Time to move away from prescriptive macro policy making

Indian economy seems caught between tight fiscal targets prescribed under the FRBM review and a government which treats it as cast in stone despite being faced with the current crisis.

The best example of failure of the prescriptive approach is the Eurozone. The prolonged sluggishness of the Eurozone is caused mostly by the restrictive tight inflation targeting (influenced largely by Germany’s phobia for inflation given its post WWII memories), fiscal deficit targets and debt/GDP ratios which were good for a select few countries but out of context for most of the rest. Those who were already better gained in relative terms but those who were not aligned already have gone into prolonged sluggishness and some into economic coma. But on overall basis, Eurozone has not gained; it has been a massive loser – a sinkhole which the Chinese have expertly filled in to their advantage.

Prescriptive and market distorting intervention in agriculture products has been around in India for a long time along with minimum wages in labour markets. But in the recent years such an approach has been extended to other areas of macro management. Prohibitive pricing under Land Acquisition Act has virtually put it out of reach. Inflation management which was largely situational or contextual has become tightly prescriptive, where the midpoint 4% has operated more like a hard-stop cap. FRBM was loosely operated till 2016. With a rigid fiscal target and glide-path and Debt/GDP ratio, it has started impacting other macro variables like output and employment and government investments, besides putting breaks on response to a 6-sigma kind of event like Covid.

Such a prescriptive approach is born out of a lack of faith in markets’ efficiency and its self-correcting nature. Fixing targets for macro-economic variables like inflation, interest rates, fiscal deficits are as detrimental to the efficiency of free markets and its equilibrium seeking ways as fixing minimum or maximum prices in individual commodity markets or fixing quotas or tariffs, or licensing in micro markets.

A circuit breaker in stock markets at 10% and 20% might make sense, but at 3 and 4% they will affect free functioning of markets and its adjustments to new information or assimilation of the effect of other economic factors. The trouble with tight constraints is that they start affecting other factors and force them to operate at sub-optimal levels. As an example, anyone seeking air tickets or hotel rooms on internet will know that the more the conditions or filters one puts, the lesser the number of options that gets thrown up. The recent prescriptions have operated like ‘binding constraints’ in a linear programming language reducing the value of outcome than act as circuit breakers.

Free of any prescriptions major macro variables like inflation, investments, fiscal deficits, CAD, exchange rates, growth and output interact with each other influencing and being influenced by others so that the markets seek optimal or equilibrium ways. Such interplay also keeps the others in check so that they don’t escape their gravity. The experience of communist countries has proven that market based equilibrium have been far more enduring and self-sustaining with fewer glitches. Prescriptions should be like circuit breakers for extreme 3-sigma events like East Asian meltdown, Dotcom bubble and 2008 and Covid.

Are there risks in letting markets play

Will inflation, for example, run away to 20-30%. Or interest rates go sky high and snuff out all investments. Or Exchange rates break loose and settle at Rs 120/$. In an open economy where most commodities as well as finances can be imported or exported there is little risk in a general inflation shooting through the roof – import parity prices will ensure domestic prices cool down. Sudden swift exchange rate variations are to release pent up pressure. If the exchange rates fall far too steeply, higher exports and greater incentive for overseas Indians to bring back money will soon cool it down. Any spikes in interest rates will increase the investments attractiveness and bring in moneys from savings here and overseas and cool it down.

Unless the government resorts to absurd 30-70% increases in MSPs (as it did in 2008 and 2010) extreme food inflation is unlikely. With our excess stocks and production of food grains there is no need for food inflation fears; surely in contingencies we have enough forex reserves to import food and cool down prices – something markets will do anyway.

Safeguards

Safeguards if any should be limited to extreme events – specified or emerging- something that has a 1% or 2% chance. For some most essential items like food it may be necessary. But even in such areas it may be better to let the market find its level but compensate the vulnerable through cash transfers.

During the 10 years before 2013, we have had some of the best growth years when the inflation range has been 4-10% and fiscal deficits were in the range of 6.4% to 3.3% with an average of around 4.7%. Surely there was a causal connection between these various factors, when they were managed with caution than prescription. To aim 4% and 3% respectively tantamount to ignoring these causalities and give hygiene factors the status of main deity. These then operate as constraints which pull down the potential of others.

