Narendar Pani

Cash transfers can be inflationary

Narendar Pani | Updated on August 02, 2011

After the cash subsidy is spent on the commodity, it generates additional spending. If this spending is not met by an increase in the supply of commodities, it will create inflationary pressure that will hurt households outside the BPL network.

The move to replace the current system of subsidies with cash transfers to the poor is gathering momentum within government circles. The eagerness to make this change is based on the belief that cash transfers are less likely to leak than the current system of subsidies embodied in the price of the commodity. While this contention is itself not beyond debate, what is of greater concern is that several serious dangers of a system of cash transfers are being brushed under the carpet. Arguably the most significant of these dangers is their inflationary potential.

The price element in the argument for cash transfers is usually limited to the fact that everyone will now pay the market price for the commodity. With the subsidy being directly transferred into the bank accounts of the poor the effective cost of the commodity for such households will not change. Indeed, since direct cash transfers are assumed to be more efficient, the poor are supposed to be better off.


The trouble with this argument is that it does not take into account the effect of the shift to cash transfers on the market price itself.

In the current system the subsidy is embodied in the price of the commodity and has no further effect once the commodity is consumed. But in a system of cash transfers the subsidy is in the form of cash that is paid to buy the commodity. This cash is income for those who sell the commodity. They would, in turn, save a portion of that additional income and spend the rest. This becomes income for those who they buy from, and so on.

In other words, long after the subsidy is spent on the commodity it is intended to subsidise it generates additional rounds of spending. If this additional spending is not met by an increase in the supply of commodities, it will create inflationary pressure.

The quick response to this inflationary potential would be to ask the Reserve Bank to tighten its monetary policy so that this additional income can be offset. But a tight money policy in a liberalised economy makes investment more expensive and hence dampens growth. Indeed, the long-term strategy for liberalisation is to move to a regime of lower interest rates. In practice, inflation is making it difficult to keep interest rates down to levels that will encourage investment. Any further increase in money supply caused by the monetisation of subsidies will make the RBI's task that much more difficult.


It could be argued that the inflationary pressure could be reduced if instead of cash transfers the poor were given food stamps. Once the food stamp is used to buy food, it would no longer have any use. But we cannot be sure that the food stamps will actually reach the poor.

If the current Public Distribution System has developed such massive leakages as officials claim, how can we be certain that the system of distributing food stamps will do any better? And if food stamps get into the wrong hands they could be hoarded and used together at times when supply is short to generate a spurt in demand and push up open market prices further.

We cannot also rule out the possibility of food stamps becoming a de facto currency. In an inflationary situation the poor may be forced to cut their expenditure on food. If there is already a demand for food stamps that can be hoarded, the poor should be able to convert their stamps into cash. In such cases the inflationary pressure of food stamps will be the same as that of cash transfers.


Such inflation-generating cash transfers will make conditions worse for at least two types of poor households. The first are the vulnerable poor households who are unable to get a Below Poverty Line ration card.

Since they are not officially recognised as poor they will not get the cash transfers either. In the more backward parts of the country the number of such households is not low. These households were always forced to buy from the open market. The only difference will be that they will now have to pay a higher price in the open market due to the inflation caused by cash transfers.

The second set of poor households that cash transfers discriminates against comprises those who are currently living in areas where the Public Distribution System works very well. These households are already getting their subsidy.

According to the simple argument for cash transfers, there should be no difference to them whether they get their subsidy embodied in the price of the commodity or in the form of cash. But inflationary pressure will make the commodity more expensive after cash transfers, thereby leaving these households worse off.

The households that are expected to benefit are those who have not got any subsidised commodity from the current system but are able to get the entire benefit of cash transfers.

In such cases cash transfers will give them the subsidy they could not access before. But a part of this subsidy will be offset by the higher market price they now have to pay. And if uncontrolled inflation eats into the entire subsidy and more, these households too would be worse off.

There are no doubt serious flaws in the current system of subsidies, but moving to cash transfers is a remedy that is worse than the disease.

(The author is Professor, School of Social Science, National Institute of Advanced Studies, Bangalore. >

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Published on August 02, 2011
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This article is closed for comments.
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