The recent inflation spiral in India, going by both the CPI and WPI, has impacted all industries. This is so especially due to the surge in global commodity prices which range from crude oil to metals to food products including wheat and corn. Almost every industry has been impacted as a user or seller. Now the question is: have companies been hedging their price risk?
Companies have been increasing the final prices of their products due to the rise in raw material costs. This started from the third quarter of FY22 and has continued since, which has in turn added to CPI inflation for household goods and consumer products.
Vegetable oils have already been under strain as India imports around 60 per cent of its edible oil requirements. With international prices being distorted due to the Ukraine war where both Russia and Ukraine are major global suppliers, the impact has been quite severe with prices almost doubling in a year. The government has had to do some firefighting by cutting duties to cool prices.
Similarly the wheat episode is remarkable because a country with one of the highest outputs has witnessed an increase in prices. The reason is that with supplies from the war region being cut off, there is an incentive to export to cash in on higher prices, leading to lower domestic procurement.
The oils and wheat episodes have impacted industry besides households. The entire food processing industry as well as services such as hospitality, tourism, airports etc. are affected by higher prices which get passed on to the consumer. Ideally manufacturers of oils, confectionery, bakery products, hedge their raw material risk on commodity exchanges.
But this is not possible today as there is a ban on futures trading in the entire oil complex (seeds and oil) as well as chana and wheat. This means that there is no option to hedge the price risk and the higher cost has to be absorbed by the firms. They would do so up to a point beyond which the consumers will have to pay higher prices.
The rise in prices can be seen already in the MRP of various products and menu cards of restaurants and there could be more hikes in the offing.
The irony of a ban on futures trading in oils and wheat is stark. The ostensible reason for this ban is to curb the rising prices. This is a hypothesis that has never been proved and is more impressionistic.
But by banning such hedging options, companies perforce pass on the higher raw material (input) cost to the consumer which adds to inflation. This anomaly needs to be corrected by removing bans on futures trading in agricultural commodities.
Interestingly, there is no evidence so far of futures trading fuelling inflation. An expert committee set up under Abhijit Sen over a decade ago pointed to this aspect. Subsequent studies have also not established any causal link between futures trading and inflation. Yet, successive governments have instinctively banned futures trading whenever prices increase, on the mistaken notion that futures trading leads to inflation.
As all futures contracts are delivery based, which means that open positions have to be closed out or result in delivery, it is hard to distort the market. Besides exchanges have in place sound risk practices such as position and price limits to restrict volatility in the market.
Bans have been in vogue in this market since 2007 when tur and urad were banned for futures trading. These were rather robust contracts where the dal and spices mills were actively hedging their risk. Subsequently, there have been bans on rice, wheat, soya oil, soyabean, guar seed, guar gum, sugar, chana etc. The latest set of bans include rice, wheat, moong, crude palm oil, Chana etc.
Besides companies dealing with these products, even user industries like the farsan (bhujia) segments, have been impacted and they have been compelled to increase their prices by passing on the higher input costs, as they would not be in a position to hedge their price risk on both — besan and edible oils, which are the main ingredients.
By imposing a ban the market has been pushed back and the entire value chain ends up being impacted which ends with the farmer. The restoration of futures trading in 2003 was done with the idea of commercialising the agricultural sector to ensure the benefits percolate to the farmer.
Exchanges like NCDEX have had good deliveries taking place indicating thereby that value chain participants were trading.
Further, farmer producer organisations (FPOs) have been active in the market with SEBI taking some aggressive initiatives. At the same time corporates find hedging useful even when they don’t take physical delivery as it is a powerful tool to protect their margins.
Companies even today hedge their price risk on international exchanges when opportunities are denied within the country. Metal companies hedge on LME, though the contracts offered by MCX have found favour over the year. The same holds for crude oil related products. The ban on futures trading on oils and wheat as well as chana needs to be withdrawn immediately. This will help in multiple ways.
First, it will help companies hedge their price risk. Second, it can help to reduce further increases in prices. Third, it will help strengthen Indian commodity exchanges which need business to survive. An exchange like NCDEX which had dominance in agricultural products, today is barely able to clock even ₹1,000 crore of average daily volume.
Today it has been seen that there are only two exchanges that have survived, and while MCX has done well in the metals and energy domains, NCDEX has been sliding down in the present environment. There is need to grow the market and not destroy it.
The present scenario is scary for the market. It affects not just the exchanges which provide a platform for trading but the entire value chain that has been built and nurtured in the last two decades.
The writer is Chief Economist, Bank of Baroda. Views are personal