When the history of China’s stupendous rise from 1980 to 2020 is examined carefully 2 things might become clear. FED’s Volcker’s constricting inflation control during the 80s diluted US’ investment spurs and helped China to grow green shoots and the self-negating Eurozone policies of the last 2 decades helped consolidate it further. Europe, once the cauldron of new ideas in many facets of science and technology and corporate governance is regrettably having to shield itself from Chinese investment invasion now.

Before we learn about Chinese manufacturing excellence, we might learn some lessons on how they have managed their economy.

India seems fatally infatuated to Eurozone ways and replicating the resultant sluggishness.

Misplaced Hopes on MSP

Misplaced hopes on MSPs

V Kumaraswamy

There is some growing frustration over governments procurement of key grains under its Minimum Support Prices (MSPs) not being to lift the open market prices of those commodities and benefit the farmers. What the policy makers and economists forget is that our MSP procurement is not an end in itself but has to be studied with its end use – distribution of such procurement under our PDS programmes and how they work at cross purposes.

Effect of MSP procurement

It is generally assumed or hoped that once the MSPs are increased the open market prices would also rise in sympathy. There is insufficient realization that such procurements hardly create incremental demand. The government has limited flexibility in increasing the quantities procured under MSP which may be a surer way of enhancing prices and how increasing farm productivity from the current levels only harms the farmer interest not help them.

The effect of procurements under MSP is quite often overestimated. It is necessary to visualize the impact of procurement operations to separate reality from hope and wishes. Lets try and understand the impact through graphical exhibits. Picture 1 orders the demand from the buyers at various prices in decreasing order of prices. The thick ridge line at the top forms the demand curve as is depicted on the left side. Any procurement by government agencies at any price leads to a kink (drawing on right side) in the normal demand curve as is shown on the right picture. It shifts the demand curve horizontally in proportion to the quantity bought (dd’ in Picture 1) at the price point equal to the MSP for the crop.

 

demand supplyIn Picture 1 due to the governments initial extra demand the total demand increases but as we will see later once the government supplies the same though PDS, the effect is neutralized.

mspdsinterplay

Picture 2 studies the combined effect of demand and supply of the same commodity as in Picture 1. The normal (without intervention) demand curve DD’ is represented by the solid blue line which shifts to Ddd’d” (partially dotted line) after procurement.

The supply curve is shown as SS’ (in solid Red line). The market price without any government intervention settles at P(free).  When the Government intervenes and procures dd’ from the market at the MSP price indicated it will move the market price of independent sellers or buyers which will not be

equal to the MSP: it will settle at lower levels. Where it will settle depends upon the elasticity of the supply curve; the flatter it is, the lesser will be the price increase. In agricultural markets there are many tiny suppliers whose cost structure hardly differs from one to another since many inputs come heavily subsidized or free to most players. Hence supply curve is often flat and highly elastic. The market price will settle at P(MSP) which is way lower than MSP but higher than the free market price of P(free).

It is a fallacy to think that hiking MSPs from the current levels will result in higher open market prices. Unless the quantities procured are increased from year on year (which will keep pushing the dotted d’d” segment further and further to the right), mere yearly MSP increases will have nil or negligible impact on open market prices.  Where P(MSP) settles will depend more on the width of dd’ than where it is above the P(free) levels. (MSPs below the free market prices are useless anyway). That’s the reason why formulas like 50% over all-in cost of farmers will prove innocuous, except benefitting those fortunate to sell their crops at MSPs directly by the Government.

Given the current levels of buffer stock in FCI go-downs, any significant increase in procurement quantities will be a hazardous exercise.

Effect of PDS distribution on prices

The crops procured under MSP are used in supplying them at cheaper (than free market prices) cost through the public distribution system to end consumers. This has the effect of changing the supply curve from SS’ (without PDS operations) to Sss’s” (partially in red dotted line in Picture 2 right side). This will lower the open market price which may even settle at levels lower than the initial free market price, as is the case in Picture 2. Will the total quantities bought and sold expand as a result of these operations? It will since production will increase due to price support and so will consumption since people more people at lower levels could afford to buy more due to lower PDS prices.  The difference between procurement and PDS supplies will be accretion/depletion to buffer stocks.

