India Economy

Could higher MSP snowball inflation?

Radhika Rao | Updated on April 01, 2018

Political economy of providing a price floor to foodgrains distorts food inflation dynamics

In a bid to offset the impact of last year’s supply glut, boost farm incomes, and address the broader discontent amongst the agricultural community, the government proposed support prices at 50 per cent above production costs for the kharif crop in the February 2018 Budget. This has given rise to concerns over its impact on inflation and inflationary expectations.

MSPs were raised sharply during 2009-13. But since 2014-15, the pace of MSP increases has moderated. On a simple average basis, kharif MSPs for foodgrains, pulses and oilseeds were up about 6.9 per cent year-on-year (YoY) in 2017-18, compared to about 20 per cent during 2009-13.

To examine the impact of MSPs, it is first necessary to ascertain the composition of production costs. In official parlance, the cost concepts are classified as, a) A2: farmers paid out costs; b) FL: imputed value of family labour; c) C2: most comprehensive; in addition to A2 and FL, it includes imputed costs of owned land and owned capital. After initial confusion, the Finance Minister clarified that farmers will be paid 50 per cent returns over their A2+FL costs, falling short of the desired C2 coverage.

A comparison of the 2017-18 MSPs and the basis on which 2018-19’s will be calculated suggests that the scale of increase will not be as sharp as the popular narrative suggests. The 2017-18 mark-ups were only slightly lower than 50 per cent for the summer crop.

For instance, for paddy, it already stands at 39 per cent, maize at 36 per cent and over 50 per cent for a few pulse groups, according to the CACP. This suggests there is small headroom for MSPs to be raised from current levels.

In sync with food inflation

MSPs as well as headline and food inflation move fairly in sync. We regressed the annual changes in MSPs and inflation (CPI-industrial workers index used as a proxy), since the 1990s. The results show that for every 10 per cent change in the kharif support prices, inflation will get a lift of 70 basis points, spread over a year. Even before inflation begins to reflect the changes, inflationary expectations are likely to be buoyant, much to the chagrin of the central bank.

As a purely supply-driven measure, the MSP impact should dissipate beyond a year. This lift to prices might, however, sustain if demand also recovers concurrently, through higher rural wage growth. High food inflation during 2009-13 was not driven only by MSP increases, but also by rural demand, up an average 12 per cent, versus 7 per cent in 2008.

In 2014-15 and 2015-16, rural wage growth moderated, before showing signs of life this year. If this sustains, stronger rural demand will provide another leg-up to inflation.

Besides boosting inflation, another undesirable consequence of support prices is that they distort production trends, mainly through procurement activity. Consider the movements of foodgrains vs pulses — MSPs are more closely correlated to prices of foodgrains (rice, wheat, etc.) than that of pulses. This is reflective of the government’s active role in foodgrain procurement, which helps protect prices. By contrast, its role in pulses is limited to periods of scarcity; at such times directed measures (imports, stock limits, etc.) are imposed to boost supply and temper prices. However, when market prices dip below MSPs, procurement lags.

As a quick fix, the government might step in when rates of farm produce fall below the MSPs. Two options are being explored: a) market assurance scheme (procurement is stepped up) or b) price deficiency system (i.e. price gap between MSPs and market prices is compensated for through cash transfers). Both these measures are likely to artificially hold up market prices, leading to marked shifts in production and, subsequently, price trends.

Impact on RBI action

For the Reserve Bank of India, MSP increases pose an additional risk to its inflation view, besides fiscal slippage worries and higher oil prices. In the near term, inflation has eased for three consecutive months to February, with the RBI’s projections for March 2018 quarter likely to be undershot.

Into fiscal 2019, base effects are expected to drive readings back towards 5 per cent year-on-year until June-July, due to base effects and seasonal forces.

The central bank had, however, signalled that it would look past the run-up in short-term prices, instead focusing on the trends from the September quarter onwards. Our base case is for policy rates to be held steady, before a modest hike in the fourth quarter of 2018-19.

Hikes might, however, be brought forward if sharp increases in MSPs are accompanied by sticky inflation — above 5 per cent —beyond June 2018, higher oil prices, and heightened market volatility (rupee weakness).

If these risks materialise, rate hikes might be front-loaded to the second or third quarter of 2018-19.

The writer is India Economist, DBS Bank

Published on April 01, 2018

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor