Clearing the muddle of rising food prices

V Shunmugam& Ritambhara Singh

The Hindu Businessline, Apr 18, 2008
(http://www.thehindubusinessline.com/2008/04/18/stories/2008041850520900.htm)

The latest data on foodgrains production released by the Ministry of Agriculture, Government of India, estimate that wheat production in India would fall by 1 million tonnes to 74.81 million tonnes compared with the previous estimates. Though it is not a marked decline compared with the previous estimates, what is significant is that it comes on the back of lowest grain stocks held by the Food Corporation of India during the current year.
Mirroring the Indian situation, global markets also witnessed a similar fall in grain stocks, especially of wheat, rice and corn, over the past five years on the back of fluctuating production levels leading to pressure on the global grain markets.
The surge in grain prices, has, in recent years, remained a major concern among economic planners worldwide. We at our economic analysis desk sat on this issue to find out the causes which may hold the keys to addressing major challenges to food security faced by developing countries.
Available global data from all the leading sources such as FAO and USDA suggest that there is widening global imbalances in demand and supply of foodgrains (particularly wheat, corn, and rice) and they have grown significantly in the last decade leading to a heavy drawdown on global grain stocks.
On the demand side, growing population, rising incomes in populous Asian countries, and discovery of new uses such as bio-fuel are leading to increased pressure on global grain fundamentals. Besides, studies also suggest that rising income levels transforming into increasing purchasing power is causing a dramatic change in the lifestyle and dietary patterns of world population, more so in developing countries.
For instance, the latest available FAO data release suggests that India and China are now consuming more high-value protein in the form of livestock products that are high-cost converters of cheaper grains. Driving the point home in the case of India, the statistics recently released by National Sample Survey Organisation (2004-05), India has experienced a significant rise in the demand for livestock and products over the last five years.
Limited land
And, remember all these requirements have to be met from a limited expanse of land, while lands are becoming increasingly uncultivable due to lack of water or turning saline because of heavy groundwater use. Added to it, global climates are becoming more unpredictable which not only makes agricultural production unstable but also affects the quality of the produce as well.
Apart from the demand from the livestock sector, bio-fuel production growing at the behest of national support (especially in the US where corn-based ethanol producers are given a support of 20 cents per gallon) adding to the demand-side pressure for which there seems to be no respite unless crude oil prices fall to make this conversion uneconomical.
Further, certain responsibility of the nations with grain surplus would help control this deteriorating situation keeping in mind the large income inequalities that exist in the developing countries. On the supply front, annual global production of cereals has stagnated at around 2,100 million tonnes since 1996, while population has been increasing by about 78 million every year. Consequently, annual per capita availability of cereals fell to 336 kg in 2005-07 from around 362 kg in 1997-99 as per the FAO data. A key supply-side factor behind rising grain prices is the increase in crude oil prices, which in turn raises the cost of production significantly.
The high correlation coefficient as provided in the Table stands to prove the same. In 1973 too, the jump in oil prices created a situation in the foodgrains market as witnessed currently. The commodities that have been most affected by the recent surge in oil prices are, in order, rice, wheat and corn showing that production and worldwide distribution (transportation) of these crops are highly energy-intensive.
Surging prices
Rice prices have been the most hit directly/indirectly by the recent oil rally as it is a close substitute for corn which is being increasingly diverted to ethanol production.
Wheat prices have more than doubled while those of corn and rice have soared by 80 per cent and 55 per cent respectively at CBOT over the past two years. While the surge in corn prices has been largely due to the demand pressure that originated from its diversion for ethanol manufacturing, it is the supply concern that has been affecting the prices of wheat and rice at the global level.
On the other hand, compound annual growth rates of areas under these crops show that the area under corn has grown at a higher rate than that of rice, which again corroborates the substitutive nature of these two crops.
Though there is a rise in their productivity too, the demand-supply gap has widened more for rice and wheat than for corn mainly on account of lower area.
As a result, the world that was in surplus of rice and wheat during 1990s is now running into net deficit by almost double the surplus size that existed during the base period (1990-91). Studies also attribute it to the abrupt supply changes in major producing countries such as India, Australia, the EU, the US, and China.
An analysis of the USDA grains data estimates that annual volatility in ending stocks had been increasing over the years led by increased volatility in production fuelled by a constant rise in consumption.
The higher price rise in wheat than in the case of rice is due to a higher slump of 24.66 per cent in wheat inventories during the last two years, while rice and corn stockpiles have declined by only 8.38 per cent and 14.20 per cent respectively.
No wonder several developing countries, including India, have become net importers from a position of potential exporters over the last few years.
Imbalances
Now what net picture we have is that the combined force of higher crude oil prices, a shift in dietary patterns towards livestock products, climate change-led production fluctuations, diversion of grains for bio-fuels, and dwindling global stockpiles has been driving grain prices north, especially over the past two years. The imbalances in demand and supply of these commodities have posed a threat to global food security, intensity of which has been increasing over the years.
As far as the emerging demand from bio-fuel goes, we are now trapped in a new labyrinth, wherein care must be taken by nations to provide priority to human over industrial consumption of grains. What is needed to resolve the above-identified issues is a cocktail of institutional, policy, and market reforms.
As the institutional and policy reforms would help in identification of appropriate technology to address challenges to increasing productivity, improving its access, better delivery, and effective adoption, market reforms would help farmers not only in realising fair prices but also in planning effective allocation of their scarce resources to optimise returns.

(The authors are with the Multi Commodity Exchange of India. Their views are personal.)

Logistics: The next big growth driver

V Shunmugam & Ritambhara Singh

The Hindu Business Line, March 29, 2008
(http://www.thehindubusinessline.com/2008/03/29/stories/2008032950110800.htm)

Creating an effective logistics environment requires continuous improvements and regular participation of all stakeholders who can contribute to and benefit from concrete improvements in terms of performance. Particularly is this so for farmers, whose incomes can be raised by creating good warehouse infrastructure.

