Monday, September 19, 2011

The loud political message from agriculture…..and why RBI cannot control inflation

RBI has increased rates a record 12 times in the last 18 months. And yet the inflation rate continues to be extremely high at nearly 10%. Why is it that rate increases have not yielded the desired moderation in inflation rates? Is the RBI right in keeping on increasing interest rates in this manner? If the RBI is failing to control inflation, is it its fault or does the fault lie elsewhere? This post looks at why the RBI cannot do any more and why in fact, it has to lower rates now. This post also analyses the failures of the government in controlling inflation by refusing to work on agriculture. Well….the message from agriculture is clear….provided someone is willing to listen.

First let’s get some basics out of the way. As is well known, inflation happens because of a supply-demand mismatch. More specifically, when the demand exceeds the supply. This mismatch can happen either because of a demand surge (called demand side inflation) or an under-supply (called supply side inflation). Demand surges are usually short-term and have to be regulated by the RBI. Under-supplies are usually long term structural problems and have to be addressed by the Finance Ministry and other departments of the government. Too much focus has been placed on the role of the RBI in regulating inflation. Too little on the government. Another basic to understand before we go ahead is to keep in mind that inflation is measured in India largely on the basis of the Wholesale Price Index (WPI). The WPI has three major components – Manufactured products (65% weight), Primary articles – food and non-food (20.1% weight) and Fuels & Power (14.9%). Inflation is measured for each of these components and the overall inflation is derived keeping the weights in mind.

The RBI’s main tool to combat inflation has been to increase the repo rates. Repo rates are the rates at which RBI lends to commercial banks. When repo rates rise, the bank’s also increase their lending rates. This makes money more costly and forces borrowers to think twice, if not thrice, before borrowing. Banks lend to commercial customers (industries mainly) and retail customers (people like us who borrow for automobiles, houses and durables mainly). When rates rise, industries borrow less – leading to lower capacity creation – this in turn leads to a supply squeeze in the future, and hence is counter-productive from an inflation management perspective. When rates rise, consumers take less loans because the EMIs rise – thus leading to a drop in demand for specific items like listed above. This works to reducing inflation in these consumer sectors. As the RBI has increased rates over the last 18 months, exactly what should have happened has happened. Demand for real estate, durables and automobiles has fallen drastically and those sectors are now either in a slump or are seeing smaller growths. Controlling inflation has led to lower growths. Overall – till now - the inflation in the 65% component – manufactured goods – has been contained at about 5.6% levels – wholly bearable. Going forward, further rate increases will lead to an increase in inflation as supply will continue to fall. This has to be avoided.

Overall inflation continues to remain pesky not because of manufactured goods, but because of the other two factors – mainly primary articles. Basically, all of us know the story here – agricultural products have shot through the roof in the last 18 months or so. All of us are groaning as prices of veggies and fruits have shot up drastically. Unfortunately, RBI’s actions have little or no impact on inflation in the primary sector. Most of us don’t borrow money to buy veggies and fruits and cereals. Even if we did, we are hardly in a position to curtail our consumption if interest rates went up.

Primary articles are suffering from a supply side inflation. Take food supplies for instance. Over the last ten years, rice production has increased by only 2%, wheat by 18% and sugarcane by 14%. In the last ten years, overall population has gone up by some 17% or so and thus per capita availability of basic cereals and sugar has been affected badly. Fortunately, production of pulses (up 35%), oilseeds (up 50%) and coarse grains (up 26%) have managed to stay above population growth rates. Yet, the question to ask is if these growth rates are good enough or not. India has a very low per capita availability of foodgrains compared to most other countries in the world. From this low base, we should really be looking at a much faster growth in production. Yet, our agriculture output continues to lag behind. There is nothing that the RBI can do here. It is the job of the government to look at the issues facing agriculture.

There are many problems ailing agriculture. Agricultural growth can only happen if productivity (yield per acre) increases since the land available for cultivation has remained constant for the last 40 years. Unfortunately, agricultural productivity is a big problem. Overall productivity for rice has increased by 18% in the last ten years. For wheat, its only 8%. For pulses, its 27%. Overall, for all foodgrains, it is about 18% - just in line with population growth. For groundnut, its only 12.5%, for rapeseed/mustard, its 26%, for sugarcane, it is zero. For tea and coffee, it is -1% and -14% respectively. Productivity gains have been reasonable only in the case of soyabean (61%) and cotton (168%). Clearly, such small overall gains are simply not enough to feed a fast growing society.