Way Out

The production of agri commodities has been surplus to requirements for several years running. The buffer stocks with FCI is far more than norms and the credit to FCI from banking system at uncomfortable levels. One way would be to export the surpluses and not supply the same back in home markets through PDS. Or sell it to private sector for food processing. Alternatively, it can allow food processors and exporters to procure crops at MSPs and reimburse the difference between market price and MSPs to them. At least the handling/storage loss can be reduced. Simultaneously, the govt should reduce the size of PDS physical distribution and reimburse the consumers through Direct Benefit Transfers even if the consumers buy their requirement in open market.

A method to tweak the supply curve by partial rationalization of subsidies on inputs to increase the market prices and thus benefit the farmers was also explored in this paper (How the Agrarian Crisis can Be Eased, June 24, 2019).

It is time we realized the areas where MSPs and PDS can be effective and where they can’t be and not be fooled by misplaced faith and theories.

Selective Rationalization of Subsidies might solve the Agrarian Crisis

 

Link to Businessline: https://www.thehindubusinessline.com/opinion/how-the-agrarian-crisis-can-be-eased/article28128069.ece

The current agrarian crisis in India is a product of two factors (i) failure to recognize when Green Revolution started giving diminishing returns and taking steps to come up with alternatives and (ii) economic impact of subsidies, which this article examines – both man made and policy failures.

The current crisis can be summed up as diminishing soil fertility, sinking water table, increasing costs (all effects of green revolution) and poor returns to farmers, periodic unaffordable spikes in key commodities, periodic excess production which are dumped on the roads ruining several farmers and a huge burden on the government.

The policy failures have arisen due to not recognizing the nature of demand and supply curves for agricultural commodities. The demand is highly inelastic – in a market which consumes 100 kg tomato if one supplies 125 kgs the prices collapse, since not much demand is there for the excess. Contrarily, where it is supplied 75kgs only, the prices skyrocket since everyone wants to garner their daily supplies.

The Graph plots the demand and supply of a typical agri crop. The cost buildup of various suppliers is arranged from lowest to highest and its ridge on top becomes the supply curve. In agriculture the demand curve is steep and supply curve is relatively flat. Where this is the case the market price is closer to supply curve. This leaves a huge consumer surplus (excess of what the people are willing to pay and what they actually end up paying) and thin profits. Where the demand curve is flat but supply curve the price line stays closer to demand and hence smaller consumer surplus and higher profits for producers.

Many people have argued for breakup of cartelization of middlemen and dismantling or reforming APMCs as the panacea for better farm gate prices.  This is as naïve as it can get. The middlemen are performing important functions like taking immediate delivery of perishables, financing farmers, storage, connecting with customers and markets, inventory holding etc. which we forget. If left to government agencies they would mess it up.

Sure most farmers are small (crops from 2-3 acres to sell) and their reach is at best the village boundaries or at best 4-5 kms. How do they perform all the functions the middlemen do? At the Mandies of course it is a case of ‘many sellers’ versus a ‘fewer buyers’. But it is foolish to think that fewer numbers by itself creates usury pricing power.  Most markets should have at least 40-50 buyers (or middlemen) versus may be 500-1000 sellers. But this is statistically enough to create conditions of undistorted trade. Imbalance might creep in if there are only 3-4 on one side and can collude overtly or covertly. Most suggestions on ‘reigning in’ middlemen for tackling agrarian crisis is bound to be ineffectual.

But the real problem is the supply curve‘s flatness. This is largely the result of governments ill-advised subsidy policy which makes no discrimination whatsoever on the various input subsidies to agriculture. When everything from electricity, water, seeds, fertilizer, interest, MSPs, are given free or subsidized without any limits of land holding or size, it leads to similar cost structures for most suppliers and hence the supply curve becomes flat as shown in Graph (Before segment). Even if all mandies are handed over to the farmers, with such a curve, their profitability is unlikely to improve much.