Wars have been won or lost on the strength of logistics capability or lack of it. Although quite an old concept, logistics has been becoming efficient only since the globalisation wave of the early 1990s and hence, the businesses supported by it, worldwide, have been pushed for competitive balance-sheets, providing consumers a better product/service and yet adding value to its investors.
Triggering intense competition, globalisation, coupled with liberalisation, forced both private and public firms to commit themselves to making available to their customers the right material of right condition, at the right time and place at the lowest cost — be it a product or a service.
The World Bank, in a recent survey Connecting to Compete: Trade Logistics in the Global Economy, has developed a Logistics Performance Index (LPI) that can serve as a benchmarking tool for measuring performance of businesses along a country’s logistics supply chain. The Bank study asserts that countries that are able to connect to the global logistics web would not only have access to vast new markets but also remain a part of the global trade growth.
The report avers that it is not the income of nations but their undergoing trade expansion that determines their logistics efficiency, as the survey shows that nations with increasing trade (imports and exports) to GDP emerged as the out-performers on the LPI scale relative to their income levels.
It also warns that those countries whose links with the global logistics chain are weak are bound to face large and growing costs of exclusion from international trade. India trails behind China on important indices such as customs procedures, overall infrastructure quality, international shipment, logistics competence and tracking of shipments, but is ahead of the latter on the domestic logistics efficiency front.
Logistics: The ills and the cures
With India’s GDP growing at over 9 per cent a year and its manufacturing sector clocking double-digit growth, the country’s logistics industry is at an inflection point and is expected to reach a market size of over $125 billion in 2010, according to a study done by Datamonitor Inc., US.
The fact that the logistics cost accounts for over 13 per cent of its GDP vis-À-vis less than 10 per cent across the Western Europe and North America. The major functions of the logistics sector include transportation, warehousing, freight-forwarding, and other value-added operations, including Management of Information Systems (MIS).
The huge diversity in geographic conditions, consumer habits, and infrastructure conditions across the country makes it a major challenge for the Indian industries to efficiently manage their supply chain.
Light at end of tunnel
What portends well for the country’s logistics sector — and the markets, in general — is that the Government has, of late, intensified its focus on improving logistics infrastructure. Almost $17 billion has been pumped in to upgrade highway networks, with the implementation of two major projects — the Golden Quadrilateral network and the North-South-East-West (NSEW) corridor.
Besides, in a landmark infrastructure-related move, the Government has thrown open rail freight operations to private players, thereby creating opportunities for cheaper and faster movement of goods. Transportation by rail, rather than by road, is expected to help domestic logistics players offer more cost-effective services to their clients, and this, in turn, is likely to boost industries’ use of logistics.
The opening up of the Indian economy to foreign investments, luring more and more MNCs into kick-starting their operations in India, is also fuelling growth in the country’s logistics market.
With India being touted as the ‘Destination Future’ among world logistics service providers, domestic logistics players are pulling up their socks which has already started with the growth the courier segment making the flow of documents and financial instruments move quicker. Creating an effective logistics environment requires continuous improvements and regular participation of all stakeholders who can contribute to concrete improvements in terms of performance.
Efficient linkages and NBHC’s role
Although logistics-related problems are rather specific, the ability to tackle them depends largely on a nation’s overall governance and institutional discourse.
Newly developed electronic commodity markets, such as Multi Commodity Exchange of India Ltd. (MCX) have played an instrumental role here. Creation and development of warehouses followed the emergence of these markets or exchanges.
MCX’s collateral management arm National Bulk Handling Corporation Ltd (NBHC), a national-level end-to-end solutions provider in warehousing, bulk handling, grading and inspection, commodity care, pest management and collateral management of commodities, is playing a key role in taking logistics and, hence, markets closer to the producers.
Sticking to their mandate, commodity derivatives markets have proved to be extremely beneficial to farmers.
The gap between prices (many of the commodities) in the post-harvest season and those in any lean season has narrowed down significantly over the past few years.
Earlier, during the pre-futures era, when prices would slump immediately after harvest, farmers would have to make distress sales. But today, with the opportunity to sell for a better price at futures markets, they stand to benefit enormously.
While growers can store (hold back) their produce in NBHC-monitored warehouses in anticipation of realising higher prices later, they can avail of loans against warehouse receipts (WRs), to help them carry on with their crop operations for the next season.
In the few years of its existence, NBHC has built a rather strong and wide logistics network with professionally managed scientific warehouses armed with market-approved quality-testing techniques. And this has attracted investors and participants from various backgrounds, creating better linkages among the markets.
The development of logistics by creating good warehouse infrastructure would surely go a long way in lifting farmers’ incomes. Such infrastructure is expected to get a fillip with the recent passage of the Warehousing (Regulatory & Development) Bill and its effective implementation.
Both public and private enterprises’ participation in equal measures is required for developing logistics and improving supply chain management.
Very importantly, the lesson for private investors is that it is not just about creating efficient business to thrive in the logistics sector, but also about exploring and revamping other areas by way of diverting energy, costs and time that were otherwise wasted in a weak logistics system.

(The authors are with the Multi Commodity Exchange of India. Their views are personal. E-mail: v.shunmugam@mcxindia.com)

How can the sugar economy improve?

V Shunmugam

The Economic Times, Sep 18, 2007
(http://economictimes.indiatimes.com/Debate/How_can_the_sugar_economy_improve/articleshow/2378694.cms)

While everyone sees sugar in terms of its most obvious function as a ‘sweetener’, very few would see it as an easily storable and usable energy provider for living beings and as a source of energy for man’s own creations to make his life easier. Of the very few, only a handful would know that sugar, through sugarcane, is a water-intensive converter of energy from sun, water, and mineral sources into a user-friendly form of energy (with alternative uses) and hence leading to environmental stress such as over-exploitation of ground and surface water and related problems of salinity, leaching of nutrients, etc.
On the other hand, the value of the crop in India is getting decided by the traditional method of cost of cultivation rather than by the market-determined prices, which often leads to a clash of interests of the sugarcane growers and the millers whose returns are decided by the market. This often results in adjustments in the value chain, in terms of their profit realisation and hence we can see both the situations wherein sugar millers run into huge losses (often having not covered their risks) and the cane producers sometimes see no demand for what they have produced and hence had to burn the crops in the field as they are not able to even pay for their removal.
This cyclical trend can be better reversed if all the segments in the value chain are exposed to market forces at all points in time, with no market-related policy interventions from the government and with dynamic information flow into the sugar economy regarding the fundamentals. This could only happen if both the end products and the raw material prices are linked to the market and an effective risk management mechanism is built upon it. Also, this would leave the burden of a wrong decision of a player in the value chain on himself, which if shared by the government would lead to the players in the sugar economy continuing to commit such mistakes and get away with it.
In the present scenario, the plausible solution would be that the players in the sugar market should also look at value addition through vertical integration so that they can offset losses in one with another. Further, the value-added products being globally linked, it would create a good case for the raw material (sugar) market as well to be globalised. It augurs particularly well in the light of sugar being increasingly seen as an energy resource than as an essential item of human consumption at the global level, and that the energy market, especially in terms of crude oil and its derivatives, is linked to the global signals.
This would substantiate the need for efficient spot and futures markets for sugar and ethanol (of course with minimum policy interventions) in the country as is the case with Brazil, which might in turn could lead to a reduction in the forex outgo for the crude imports (accounting for about 70% of our total consumption) and would reduce external energy dependency to some extent.
The existence of transparent spot and futures markets would ensure that there is appropriate information flow into the market for the players in the sugar economy to take informed decision and yet hedge themselves against any unfavourable developments in the market. In the light of increasing use of alternative sweeteners due to lifestyle-related problems (obesity and diabetes), it is time that policy makers stopped looking at sugar in terms of its traditional function as a ‘sweetener’ for the common man and change the mindset of the larger public to look at sugar as an alternative energy source, besides reducing the stress on one of the precious resources of our economy, that is, water.