Though most of us feel that fuel prices have been going up very fast, the data indicates otherwise. While inflation in 2010-11 in fuels was high at 12.6%, it was actually -2.2% in the year before (2009-10). Similarly, while in 2008-9, the fuel inflation was high at 11.6%, it was zero in the previous year (2007-8). Overall, fuel inflation has been at an average of 7-8% on a two-year cycle basis.

Clearly then, if overall inflation has to be controlled, agricultural productivity has to be increased. And this is where there has been little or no action by the government in the last 10-20 years. This is not a political subject. It is not a Congress v/s BJP issue. All governments have failed to stoke the growth of agriculture by having new and progressive policies towards technology adoption, growing irrigation, more farm mechanization, better fertilizers and pesticides utilization or power availability for the farm sector. It’s rather shocking for example that pesticides consumption has remained stagnant in the country for the last 30 years. The reliance has been on fertilizers – where also the growth rate has slowed down significantly in the last 10 years. Likewise, after so many years of freedom, the area under irrigation is only about 44% of total crop area. Increase in irrigation has also slowed down significantly in the last 15 years. In the absence of adequate irrigation facilities, we remain at the mercy of the weather gods. In fact, one of the biggest reasons for food inflation has been the repeated occurrence of droughts – last year’s being the latest. Of course, there is the option of imports available when domestic crop production fails for any reason. However, India is such large consumer of foodgrains that any signal in the market that an import program is underway leads to a price increase around the world.

BJP supporters like to believe that the Gujarat government has been the best as far as agricultural growth is concerned. This is indeed true. Over the last 10 years (most of it under Modi), overall foodgrain production has nearly tripled. However, one must keep into account the fact that the base was very very low. Even today, after the tripling of production, overall foodgrains production in Gujarat is just 7.8 million tonnes. Compare this with UP (47 million tonnes), Punjab (27 million), Rajasthan (19 million), Haryana (16 million), Andhra (16 million), Maharashtra (15 million), Madhya Pradesh (15 million), West Bengal (14 million), Karnataka (13 million) and even lowly Bihar (10 million), and Gujarat’s growth number starts looking pale. Gujarat’s foodgrains production is just about comparable with Orissa’s and Chhatisgarh – a number that must surely irk Modi supporters. The only place where Gujarat has done well is in cotton production (up 9 times). Also, agricultural production is good and bad in both BJP and Congress ruled states – the Congress does well in AP (26% growth in 10 years), Haryana (21%), Maharashtra (49%) and Rajasthan (86%) while the BJP does well in Gujarat and Chhatisgarh (142%) but it does very poorly in Madhya Pradesh (-30%) abd Jharkhand (-9%).

There is a strong political message that farmers and the rural folks are giving to various governments all over India. UP has continued to suffer under repeated governments (BJP, SP and now BSP) with an agricultural growth of only 11% in the last ten years. No wonder then that the voters have been voting out incumbent governments every time. It’s the same in West Bengal where the Left government failed to grow agriculture (-1% over ten years) and they got booted out. In TN, agricultural growth has been -4% over the last ten years, and again voters have first booted out AIADMK and now DMK. On the other hand, Gujarat has delivered growth and Modi has been elected three times. Nitish Kumar in Bihar has delivered 50% growth in just the last five years, and he’s been re-elected. Chhatisgarh delivered good growth and its CM was re-elected. Andhra delivered growth and Congress was re-elected. Ditto with Naveen Patnaik (53% growth) who got elected three times. Going into the future…..there is trouble brewing in Jharkhand, Karnataka (no growth in last 5 years), Madhya Pradesh and Punjab (just 7.5% growth in ten years). If there is one variable that affects political fortunes even more than caste and religious alignment, it is the well-being of the farmer!

Net net….subsequent governments have failed in improving the fortune of agriculture in the country. And yet, it is the RBI that has to take the responsibility of reducing inflation. How the RBI can control food inflation is something that beats me. In fact, in my opinion, the RBI is making a big mistake by keeping on increasing rates. It is choking industrial growth…..which in turn is bound to lead to more unemployment and consequently social unrest. The RBI has to lower rates now… that industrial growth is unaffected. And the government has to launch a new program for agricultural reforms which will bear results over the next two decades or so.

The real truth is that inflation is not an animal that can be controlled any more by the RBI. It has to be controlled by the government through better policies for agriculture development. Pranab Mukherjee’s hopes for a reduction in inflation come from a good harvest on account of a good monsoon this year. How long can we continue to pray to the weather gods for low inflation? Surely, a country’s fortune is dictated by its own policies rather than by the weather gods…..

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