The solution should revolve around exploiting the inelasticity of demand. The sure fire solution is to make the supply curve more elastic and harvest a huge ‘consumer surplus’ (which is what the middlemen do – they don’t take away farmers’ profits; they take away consumers’ willingness to pay).

This can be achieved by rationalizing subsidies. This can be done by restricting subsidies to only those holding 2-3 acres or to the first 2-3 acres only for even for larger farmers. With precise targeting through DBT, it is possible in the current scenario. Or it can be graded like 100% of current levels for 2-3 acres, 50% for 4-8 acres and nil thereafter, like in the graph. This will increase the cost for larger farmers (all units with ‘L’ label on x axis) and induce a steepness (as shown in the After situation in the graph).

Rationalization of Subsidies

Effect of rationalizing subsidies

The prices as is seen in the graph will raise (in the illustration from Rs 69 to 84). This shifts a portion of consumer surplus to producer profits. This will mostly benefit the small and marginal farmers. This transfer is perhaps much needed. We cannot have a society where 55-60% of people get a share of 15% of GDP.

The quantities bought and sold will fall. But given the inelasticity of demand, it will be relatively much less.

The larger units which lose a part of their subsidies will become uncompetitive in their traditional crops. They will diversify into other commercial crops or crops for which there are no subsidies now so that they won’t suffer in relative terms versus subsidy supported small farmer.  This is an important necessity. Our food grains production is in surplus and for increasing its income, diversification is a pre-requisite.

This will also partially address the rural income inequality problems.

Governments finances

The Government will save a lot by curbing subsidies going to larger farmers. It can reduce the crops procured under MSP since the market prices would have substantially moved to enhance their incomes. This would have come from consumers who were willing to pay, hence may be without much pains (other than a onetime price adjustment as inflation). The Government may have to spend a part of its savings on covering some poorer marginal sections (who are net buyers of food) through higher PDS subsidies.

A portion of PDS procurement can be reserved for organic farming by larger farmers. With the promising growth for organic products the world over, it could give an early mover advantage.

The Government need not do this rationalization for all products. It can start with those where there are surplus buffer stocks. If prices of those products move up, consumers will diversify their consumption basket to other products and their prices of unsubsidized products will also start moving up. Larger farmers would gravitate towards such products.

Make in India spoilt by persistent low manufacturing inflation

A Copy of this appeared in Financial Express on 12-03-2018. Link: http://www.financialexpress.com/opinion/make-in-india-delivery-patchy-heres-why-rethinking-is-needed/1094828/

V Kumaraswamy

Make in India is one of the key cornerstones of the current government to raise growth rates and create employment. It has been almost 4 years since the Make in India was launched with much hope and fanfare. The Government has initiated several useful steps and reforms to actualise it. The most recent upgrade in credit rating and 30-odd points jump in Ease of Doing Business will get us some mileage.

But it is clear that the delivery of Make in India is rather patchy. Several reasons have been advanced for its lacklustre show – highly overvalued currency, unfavourable ASEAN FTA, tight and unyielding monetary policies, very high real interest rates, high logistics costs etc. All of them have a degree of truth.

But it has to be recognised that beyond all these, an entrepreneur or corporate will invest only if they get remunerative prices returns are competitive to what the other sectors yield. This last aspect has not been addressed at all by the Government or inflation conscience keepers. Had this single factor been corrected, Make in India would have had a far better report card to show.

Nature of Indian Manufacture

Indian manufacturing is not high tech where heavy engineering, high end electronics, aircraft and space crafts, ship building etc. dominate. It is relatively low to medium grade in its maturity. It has a heavy dominance by industries which prepare or convert produce from agriculture for domestic consumption.

To give a few examples: Textile sector (the biggest industry by employment) is dependent on agriculture for cotton supplies and silk which can account for about 60% of final product costs, Sugar industry on sugarcane, Cigarette on tobacco, Beedi industry on Tendu leaves and tobacco, Vegetable/ cooking oil industry on sunflowers, groundnut, sesame, Food processing industry on wheat, maize, fruits, fish, poultry and Dairy industry on milk. Roughly 40-45% of Indian manufacturing sector depend on agricultural for their inputs. And a few more for inputs from Mining.

