Food inflation in India - a perspective

A lot of people have expressed their views on this topic. This article/post doesn’t do anything different. Focus of this article remains on how bad overall policies are leading to high food inflation in India. Over FY05-FY11, food articles prices have been increasing at 10.3%, which is considerably high for any country. The pace of price rise has increased in the past two years. 


What I am trying to show here is that inflation in India is a result of a) bad monetary policies, b) lot of money flowing in the economy and c) lack of improvement in productivity.

First factor is a large bank credit flowing into agricultural and allied sectors without generating adequate output growth. RBI mandates banks to disburse ~12-13% of incremental credit to agriculture or allied activities, as “Priority Sector lending”. In addition, regional & rural banks, cooperative banks, institutes like NABARD, provide credit to agricultural sectors. Total credit to agricultural sector has grown at 24% over FY05-09. In contrast, Agri sector at constant prices has grown at a measly rate of 3% and accounts for <15% of India's GDP. Clearly disproportionate amount of credit is flowing into the sector. This results in crowding out for private creditors and also at higher cost in order to compensate for low cost agri-credit.


One should wonder where this money would be flowing into. The credit is essentially used for purchase of agricultural inputs like seeds, fertilizers, irrigation, machinery and in agri-process industries. Increase in usage of farm inputs (to improve production yield) and their prices increase leads to exponential increase in total input cost for the farmers. This working capital is financed by banks and other institutions. Sadly, due to banks’ eagerness to fulfil priority sector lending quota, credit is easily available and at cheaper rates.   


Second factor is Government fixing MSPs of various agriculture produce. Here, Government tries to fix prices such that impact of increase in costs is absorbed in addition to some mark-up for the farmers. This has two unintended effects. One, there is less incentive for farmers to efficiently use the inputs. Two, agri input providing companies have incentives to increase prices to improve/maintain their profitability. A higher increase in MSPs would lead to larger amount of money flowing into hands of farmers. This money competes for consumption goods which are limited in number. It is no surprise that rural economy is growing.

Third factor is lack of improvement in agri productivity and is related to two earlier points. 13% incremental credit is flowing into agri sector. If one assumes that credit-to-capital ratio remained the same, this means agri-input cost is increasing at rate of ~20%+. However, output growth inclusive of productivity improvement is just 3%. Government tries to fix MSP breach this gap. But even MSPs of major crops have grown at 11-12% over the same time period. We can conclude that farmer's profitability has been declining over the years. 

What worries me that this is very similar to what happened in the US real estate sector. The agri sector growth in India is fueled by low cost credit. RBI’s policy makes sure that constant credit flow to the sector continues. Regular increase in MSP acts together with Government’s implicit agenda to support the farmer acts as “Bernanke’s Put” for the banks and all the players involved. And we are not seeing any real output growth. The problem would not surface as long as regular albeit smaller growth in agri output continues. But it would be growing in magnitude. Any external shock like natural calamity, irregular monsoon would create havoc. The impact would be first on farmers not being able to pay the loans they raised for various purposes. This would result in large scale defaults including social problems like large scale suicides, etc. In addition, Banks would large scale loan defaults. Results would be catastrophic and would soon spread to other sectors.

How can we avoid this problem? Free market. Either of the first two points mentioned here should be market determined. Either credit flowing into the system should be market driven or output prices should be liberalized. Both are difficult to implement and would result in series of social and economic issues. But this needs to be done, and sooner than later.