Use derivatives to deal with turbulence in the air

V Shunmugam

The Economic Times, Sep 25, 2008 (http://economictimes.indiatimes.com/articleshow/msid-3524324,prtpage-1.cms)

India’s aviation industry has just a 2% share in the $470-billion global industry, but accounts for a third of its total losses. Blame the fuel cost volatility and high capital expenditure.
If the market turbulence lasts longer, domestic carriers may not be able to sustain their business unless major structural changes are carried out. Interest and fuel costs need to stabilize. This will allow carriers to adjust fares and thereby keep demand stable for a long period.
In a falling economy, the aviation industry would normally be one of the early birds to hit the air pocket. The reason is intense competition from other transportation modes and the growing ICT infrastructure that can somewhat obviate travel.
Currently, the airline industry in India is going through an intensely competitive phase thanks to new entrants and expansion of operations by existing players. Rising fuel expenses, which account for 35-50 % of operating costs, are adding to its woes. Low-cost airlines that have a higher elasticity of demand can be particuraly hit.
Fuel cost increases are passed on to passengers as rising fares or fuel surcharges. This would force the borderline consumers of full service airlines to shift to low-cost carriers. But this woud hardly make up for the erosion in the capacity utilisation of the low-cost airlines due to their marginal travellers shifting to other modes of transportation.
The operators would naturally take cost-cutting measures such as route rationalisation and HR cost cut. But, all this would not offset the high and volatile fuel prices. In such an eventuality, industry growth would begin to ebb out as is happening right now.
Many airlines have already shelved their expansion plans, forcing some players to postpone the deliveries of new aircrafts, surrender a few of their leased aircrafts or sell their aircraft delivery rights to others.
Role of derivatives
Availability of appropriate derivatives and a policy of using them efficaciously have helped international aviation players remain market-fit. While managing the interest rate risk is not possible in India due to lack of a derivative, the fuel costs could of course be stabilised through crude oil derivatives such as the one on MCX with good liquidity to enable their participation.
This is because the fuel used by airlines is a derivative product of crude oil and their prices, accordingly, share a high correlation of more than 90%. In MCX’s liquid crude oil futures contract, Indian airliners have the option to cover their entire fuel price risk at the domestic level without having to expose themselves to the foreign exchange risk.
Our case study of Deccan Aviation clearly demonstrates the pressing need for domestic aviation companies to have the policy of using the derivative instrument.
Air Deccan case
Increasing volatility in the northbound oil prices had caused about 54% of Air Deccan’s losses, which were preventable, during FY 2007-08. This essentially means that both the northward moving markets and the volatility in them led to the losses estimated at Rs 528 crore.
Crude oil contracts, which can be used for surrogate hedging, had enough liquidity for Air Deccan to participate in the first month of each financial year ie, to buy at an average price at which crude oil was traded on the exchange.
Though it would account for 54% of the total losses, a major part of the other losses could have been prevented by adding to the revenue flow keeping their fare structure steady and competitive. An analysis of international ATF prices (INR equivalent) and MCX nearby crude oil prices suggests an optimal hedge ratio of 87%.
This means that to participate in every Rs 100-crore worth of ATF the airline might have to buy Rs 87-crore worth of crude oil on the exchange platform. Given the assumptions for FY 2008-09, the losses are likely to double, suggesting that there is no way to reduce this other than implementing a derivative use policy.
Other players
International airlines usually lock in their costs through an effective derivative use strategy. The percent of costs hedged by the airlines varies with their risk appetite. For example, Singapore Airlines (SIA) is reported to be hedging within a range regardless of oil price movements.
The airline has hedged 36% of its fuel costs at an average price of $104- $109 a barrel. The company hedges between 30-60 % of its fuel requirement. Operators like Air New Zealand and Qantas have locked in up to 65% of their fuel costs, while Japan Airlines has hedged 75%. More significantly, Southwest airlines reportedly locked in more than 70% of the fuel they are expected to consume in 2008 at about $51 a barrel, far below the current crude prices.
Interestingly, a Morgan Stanley analysis of the Airline Earnings estimates for 2004 says that increases in oil prices by up to $4 a barrel would have little impact on the EPS of Southwest and Jet Blue, as they hedged up to 80% of their consumption. At the same time, airlines such as American, Delta and Northwest that did not have a sustained price risk management programme and, hence, were more likely to report a negative EPS due to rising oil prices.
The principle that underlies the use of derivatives is lock in costs that vary in short durations, enabling airline companies to structure their fares. This will not only keep their balance sheets healthy but also will help achieve better capacity utilisation and add value for all the ecosystem participants.
Very clearly, fuel costs are an area of concern for Air Deccan, particularly so, because crude prices have been highly volatile during the last six months. The fact that interest costs and fuel costs constitute a significant part of the total costs of airlines necessitates the need of utilising the derivatives to fix their costs allowing them to stay competitive and yet remain healthy.
However, risk management with regard to volatile fuel prices does not necessarily mean locking in fuel prices only when the prices are moving north. Even when the prices fall, an effective derivative use would help operators secure their bottom lines.
In a real sense, one may not be ready to face short-term surprise movements in prices which often keep balance sheets shaky. After all, it makes no sense to leave costs uncontrolled and chase returns.
Derivative use for risk management strictly involves simultaneous actions in both the derivatives and physical markets in terms of quantity and entry and exit. In addition, it needs efficient hands to analyse the markets, take appropriate positions, and close them at appropriate levels.
While it may be possible for Indian aviation players to cover their fuel price risk, covering the interest rate risk would be impossible sans efficient interest rate derivatives being traded on a transparent exchange platform.
Global aviation players’ ability to absorb oil price shocks has improved with effective derivative use policy. While forwards are a traditional way, derivatives are the modern tool.

Financial & market inclusive growth

V Shunmugam & Yogesh Kochhar

The Economic Times, May 27, 2009
(http://economictimes.indiatimes.com/Opinion/Financial--market-inclusive-growth/articleshow/3074630.cms?curpg=1)

Globally, economists measure growth as the percentage by which a nation’s output (GDP) has changed over a period of time and view development as a ‘qualitative phenomenon’ to find if the benefits of growth of an economy have reached its stakeholders.
UN organisations such as UNDP, World Bank, and UNCTAD measure aspects of development through measures such as Human Development Index, World Development Indicators, Human Capital Index, etc. However, till today there is no one holistic measure.
In effect, this means that while we can measure a statistical sum of aspects of the status of stakeholders and their economic wellbeing, but measuring the individual universe, i.e., their total wellbeing, is an issue that still continues to dog development economists.
Ignoring development leads to socio-economic disparities, unproductive labour, increase in unproductive investments (subsidies, market support, etc.), social unrest and so on. Let’s apply this to the Indian context.
A dipstick on the 9% growth could be rural economic development. Unfortunately the signals from the rural economy (in terms of common economic denominators, i.e., income/ employment/ investment) do not augur well. The recently released World Development Report, 2008 attributes this to market and state failures characterised by insufficient and unequal access to information/ imperfect competition/ high transaction and supply chain costs, etc.
It is important to note that while financial inclusion provides access to financial products, it would be of no avail until they make efficient production decisions and sell their products at prices reflective of supply and demand. This necessitates that rural areas need market-inclusive growth and an important catalyst that can enable this is telephony.
The imperative answer to all these hurdles in rural economic development is sound policies promoting ‘financial’ and ‘market’ inclusive growth. While financially inclusive policies take the financial products closer to the rural masses, market inclusive policies would take markets nearer to them and alchemise the financial inclusion.
The tie-up between MCX and Tata Indicom to deliver this facility to provide market signals on a toll-free platform to the agricultural commodity value chain is an example of the ‘marriage of convenience’ which would soon become ‘marriage of choice’ given the commercial challenges and opportunities that envelop it.
To strengthen the efficiency of the prices discovered on the exchanges, it’s imperative that the price discovery process be a two-way communication process wherein farmers respond to market signals and also pass on signals back to markets, without which the markets are paraplegic leading to unrealistic options and indices. In order to expedite relevant participation it is necessary that policy makers provide financial incentives to make it attractive or allow enabling institutions. Telecom is the key.
While futures by principle enable commodities of specific quality for delivery at specific place/date, stakeholders need access to markets of similar nature, i.e., national and connected on a real-time basis to make the rural products deliverable under perfect market conditions. Suffice it to say that with 300 million mobile phones, the time is now. The rates of agri-produce on an IVR are the ring tome equivalent downloads in the rural markets. Such markets which provide alternative platforms for delivery in rural areas can be established expeditiously if the government treats investment in supporting infrastructure preferentially (making the source tax free or providing a tax holiday for the income stream) to help them break even on par with commercial projects.
An analogy quoted by Yunus Muhammad of Grameen bank sums it up, “the government ought to treat a loan for a small fishing boat differently from a loan for a big fishing vessel, the economies of scale and scope for the two are different”. The World Bank is listening.
If the markets provide the right impetus to the rural areas, they would earn enough to save. In turn, they would invest more to ensure a safe, healthy, and secure livelihood than to remain a burden on the exchequer. It shall lead to the development of appropriate financial products as also various delivery models making financial inclusion a viable proposition than to make it a financial burden on treasuries, through products based on what they produce and own; such as a savings bank for grains. Health, education and livelihood are supported by this model too.
A healthy cocktail of financial inclusion and market inclusion with an appropriate dose of required policy changes (financial/ market/ telecom) would do wonders not only for economic growth but also economic development.
There is a space in the market and there is a market in such space. The act of discovery does not lie in looking for new lands alone, but also looking with new eyes. Ancient Indian wisdom says, ‘when you shut one eye, you don’t hear everything’. In an environment of appropriate policy change, with a healthy cocktail of financial inclusion and market inclusion; ‘shaken not stirred with telephony is the new bond.’

