WisdomTree Dreyfus Indian Rupee Fund ETF (ICN), EG Shares India Consumer ETF (INCO): India’s Partial Deregulation of Sugar Mixes Politics with Economics

The sugar price in India has finally been partially deregulated by the Cabinet Committee on Economic Affairs (CCEA). This was a greatly anticipated decision and now allows the sugar companies to sell their product in the open market. This decision is just part of the Committee’s report which covers larger economic reforms of the agricultural industry.

The levy breaks

The government, however, will continue to sell sugar at a subsidized rate from Public Distribution Shops (PDS). According to the authorities this decision will not increase the sugar prices and there will be no levy mechanism. State governments will purchase sugar as per their requirement for the Public Distribution System from the open market and later, the difference will be reimbursed by the Central government. This will be unsustainable and soon grow to be a drain on the public finances in the same way that the recently-reformed diesel fuel subsidy was finally scrapped.

The system in India is even more complicated than this, as there exists a levy – 10% of total production – which is set aside for the PDS. Sugar mills will not bear the obligation of levy for 2 years. This system has been costing the Industry $556 million US annually, which after the deregulation can be saved by the sugar industry, at least for the next two years as they have been freed from their obligation to supply the levy. Moreover, the release order mechanism has also been abolished, under which the government dictated the terms to sugar companies about the time and quantity that the sugar could be released for sale.

The price of levy sugar was fixed at Rs13.50 per kilogram — $0.114 per pound — in 2012 and has remained at that price since then. Even though Sugar futures prices have been falling in for the last two years they are still, in the international market, well above the current levy price. This will cause a bifurcated market at a minimum and cause an additional drain on already strained government finances in the first place.

The government has given the assurance that the retail price of sugar will not be increased, and will probably increase the subsidy burden of the government to Rs 5,300 crore ($985 million US) annually from previous 2,600 crore ($483 million), in essence putting the entire subsidy scheme on its back.

Sugar-coating the costs

The scheme is politically, a very savvy bit of electioneering – given that we are a year away from general elections in India –to buy votes in states such as Uttar Pradesh and Maharashtra where a majority of the sugar producers are while maintaining the current consumer market. This is necessary after the unrest caused by the ending of the diesel subsidy. The sugar companies have long maintained that their profit was declining due to government control of the market, which protects large firms and prevents new companies from springing up due to a lack of economy of scale. Moreover, demand for sugar is artificially stimulated by such a pricing scheme which creates a demand for imports. Now the farmers can at least be properly compensated by the sugar processors. It’s a big price to pay for a few thousand votes.

But, this new scheme will be good for sugar producers like Balrampur Chini, Bajaj Hindustan, EID Parry, Dharani Sugars and Chemicals, as their businesses have been freed from a huge drag on their bottom line. The Rupee’s current weakness will not be helped by this new scheme as the central government’s finances will be replacing some of the strain lifted earlier.  The closest investment vehicle to the Rupee pair is the WisdomTree Dreyfus Indian Rupee Fund ETF (NYSEARCA:ICN), which shadows the Rupee exchange rate with the U.S. Dollar and changes in the short-term money market.

Reform in India is going to be a process of two steps forward and one step back. This will be especially true between now and the elections in 2014. The Singh government has been fighting a wave of discontent as it struggles with high inflation, eroding real growth and the need to liberalize a number of core industries to return balanced growth to India’s infrastructural industries.

Smaller is better

There are a number of ETF’s which cover the Indian market. Given the nature of these changes there will be a boom in small scale sugar farmers and producers as that portion of the market is freed up. Once the subsidy becomes unsustainable from a budgetary standpoint the market will again change completely. But, doing away with the levy is the first step to a better functioning market.

Expect consumer firms to invest in the growth of India’s sugar industry and expand supply as a result. EG Shares India Consumer ETF (NYSEARCA:INCO) is an interesting choice. It is small at just $6.7 million AUM but focused on the growing Indian consumer market. Market Vectors India Small Cap Index ETF (NYSEARCA:SCIF) is a mid-sized fund at $112 million AUM that is focused on Indian small-cap companies and more than 40% weighted to industrials and consumer cyclical stocks.  Both of these ETF’s should perform well as a result of changes to the sugar industry, the phasing out of the diesel subsidy and opening of foreign investment into retailing.