries which have a surplus production of such commodities and have to keep up their prices artificially at high levels so that they could export these at remunerative prices. A country like India, which has to balance the interests of millions of semi-literate farmers with those of even more numerous consumers, cannot afford to hand over sensitive commodity markets to reckless speculators. 


The critics of the government decision, however, have a point when they say that such temporary measures like suspension of futures will have no impact on prices as such a decision will not increase the availability of the sweetener.


In fact, the government policy on sugar is so faulty that everyone—growers, millers and consumers—is unhappy about it. What explains this extraordinary state of affairs? The short answer is: government interference and control. Everything from the price of cane to the quantity a sugar mill can sell in the so-called open market is decided by some law or fiat of the government. Instead of addressing structural issues of the sector — cyclical nature of cane output, wide inter-state yield variations, fragmented crushing capacities, diseconomies of scale, lack of technology absorption and investment for modernisation — New Delhi has been tinkering with trade and tariff measures. 


The sugar industry has for long been the victim of over-regulation and muddled policy regimes. Needless Government interference has disturbed market dynamics and discouraged investment and modernization. Instead of tinkering with quotas, releases and import/export norms, the industry deserves total decontrol, deregulation and rational cane pricing. This would encourage fresh investment, consolidation of fragmented capacities and modernization of factories.

The current policy imposes a plethora of curbs on production and distribution while leaving trading free for speculators. It is essential to reverse the direction: free production and distribution and take out unhealthy speculation from trading.

The author is Executive Editor, Corporate India, and lives in Mumbai