(Yogesh Kochhar is head, E-governance Business Unit, Tata Teleservices Ltd.)

Oil slump: No room for complacency

V Shunmugam

The Economic Times, Jan 10, 2009
(http://economictimes.indiatimes.com/Opinion/Comments__Analysis/Oil_slump_No_room_for_complacency/articleshow/3958830.cms)

With its predominant hold over transportation which has pervaded most economic activities in human life in one form or another, the bull run of crude oil during early 2008 affected all the importing nations. Some of the nations passed the burden of rising crude oil prices onto the stakeholders and most others passed it partially, bearing the brunt of it in their budgets with the hope that the situation would reverse soon. Market analysts too were divided on their take on the direction of crude prices, and those who were of the belief that it would reverse, feared the domino effects it could create given the extensive participation of the economic stakeholders from developing nations in crude markets.
Looking at the pace of bull-run, analysts predicting the reversal even feared that it could cause a major damage to institutions in developed economies with its ripple effects seemingly passed on through the globally integrated network of commerce and trade to other nations. Thanks to the initial spark to the current financial crisis in the form of the subprime crisis which started earlier to the crude market reversal, the crude effect had become a subset of the whole crisis that the global financial institutions are currently facing.
Interestingly, as the crude prices came down and in economies where the effects were immediately passed on, much of the purchasing power had already been washed off due to the credit crisis that had already crippled them and hence could not help build up demand sentiments. This resulted in building up of bearish sentiments in both the physical and derivative markets leading to the reversal of the increasing trend in crude prices with a fall that is steeper than its earlier rise. As the credit and other related bubbles bust, it took the other asset classes on a downward path due to weakening demand sentiments. Crude being one among the commodity asset class, its fall would have definitely provided relief to the policy makers of the largely import dependent emerging economies such as that of China and India. Though the effect of it, particularly in India had not been passed on fully for it to get reflected in other sectors, the prices of other commodities have fallen either due to increased supplies or the weak demand affected by the current financial crisis. Besides, after the elections were over, the government had announced a cautious cut on crude derivative prices by 5%-10%.
Since the issue of cross-border terrorism has hogged all attention, the price cut did not attract much comment. However, there have been public remarks as to the quantum of cut in the media. Setting aside the refining economics that many would feign ignorance about, one should appreciate the recent quantum of reduction if one were to agree with the below analysis. The moot point is that oil prices at the current level can harm the overall oil economy more than it could benefit the importing countries.
As everyone would know, the increase in crude oil production to a large extent is dependent on increased investments in exploration incentivised by higher oil prices. Contrarily, the current low prices had already taken a toll on the Federal Government of Nigeria, the world's seventh largest exporter of crude oil which had presented a deficit budget of Nigerian Niara 800 billion for its 2009 budget with a benchmark of $45 per barrel. A country that had already been riddled with high incidence of socioeconomic problems, lower government spending would further worsen the socio-economic situation in Nigeria. Even if exploration were to be made with external funding, with worsening socio-economic situation it would not incentivise any interest abroad to bid for new fields that may be thrown open. Another nation that is increasingly trying to reduce the dependence of its budget on oil revenues is Iran, with the current fall in oil prices, as part of its good governance. According to President Ahmadinejad, his government has cut dependence of the budget plan on oil revenues by 10%, i.e., from about 62% of the previous budget plan, the current budget plan has only envisaged 52% of the total revenues attributed to oil-related income. While it is good that a nation is reducing its dependence on a single source of revenue, it would be interesting to watch its implications on government spending and efforts to develop other sources of revenue without pumping more oil from the existing reservoir at current prices. Obviously, for a not so open economy in terms of foreign investments such as Iran, it would only mean that there will not be supply augmentation beyond a point.
Amongst the top producers, Russia too is facing the perils of its gloomy oil and gas industry. To sustain production, Russia needs to overcome the 'Greenfield challenge', i.e., the need to develop remote and capital-intensive new oil and gas fields in an environment where newly created "national oil and gas champions" are too heavily leveraged with debts. According to estimates (2008-10), Gazprom, the Russian oil and gas major, faces a high probability of its cash flow moving in loss territory by 2009. As a result, now when many of Russia's brownfield oil and gas potential are on the verge of expiring, the development of the greenfield potential to compensate their losses is proving to be difficult as it requires increased capital investment.
Having been convinced of the implications of current low oil prices to the entire oil economy and taking into account the opposition that the Indian government faces while revising petroleum product prices upward, despite the huge fiscal burden to the exchequer and accumulated losses to the oil companies, it would be unwise to call for further reduction in the administered prices unless the economic situation and the oil prices warrant the same. However, it would be wise if the government strategically tackles the effects of oil price movements through increased participation in overseas exploration, participation in derivative markets, augmentation of domestic production and last but not the least focus on research in alternative energy sources keeping in mind its long payback period.

