Risk management for the small farmer

Causal factors for some challenges faced by the Indian farmer

1. Fragmentation of land holdings and degradation of soil quality;

2. Inadequate level of investments and poor productivity; 3. Poor quality of seeds; very poor access to information

regarding sowing practices, choice of crops and market trends;

4. High exposure to rainfall risks; 5. High exposure to commodity price risks; 6. Very low levels of “equity capital” with the small farmer to

absorb these risks, high levels of leverage;7. Very poor access to credit.

Some interventions to help the farmer

• Minimum Support Price (MSP) on several crops• Heavily subsidised crop insurance• Massive loan waiver scheme for farmers with over-due loans

to banks• Continued priority sector requirement recently making it

even more important for the small farmer to be targeted and requiring the loans to be made at very low rates of interest.

Many of these interventions seek to subvert market forces in order to protect the small farmer. While they may indeed provide relief in the near-term, in the long-run they are not sustainable interventions and may even end up exacerbating the problem.

The flip side

• MSP: An excessively high MSP which is provided for free to the farmer represents a Deep-In-The-Money Put Option that is being offered to the farmer as a conditional cash transfer only if she takes the “incorrect” decision of planting a crop for which there is inadequate demand!

• Subsidised crop insurance: The subsidy may encourage farmers to systematically underestimate rainfall risk in their cropping decisions .

• Loan waivers: The massive loan waiver may make it harder for farmers to get access to credit in the future.

• PSL: Very low interest rates on priority sector may be encouraging higher levels of capital intensity in farming than is optimal given the relative availability of labour,

Market based interventions

Some of these interventions include: • Improving Spot Price discovery for the smallholder farmer.• Addressing the Access to Credit and Warehousing

challenges being faced by the large farmers and traders. This would include Warehouse Receipt Finance (WRF) for the larger trader – the argument being that there is a great deal of underlying price risk even around the seasonal pattern and it would be difficult for the small farmer to “play” this market.

• Providing the smallholder farmer with good weather forecasts, rainfall insurance contracts and good advice on cropping patterns.

• Developing and permitting a range of hedging and price risk management products and aggregation services for smallholder farmers including options on spot and futures prices.

Hedging for the farmer

There are broadly two types of instruments:1. Hedging Instruments: Futures Contracts and Forward

Contracts.• Eliminates downside but also eliminates upside. • Only accessible to traders and producers. • Forwards contracts offered by risk aggregators such as banks may

be more suitable.2. Insurance Instruments: Options Contracts, Insurance Policies,

Price Guarantees.• Most farmers look for an upside – store commodity to ride seasonal

patterns, borrow against commodity from traders. An option is what they really require.

• MSP is a put option sold by the government and paid for by taxpayers.

• In terms of payoffs, the MSP and options bought by the farmer would achieve the same outcome.

• The economic rationale for using options to achieve the same means is that trading in options would lead to price movements and price equilibrium. Minimum support price on the other hand restricts price movement and does not result in equilibrium.

Conclusions

• Systematic steps that are taken to harness market forces in support of the small farmer would not only provide relief to the small farmer in the near term but more importantly work in consonance with market forces and therefore feed into more sustainable longer term solutions for the farmer.

• While there may still be a need for the government to provide subsidy, it should support the orderly development of a market that the small farmer any way faces, and ensure that she does so on terms that are more equitable.

The key challenge in our view is to protect the farmer from short-term shocks and provide her with the best possible returns on her farm related investments while making her fully cognizant of longer term market dynamics so that she can gradually adapt to them.

IFMR Trust's pilot in Gujarat

Goals of the pilot:

• To provide price discovery to farmers for their crops in a fair and transparent manner (ATMNE).

• To explore other services that are required, but are currently not available to the farmer such as transportation from the village to the market / buyer, village level warehousing capability and agricultural extension services (ATMNE and IFMR Holdings).

• To provide commodity backed finance for those farmers who would like to avail of finance against their commodity as collateral (IFMR Holdings).

• To explore other financial products and services that are required, but are currently not available to the small farmer such as commodity forward contracts and delta-hedging (IFMR Holdings and ATMNE).

• To develop tradable Asset-Backed Warehouse Finance Receipts (ABWFRs) so that they may be sold to mutual funds and other financial institutions (IFMR Capital).

Trading operations in Kadi

• The trading facility is located at Kadi in the exchange managed warehouse premises.

• As a part of the servicer agreement, the exchange provides guarantee on quality, quantity and storage of commodity into warehouses managed by it. The electronic exchange market provides nationwide access to buyers and sellers.

• The first crop to be traded was castor seed. While the market is still in its nascent stage, the volumes have been encouraging.

• The market caters to farmers from around 125 villages around Kadi.

• Farmers come to the warehouse with their commodity which is then put through a standard weighing and quality testing process. Depending upon the quality, weight adjustments are made and the commodity is then packed in 75 kg bags and stacked away.

• The collateral manager issues a receipt of weight and quality and then the farmer places a sell trade through the ATMNE Agri broker sitting at the trading terminal at the warehouse.

• Once the trade goes through, the farmer is handed over the cash and receipt for the same.

Financing operations in Dharampur• Warehouse receipt finance in India is typically used by traders

and affluent farmers. It is largely perceived to be non-applicable to or non-viable for the small and marginal farmer.

• Barriers to participation from the financiers’ side include reluctance on their part to deal with small sized transactions due to operational reasons.

• From the farmers side, there are issues concerning non availability of reliable price information, lack of storage space, inefficient quality testing procedures, existence of multiple layers of intermediaries, hidden charges, documentation challenges and high transportation costs.

• In our experience, the biggest challenge in terms of giving the farmer an access to warehouse receipt finance has been awareness creation.

• IFMR Holdings provides loan against commodities as collateral. The purpose of the loan product is to provide short term finance to farmers collateralized by commodities for which warehouse receipts are issued by a collateral management company.

What does it take to avail a loan?

• The farmer needs to have completed our KYC formalities.• The commodity must be stored in our accredited

warehouse.• He must complete the documentation at our branch in

Kadi. • We charge a 30% margin against value of commodity. For

the moment we are not charging processing fees.• Loan can be returned anytime.

IFMR Capital1. Cenotaph Road | Teynampet

Chennai - 600 018 | IndiaPh: +91 44 4305 1526 | Fax: +91 044-4305 1558

http://www.ifmrtrust.co.in

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