It is important to maintain a balance between input and output prices in these sectors and they should ideally move in tandem, if the manufacturing sector has to stay attractive for investments.  In India since agriculture feeds industry and industrial final goods are sold to those in rural and agriculture areas, any persistent imbalance could hurt both.

Our Manufacturing Prices are down 41% since 2004-05 in relative terms.

Terms of trade in international trade means the prices a country gets for its basket of export goods versus what it pays for its imports and how the relative price moves over a period of time. In domestic trade it means how the prices which a sector gets for its output moves in relation to the prices it pays for its inputs from other sectors.

From 2004-5, the terms of trade have been relentlessly moving against Manufacturing. If the manufacturing sector has had to pay 165% more for its key inputs from agricultural sector, it has been able to recover just about 57% from its customers. If Agricultural input prices are taken as the base, the manufacturing sector is getting nearly 41% less today for what it sells to other sectors compared to what it pays for agri inputs. (see Chart)

WIN_20180312_21_17_06_Pro

At one level it helps transfer of income from non agriculture sectors to rural and agriculture sector and thus corrects income skewedness. But a consistent increase of this magnitude has continuously eroded the margins of the manufacturing sector to unattractive and unsustainable levels leading to lack of enthusiasm in investing.

Reasons

Year on year for almost a decade and half, Agri inflation has been more than parity. This has come about by steep and arbitrary increases in Minimum Support Prices (MSP) announced by the Centre for many crops, especially in 2009-10, 10-11, 12-13 and 13-14 possibly due to electoral compulsions (see Table). Although MSPs are restricted to certain crops, farmers tend to gravitate towards higher MSP yielding crops till the yield per hectare for other crops equalises with those under MSP. Thus MSPs impact transmits with a lag on other crops as well. One has witnessed a similar phenomenon in rural wages consequent upon implementation of NREGA.

On the other hand,  ASEAN FTA agreement has more or less put an effective ceiling on the prices that manufacturing can recover for its end products. Free trade has more or less made recovering cost inflation through domestic price increases an impossibility over the years. India’s over-valued currency has played a spoil sport on top of these.

Need for Correction

India’s growth story to continue requires Indian manufacturing to expand and diversify and create employment for those released from rural and agri sector. As the sector saddled with the responsibility of creating jobs for those entering the market, it should be the one which is relatively more attractive. Unfortunately, things are exactly the opposite for the last decade and a half relentlessly.

Ease of doing business can contribute to encourage entrepreneur by making the state machinery less intimidating but it cannot alter the base investment arithmetic of Return on Investments (ROIs).

Year Wise Inflation for Mfg and Agri Products                     (2004-05 = 100)
Year Mfg Inflation Agri Inflation Agri Inflation / Mfg Inflation
2005-06 2.4% 3.4% 140.3%
2006-07 5.7% 8.8% 155.4%
2007-08 4.8% 8.0% 167.0%
2008-09 6.2% 9.9% 160.9%
2009-10 2.2% 13.1% 589.6%
2010-11 5.7% 17.0% 297.9%
2011-12 7.3% 7.8% 107.6%
2012-13 5.4% 10.0% 185.5%
2013-14 3.0% 11.2% 370.7%
2014-15 2.4% 4.7% 195.8%
2015-16 -1.1% 3.4% NA
2016-17 2.6% 5.0% 195.0%

 

The approach announced in the recent Budget for MSP fixation might lend stability and certainty. If the MSPs are linked to the input prices which should include manufactured items like fertilisers, pesticides, seeds, etc. the inflation of manufactured products would have a decisive say in the agri inflation and hence MSPs. They would get inter locked.

Details are awaited on the exact scheme. Even if a margin of 50% is built in (which should take care of imputed interest, rent and profit besides inflation of inputs), it would build some parity and hence rein in persistent deterioration of adverse terms of trade against manufacturing.

Even so the heavy backlog built up since 2004-05 would need to be corrected if manufacturing is to see green shoots again. The States also should have a say in the future FTAs; they should have a choice of what industries and products to offer for free imports and what products to seek exemption from our overseas importers. States should also have a say in the fixation of MSPs.