Currency futures a boon for retail end users

V Shunmugam

The Economic Times, Nov 30, 2008
(http://economictimes.indiatimes.com/articleshow/msid-3774689,flstry-1.cms)

A friend of mine, who bought about $1,000 to back up his parents’ journey to the US, asked me why there is a huge difference between the buying rate and the selling rate?
Frustrated with the differential treatment by the currency dealers of the buyers and sellers, he wanted to find out where he could find a market where currency is bought and sold at the same price. I informed him that he could not exchange currency as and when he needed it, but he might have to plan for it. I further explained that they are currency derivative markets such as the one on MCX-SX, and that he could access the exchange, but through its members/ brokers.
Importantly, one would only get the equivalent value of rupee differential of the rate that exists between one’s entry and exit out of the market. One would have to take the earlier earmarked money for buying the dollar less/ plus the loss/ profit in the market to the currency dealer to change it into dollar at his pre-announced rate.
This is the only market where there is zero spread between the buyers and sellers’ rates. Also, the participants have the advantage of buying it at a rate they see on the exchange so that their rupee expenditure to buy a required quantity remains the same — management of exchange rate fluctuations. However, what one would need to buy is not exactly the dollar but the contract, which has the obligation to deliver the rupee differential between the time of entry and exit into the contract.
One would, however, have to buy a minimum of $1,000 or multiples thereof.
As for how to approach them and purchase dollars, one will have to visit one of the exchange brokers and fill the KYC/ client membership form besides submitting the required documents and wait till the application is approved by the exchange and one is allocated a client code along with password. Using the client code and the password on the brokers’ terminal — the PC which is connected to the exchange — one can log into the exchange and do trading.
To buy or sell a contract ($1,000), one will have to keep the necessary margin (as prescribed by the exchanges in its contract) with the broker i.e. the advance similar to what one pays while entering into contracts in buying or selling other assets. In addition, as like the brokerage fee paid to the match-maker in various other asset deals, one will have to pay the fee as fixed by the broker.
Of course, one may argue that it may not be useful to wait till the contract matures to take money to the forex dealer to buy the required dollars. Well, this is not the case. Unlike other markets, the exchange-traded currency derivative markets will not press you with the obligation of delivery (taking/ providing) of the contracts but to leave out of your contractual position by paying out of the loss or by receiving pay in of the profits i.e. the differential between the entry and exit price into the buy/ sell position of a contract.
The same mechanism of pay in and pay outs also happen on a periodical basis when you maintain your buy/ sell positions over a period in time on a given contract, which is also called as mark-to-market margin i.e. a way of managing the financial risk that may arise in a market place.
Thus, it provides you with the freedom to enter the market for buying currency and exit by selling it off in the market to manage your risk that too with a unified quote in both entry and exit.
In fact, these are efficient markets which not only treat the retail and bulk participants equally, but also help the buyers buy the contract at the same price that the sellers are selling at, and vice-versa.
Finally, he pessimistically asked me what was the use of the markets where I could get the unified rate but not the currency and I have to still go to the same currency changer to get the currency. I told him that it is currently not allowed due to certain regulatory reasons but it is not far when the regulators may allow delivery of currency but may be under certain conditions.
Well, you have so far overheard a dialogue between me and my friend that would definitely be of use if you have kids studying overseas under your expenses or planning for a long vacation abroad or shifting temporarily for a job abroad, etc.

Mapping Indian exchanges on the global exchange services mosaic

V Shunmugam

The Financial Express, May 04, 2008
(http://www.financialexpress.com/news/mapping-indian-exchanges-on-the-global-exchange-services-mosaic/305164/3)

As India opens the door to trade and transactions, it is logical that domestic goods and services would move from a high cost economy to a low cost economy. Comparative advantage in costs would remain the mirror of the efficiency of the economy’s manufacturing and services sectors. Commodity futures trading service offered by the national online exchanges would be no exception to it when it comes to competing within themselves and competing with the global exchanges, as borders disintegrate with a country’s progress in its path towards globalisation. While competing within themselves, national exchanges follow established domestic benchmarks or establish their own benchmarks by way of their own innovative business practices, in all to add value to users of the platform. Upon opening up of the borders to foreign currency transactions, the participants would benchmark even the efficiency of the domestic benchmark exchanges with that of their global counterparts in terms of their ability to deliver value for money.
Value for money on commodity derivative transactions is a composite function of a number of factors that could begin from the design of the contract, healthiness of participation, availability of information, effective management of trading risk, impact cost (a function of volatility and trading cost), efficient price discovery, liquidity, etc. Of these, while some are within the control of the exchanges governing their own rules and regulations besides the exchange practices and trading procedures, the others are beyond the ambit of the exchanges. Hence, it is clear that the exchanges by improving their operations, contract design, stricter surveillance, etc, shall be able to contribute towards an increase in their service delivery efficiency. This would finally contribute not only towards improving their operational procedures and efficiency but would also push themselves towards benchmarks. These benchmarks could be domestic or global, depending on whether the markets for exchange-traded derivatives are close or open both the ways.
Apart from having a larger production capacity by sheer cultivable size of the area in the case of agricultural commodities and larger reserves in the case of certain mineral ores such as iron and aluminium, being a billion plus populous country puts India in the position of an influential player in global primary commodities markets along with China. It necessitates that the primary markets are efficient not only to squeeze the supply chain costs but also to send the right future prices signals to the secondary or the tertiary sector. Hence, it is not only necessary that these markets should be competitive for the participants to trade in them, it is also necessary that these markets discover efficient future prices of commodities.
Commodity exchanges trade primary commodities that are at the bottom of the economic pyramid of our country and hence any inefficiency in the price discovery process is more likely to have a magnified impact on the economy as these pass through several hands in the supply channel and on most occasion gets value added as well. An efficient futures market is one that enables effective participation of traders with varied objectives (facing other risk management alternatives), converging all possible information about the fundamentals on the platform to discover the best possible price. The more efficient the discovered prices of commodities on a futures exchange platform is, the most effective would be the business and policy decisions that were taken based on these prices. The efficiency of price discovery depends on the robustness of the trading platform, its regulations, having the right mix of participants with relevant price information, making their participation cost effective vis-à-vis the alternatives available for risk management or investment, effective management of risk of the participants, and last but not the least - a robust clearing policy.
To make participation effective, it is necessary that the risks to the participants are effectively managed. Tools of risk management include margining, limits on open positions, and effective surveillance (Refer Table). Price volatility of various commodities on an exchange platform is an indicator of how effectively these tools are used by the exchange managers to improve the efficiency of the prices discovered on their platform. Price discovery efficiency in layman’s term refers to the ability of the futures contract to better predict its maturity prices ie the percentage deviation between the first traded price of the contract and the last traded price of the contract. The efficiency of price discovery can also be indicated by the closeness of spot and futures price movement. In the case of the MCX gold contract, the correlation between domestic futures and spot prices is around 99.2% in the last two years (2006& 2007) indicating strong inter-linkage between domestic spot and futures market, while the correlation with COMEX gold futures contract at around 99.4 (2007 and rupee adjusted) reflects how good is the Indian futures market in capturing global cues.
The efficiency of the MCX gold contract seems to better its global benchmark the Comex gold in terms of price discovery (table). More importantly, it is notable that the efficiency comes at the lowest impact cost of trading on MCX gold ie a typical combination of low cost of participation and lower volatility. Lower volatility is the result of close monitoring and the robust margining system adopted by the Indian commodity exchanges vis-à-vis the same adopted in domestic and global benchmark exchanges. Notably, MCX follows strict vigilance with an automated system in place for the same. For example, the system is designed such that it provides automated alerts when member’s margin utilisation crosses various levels and if margin utilisation crosses 100%, the concerned member is put automatically on a “Square Off” mode. Apart from the functional efficiency of trading, the robustness in technology (both the hardware and software) also adds value to the participants through reduced costs. Any additional cost burden on them in terms of taxation would only impair the efficiency of their service delivery in this globally competitive market, leading to flight of trades or their disappearance into the ground.
Having come to India just about four years ago, the national online commodity exchanges seemed to have exceeded the expectations of the policy makers catching up with their age-old global peers in terms of performance. As one would recognise Indian commodity exchanges after reading this for their global feat, it may not last longer in their minds unless they understand the efforts that had gone behind it. It includes choosing commodities relevant to the stakeholders, right contract design, taking it to appropriate participants, creating awareness, besides expanding infrastructure, etc. No doubt that the professionals with strong domain knowledge and technology, exchanges’ efforts to reach out, besides vigorous procedures have taken Indian commexes to their current position. Considering the large production and consumption base of the country, Indian commexes have the ability to outwit the existing domestic/global benchmarks and set their own mark at the global level given an appropriate policy dosage.

