Agricultural commodity futures in India should they exist?

Abstract

In February 2007, India banned the trading in outright future contracts in agricultural commodities, rice and wheat. The ban has been introduced after months of debate amongst economists as well as government policy makers on whether the over-speculation in the primary agricultural commodities futures market is driving the increase in spot prices of primary products and hence fueling inflation. An expert level committee has also been setup to study the impact of future trading in agro-products and the ban might be extended to other agro-products as well. Agricultural commodity futures have vast implications for Indian farmers in terms of price discovery and risk hedging. A ban of these future contracts, if not reasonably justified, is a retrograde move and denies a useful tool to the farmers in order to hedge risk against price volatility. This paper intends to analyze the various arguments put forth in support of and against the ban by various political parties and economists, and checks their validity through empirical study of available price data of select agricultural commodity futures viz. Chilli, Pepper, Soya oil, Cotton and Mentha oil. Statistical tests are performed on the spot and future prices data taken over the past two years and the validity of the following arguments are discussed: 1. Current commodity markets are not efficient 2. Futures prices are inducing inflation in the spot prices A contract wise analysis of the price data, and the granger causality test conducted on several 3 month futures contracts of the above mentioned commodities show a very significant influence of the future prices on the spot prices. In the short term, the future prices seem to drive the spot prices and hence it can be reasonably suggested that the future prices contain better information about the spot prices and hence price discovery is effective. It has also been observed that a sudden surge in future prices is followed by a surge in spot prices and it has been concluded that future prices are driving the inflation of spot prices. Cointegration tests have been conducted on the 2 to 3 year data available for the selected commodities. The tests show that cointegration exists in all these commodity markets thereby establishing that the future and spot markets are exhibiting a trend towards long term equilibrium. The futures market clearly exhibits a weak form of efficiency in the long term, with the prices seemingly following a random walk. The future markets also show a significant influence on the spot prices in most of commodities, and it can be reasonably assumed that the future markets are absorbing the information better than spot markets. The spot market in many cases have shown a dependency on past prices and also less receptivity towards the information contained in the future prices. They are gradually moving towards the trends in the future prices but are slow to respond to new information in the market. It has been concluded that future markets are more efficient and spot markets exhibit much lower efficiency in the long term.