Markets can help slow down global warming

V Shunmugam

The Financial Express, Aug 11, 2008

(http://www.financialexpress.com/news/markets-can-help-slow-down-global-warming/347097/3)

Unlike the markets for other technologies where the value of technology arises from the resource/cost savings it can contribute only, the market for clean technology is driven by yet another factor, which is the return on savings on greenhouse gas (GHG) emissions to which it can contribute. However, the earnings from GHG savings measured in terms of certified emission reductions (CERs) issued by the United Nations Framework Convention on Climate Change (UNFCCC) emanate from a market that has been created with a scientifically felt need in mind. A tangible economic justification is yet to be done.
In an ever-changing world, the long-term valuation of clean technology would have to be measured by both the savings and returns to emissions reductions that it can contribute to. However, the returns on CERs that clean technology buyers may look for have so far been highly volatile as the regulator (UNFCCC) had left the choice of deciding rules of the game to the buyers themselves in the long-term interest. In addition, the buyers are concentrated in non-Annexure I countries whose IPR protection regime is not yet proven. It contributes to an additional risk when it comes to transferring the technology.
And in such a case, the long-term potential of clean technology becomes blurred. It could lead to evaluation of the technology based on medium-term cost savings that it can contribute to. As a result, most technologies that could contribute larger emission controls stay only within the confines of design rooms, much to the disillusionment of the objective behind creation of the markets for emissions reduction. So, it is necessary that we have markets that not only decide returns on the existing technology but also provide a fair valuation on it. Additionally, this would also bring in sustainability to these markets by providing adequate signals to the policymakers on how to sustainably develop this market regime.
The emission markets today face two sets of risks that are closely related to each other. The origin of these risks lies in the policy regime that directs these markets and their own supply and demand. While it would take time for these markets to structurally mature before the policy regime stabilises, there are several other factors that would contribute to the price risk that exists in these markets for CERs. Most of these risk factors could ideally be mitigated by the implementers of CDM projects in India through strategies in the physical markets or by hedging it on the respective commodities that may contribute to price risks in CERs or in the CER futures such as the one recently introduced by MCX. Such risks include the risk related to prices of natural gas, crude oil and power from other sources that may lead to large emitters such as power generators or the transportation sector to switch their consumption in order to remain competitive. It would lead to demand volatility in buyers’ markets (Annexure I countries) leading to price volatility.
As the implementation of CDM projects might involve additional costs on technology or other accompanying inputs, its success would revolve around the savings in costs it could generate and the potential revenue it could earn out of additional business opportunity the implementation would entail or the revenue accruing from the CERs. Most of the CDM projects implemented in India largely rely upon the revenues from CERs rather than the other two factors. And in such a situation, there is a dire need for markets that could give long-term price signals, taking into account the demand (managed from the policy side and the fundamentals) and the supply factors (affected by fundamentals). In short, this needs vibrant futures markets that are indulged in green trading. Green trading would include trading on emission reductions, renewable energy and energy efficiency that are interrelated. It would help in generating market-based incentives to meet the goals of deployment of new, cleaner technology to meet rising demand for energy, which is the major culprit behind the process of climate change that has attracted the attention of the world through IPCC’s path-breaking techno-economic research report.
After the failure in achieving the process of slowing down the climate change through commands and controls and fiscal instruments, it has widely been accepted that markets would remain the ultimate saviours as evidenced through the wider acceptance of the Kyoto Protocol. However, with the rules of the game left to the players in the market, the EU-ETS trading mechanism as it existed two years ago was much unsettled compared with the current conditions due to the policy risk arising out of allocating allowances. It took almost about three years for the EU-ETS markets to come to a position where they are now. Though the stability of the current CER prices in the EU-ETS markets falls short of the players’ expectations, it might have given a fair understanding of the markets to the players in the physical markets. If not for the futures exchanges such as the European Climate Exchange (ECX) and others such as EEX and Nordpool, and the transparency created by them, this understanding and policy stabilisation would not have happened in largely opaque markets.
If we were to achieve the objective of creating efficient markets to mitigate the process of climate change through the CDM mechanism and ultimately through development and transfer of clean technology, the opportunities for participation in the markets should be extended for Indian participants as has been the effort of MCX through the launch of CER and CFI contracts on its platform. In addition, the technology developers shall hedge their interests if their implementers fail to do the same. Efficient futures markets could not only facilitate technology development but also help CDM developers get the best of technology valuation during transfer negotiations.

A long way ahead for commodity futures

V Shunmugam

The Financial Express, Oct 2, 2008
(http://www.financialexpress.com/news/a-long-way-ahead-for-commodity-futures/368467/)

Any two-player or team- game in this real world ends up either in a win for one and a loss for the other or in the rarest of the situations both might end up in a tie. It holds true except in the game of discovering the futures prices of the underlying instruments as played on the derivative exchanges, which gives both the players a win-win situation.
At the end of the game, this not only ends up with both the sets of players leaving happy, but also lets their supporters live serenely. In this game of commodity futures all the stakeholders of the economy would also benefit by stable, social, economic and political conditions. So, what do the commodity derivatives exchanges around the world do to keep both the parties happy about it?
It matches the interests of risk takers with that of risk providers, thereby reducing the impact of risks that might affect the entire spectrum of people connected to the commodities due to the price uncertainty. While the interests are being matched, they discover a price that better reflects the fundamentals among the ecosystem due to the transparency it creates. As the prices are being discovered, it helps the market participants manage their risks. Those, who are out of these markets, are helped by transparency in efficient decision making in production, consumption, inventory management and marketing.
Theoretically, as the participants make efficient choices in markets whose functioning resembles the theoretical setting of perfect spot market places (anonymity of the buyers and sellers, universal participation etc.), it collectively leads to an improvement in the economic efficiency of a nation, helping it develop global competency.
As the government’s role declines in a liberal economy, individual and business choices are left to the market forces and hence it is vital that these markets remain efficient to lead the individual and collective choices to keep the economy more efficient in terms of equity with growth, which is better than its past avatar of being regulated.
The degree of success of the decisions taken up based on the market information is dependent on the strength of the price signals. To make the markets more efficient, it is necessary to make them widely participatory. Efficient markets in turn make sure that the goods and thereby the services are produced and marketed at globally competitive prices in the economy.
Penetration of markets into the economy is more of a qualitative phenomenon that would fail to meet the eye of the common man unless that is quantitatively proven. Attaching numbers would help value this utility that is comparable with either the ideal or the best.
Here is an attempt to measure it. The size of the economy is measured in terms of GDP and the size of the market is either the number of lots traded or the value of the lots. So, either the number of contracts traded per million dollar worth of GDP or the value share of futures in every million dollar worth of GDP would be a better measure that makes it comparable with the industries in both the developing and developed parts of the world. The only flaw in this measure could be that the differences in the share of primary sector GDP (whose commodities are traded on exchanges) in total GDP would not be captured and hence this can only be a crude measure of the penetration of the markets into the economy. A better measure would be to compare the lots or their value with the value of the primary sector GDP – a number which is hard to get in most countries of comparison.
Despite the fast growth in the Indian commodity futures industry, the economic penetration of the commodity futures industry is lower than that of the developed economies and few other developing economies as well. If we look at China and put it on a common scale of number of commodity futures contracts traded per million dollar worth of GDP, we rank slightly lower (101.36) than the Chinese markets (110.6).
Attaching the total value of commodities traded as said above and comparing it with the GDP of a given economy would make our markets yearn for those scales to achieve. Given the size of our primary sector and the global benchmark physical markets multiplier for commodities and the current value of the trade happening in them, the commodity futures markets in India have greater heights to scale. Yet, within the short period of four years compared with the short history (10 years) of the Chinese exchanges and the basket of products and participants in their markets, the current level of growth in the Indian markets is no less appreciable.
Comparing the contracts in terms of their value and the value of GDP of the economies, the ranking of our markets would further slip. Given the right policy measures and institutional support to their growth, these markets would not only permeate the Indian economy in a seamless manner, but would also help scale up this multiple player win-win game taking its benefits to the bottom of the pyramid rather than to face the hostile policy environment.

Making sense of the global agricultural commodities meltdown paradox

V Shunmugam

The Financial Express, Dec 25, 2008
(http://www.financialexpress.com/news/making-sense-of-the-global-agricultural-commodities-meltdown-paradox/402679/2)

As the nations competed with each other, it was the notion of ‘self-sufficiency’ that drove their food policy. Subsequently, as the economic boundaries melted down during the globalisation era, it was the paradox of agricultural commodities that haunted the trade negotiators and policymakers. This paradox in agricultural commodities becomes all the more critical to countries like India where a larger segment of the population and the economy depends on the income generated from it with less opportunities to either increase their income levels or diversify employment avenues.
Prices of agricultural commodities like wheat, rice, soybean and palm oil have dropped significantly. It is relevant to find out what this paradox holds for Indian stakeholders.
This will definitely not hold any ground for many of our large agricultural commodities as we are neither dependent on the export markets nor on imports except for edible oils and pulses to a major extent that it can make a dent on the economy or its stakeholders.
However, it would affect exports in terms of value realisation by the exporters, which would have its impact on the domestic markets as they would be easily outpriced in the export markets. Given that agricultural commodities constitute about 10% of the national exports and our exports constitute about 17% of national GDP, one can loudly proclaim that it would have least impact on the economy.
The current meltdown would have its impact on the producers of exportable commodities. They would be partially supported by continued higher domestic prices depending on the kind and level of trade barriers that might exist, though.
As the current meltdown gets passed on to the consumers as the case may be with commodities such as pulses, it would definitely relieve the current pressure on the part of the policymakers and shift their current focus from inflation management to keeping the growth momentum in their policy measures. The thin line that the policymakers would tread under the current situation would be that the meltdown should not affect the agricultural producers in the country but will be good to the economy and its stakeholders if that can be passed on to the consumers.
Thanks to the continuing trade barriers to agriculture in most of the commodities, growers of most agricultural products would be comfortable with the insulated markets except for highly export oriented agricultural product categories such as spices where meltdown pressure has the possibility of affecting economic fortunes of the growers.
Though the current meltdown in agricultural commodities could be due to cyclical reasons, the fact that producers in most developing or less developed countries face inflexible costs would prove to be a double whammy if it is passed into the domestic markets. That is not enough an argument to make a case for either continuing with the existing trade barriers in agriculture or domestic support for agricultural producers.
Where does this lead us to? Should the policymakers go ahead with agricultural trade liberalisation and reduce the domestic support? If so, what should we do to keep intact the business of farming? It leads us to think of a market mechanism that can better predict the future prices of both their inputs and outputs that allow them to make decisions, and at the same time to take advantage of it.
This represents risks that would exist in the industrial economy as well, but is managed by them sharing these risks with participants in the derivatives market who are willing to take it or by forward managing their demand and supplies with flexibility built in their business. A well developed commodity exchange with sound regulation, strong market infrastructure, trading on agricultural commodities and a well developed information system to support its price discovery process would go a long way to keep farming a profitable enterprise and at the same time help the consumers take advantage of the global meltdown in agricultural commodity prices.

Stabilizing the sugar industry

Stabilizing the sugar industry

http://www.livemint.com/2009/02/04214538/Stabilizing-the-sugar-industry.html

High energy prices and ethanol blending of petroleum offer a chance to revive sugar cane’s sagging fortunes

V. Shunmugam and Nazir A. Moulvi

India is one of the largest consumers and producers of sugar, with sugar-cane farming generating livelihood for at least 45 million farm families. The sugar-cane cycle, however, remains a major stumbling block in improving their livelihood. In fact, every four to six years, the sector slips into a crisis with either a shortfall or bumper production creating uncertainties in the market, making matters difficult for policymakers.

At times of glut, the losses incurred by sugar mills force them to delay payments, creating disincentives for farmers to subsequently take up cane growing. In spite of this, the government always acts to clear the mess by allowing exports, and by that time existing prices change. This has made our policymakers announce WTO-compliant subsidies for sugar exports. Notwithstanding WTO-compliant export promotion, in 2007 the government had to bear carry-over costs of sugar mills, besides easing the working capital requirements of the mills to make them healthy. Logically, neither of these measures seems to be a long-term solution. With ethanol—a by-product of the industry—there is a new avenue for its profitability, especially at a time of volatile energy prices.

In India, ethanol is mainly derived from molasses, a by-product of the crushing industry due to statutory requirements. The ministry of consumer affairs, food and public distribution issued an order in December 2007 allowing sugar mills to directly produce ethanol from sugar cane in a move to diversify their product portfolio and to provide them income stability, especially during industry downturns, to protect margins. The policy was also to help the government achieve its target of 10% ethanol blending with petrol by October 2008.

Though the Centre mandated 5% ethanol blending from October 2006 across the country, industry estimates put average blending at not more than 2%. This has mainly been attributed to infrastructure constraints at the marketing companies’ end, lack of a transparent and mutually agreed upon pricing formula and oil marketing companies in some states (such as Tamil Nadu and West Bengal) facing unattractive ethanol prices due to high state levies, among others. Despite the commercial possibilities of ethanol blending in most states, oil marketing companies continued to underperform in meeting this mandatory requirement. Hence, the logical first step would be to ensure duty parity for ethanol across the country, allowing its free movement. This revision is crucial if the government is to achieve its target of 10% ethanol blending.

The second step would be to come up with a mutually accepted and transparent pricing formula that would help promote blending. With the fall in acreage of sugar cane this year cane availability will be reduced. However, ethanol produced from molasses faces competition mainly from two other industries, as alcohol derived from molasses is used by the liquor and chemicals industry. At a fixed price of Rs21.5 per litre, it may not appeal to an ethanol manufacturer whose raw material (molasses) price fluctuates by two to five times between peak and off-peak seasons.

Given this situation, the fall in acreage during the current sowing season and a rebound in domestic sugar prices will incline millers towards producing sugar instead of crushing for ethanol. Hence, in the current price scenario, the co-generation model of making sugar, ethanol and generating power will be profitable for crushers instead of the direct cane-to-ethanol model. This year, if pricing is not linked to market conditions, it will make it impossible to reach the current blending target of 10%.

It is evident that given the current targets for ethanol blending, it would be quite impossible to achieve them in view of current sugar prices. They favour co-generation and not mere sugar to ethanol conversion. This should not be a reason to discard these goals, as 5% or 10% ethanol blending can help India save large sums of foreign exchange by reducing the oil import bill.

With deregulation of the sugar industry still a far cry, the government should adopt a two-pronged agenda to effectively achieve the current target of 10% ethanol blending. First, the government should come up with a transparent floating price formula linked to factors such as raw material prices, alternative demand and global fundamentals. Alternatively, an exchange-traded ethanol contract would help in benchmarking ethanol prices for blending purposes to be paid by the oil marketing companies. Second, fixing a trigger price for international trade in sugar and ethanol would take care of the interests of sugar consumers and oil marketing companies. The trigger could be pulled at both the upper and lower end of the price band that would be reviewed by the government from time to time. When there is a sugar glut, mills would have more avenues to divert cane for its best possible use, and during a shortfall the international markets could be tapped to augment domestic supplies. This will help the Indian sugar industry achieve sustainable growth and improve the livelihoods of farmers, besides tapping alternative business opportunities.

V. Shunmugam and Nazir A. Moulvi are chief economist and senior analyst, respectively, at the Multi Commodity Exchange of India Ltd, Mumbai. Comment at theirview@livemint.com

Time to take stock of wheat
V. SHUNMUGHAM & NAZIR A MOULVI

http://www.thehindubusinessline.com/2008/02/19/stories/2008021950140800.htm
Fluctuating fundamentals, increasing population and rising incomes have led to dwindling of wheat stocks in both India and China. The differences in emerging consumption trends may offset the effect of a probable slide or stagnation in Chinese production, while a decline in Indian output may prove disastrous to the country’s economic planners, say V. SHUNMUGHAM and NAZIR MOULVI

When the costs of basic raw materials rise without a corresponding hike in the consumer’s earning level to make up for the rise, it makes human life costlier. The same seems to be happening in Indian wheat, which is traded in a partially closed market disconnected from global markets in terms of prices but pretty much connected to them in its response to global signals.
Despite the projected higher production this year compared with last year, wheat prices seem to be holding firm on weak stock positions not only in India but also globally. China too faces a similar situation inspite of having a decent stock. However, the Chinese authorities seem to be managing the situation better.

Hence, we explored the Chinese wheat market with the hope that we may get a lesson or two to learn from the policies employed by Chinese food grain managers. We came up with a few pertinent linkages that were missing in the sectoral management of the economy, which deserve the attention of Indian planners and policymakers alike.

With an annual output of 70-75 million tonnes, India ranks second in the world wheat chart with China on top with 90-104 million tonnes as of today. Since 2000-01, population and income levels in India have risen by 1.73 and 11 per cent, respectively, vis-À-vis 0.72 and 16 per cent in China.

This indicates that given the efforts of both the governments to keep the market flat or let it move marginally up, there is a strong probability for a potential build-up in demand in these two world’s most populous nations due to augmented economic growth.

Productivity enhancement
As reported by USDA, in 2006-07, China produced 4.5 tonnes of wheat per hectare, nearly double that of India’s 2.66 tonnes. A study by Huang and Rozelle (1998) concluded that though institutional innovations are important, government investments have contributed the highest to China’s yield growth during 1976-95.

Although India’s public research is committed to developing hybrid varieties of wheat, there has not been significant breakthrough to match the China-like success. Besides, in India, private investment in wheat productivity improvement research has been hampered by lack of adequate protection of private investment interests, commercial feasibility of investment in wheat improvement research, etc.

Consumption patterns
Coupled with the production instability (volatility in India and China at 7.92 and 7.63 per cent, respectively), the constant surge in population has led to unstable per capita wheat availability in both the countries. The same in India and China varied from 64.2 kg to 71.5 kg and 67.0 kg to 79.2 kg, respectively, between 2000-01 and 2006-07. With the current rural demand in China exceeding urban demand, analysts feel that urbanisation would dampen consumption. However, Indian statistics offer an inverse picture.

A comparison of NSSO statistics on rural India’s wheat intake as a percentage of total cereal consumption between 1993-94 and 2003-04 shows that it has been stagnant at 35 per cent during the decade compared with urban India’s gradual rise from 44 to 50 per cent, indicating that as India gets more urbanised, its wheat consumption would rise.

Though our analysis suggests that India needs to spend very little in terms of subsidies to bridge the urban-rural divide in wheat consumption, an increasing burden of low-income urban population makes it sensitive to the government.

Further, the government should focus on measures such as diversification of the urban consumption basket, promotion of healthy alternatives to wheat, reduction of post-harvest losses, increased processing, and scientific storage, which can raise wheat availability.

Tapering procurement
Despite the rising wheat output, both India and China have recently been facing difficulties in procuring the grain to meet their buffer stock norms. In 2007, China procured only 29 million tonnes (against 40-45 million tonnes in earlier years) from 104 million tonnes that was produced.

India procured just about 9.23 million tonnes from 69.35 million tonnes produced in 2005-06, while the average of last five market year procurement quantities was double at 17.41 million tonnes. This trend of falling procurement has sent out a loud message: Farmers in India and China are no longer ill-informed distress sellers.

They have become smarter with increased market awareness and holding power, thanks to the relentless efforts of commodity futures exchanges, in the form of effective price discovery and efficient dissemination of price signals through developments in information and communication technologies (ICT).

In India, wheat prices this year (2006-07) are lower than last year due to higher production of 74.89 million tonnes against 69.35 million tonnes in 2005-06 (see Table). However, in China, prices have gone up despite higher output (104 million tonnes in 2006-07 against 97.5 million tonnes in 2005-06).

This apparently absurd situation is partly attributable to lower procurement by the Chinese government, and partly due to farmers’ reluctance to sell at low prices, as price signals from futures exchanges have made them hold their stock to benefit from likely price rises in the future, amid their rising income levels.

The lessons learnt
A combination of fluctuating fundamentals, increasing population and their rising incomes has led to dwindling of stocks in both India and China.

However, the differences in emerging consumption trends may offset the effect of a probable slide or stagnation in Chinese production, while a decline in Indian output may prove disastrous to the country’s economic planners. Public sector research needs to be focused on priorities in grain research in India, as that of China. Also, public-private partnership in agricultural research deserves encouragement.

Though currently not traded on the futures platform in India, wheat trade in the past and that in Zhengzhou Commodity Exchange had made farmers in both the countries smarter to earn better by simple means of price sensitisation. This has been furthered by the recent strengthening of the wheat markets across the globe.

Further, with the development in ICT, awareness about the benchmark global markets and developments are today at the fingertips of smart farmers in most of India’s wheat belt, which had denied a significant fall in prices (exports window closed) despite an 8 per cent rise in wheat production last year.

Increasing urbanisation would put pressure on India’s economic planners to better manage wheat economy as consumption is expected to increase, and prices are likely to be on the boil in the years to come. Hence, it would pay to effectively manage stocks and thus, the price situation.

(The authors are Chief Economist and Analyst, respectively, with the Multi-Commodities Exchange of India. Their views are personal.)