Based on the research of Bharat Ramaswami, Sridhar Seshadri and Krishnamurthy V Subramanian
How increasing minimum support prices are leading to burgeoning buffer stocks for cereals, persistent food inflation and increasing food subsidy.
Over the last two decades, the role of the Indian government in stabilising prices of grains has led to significant accumulation of food grain stock. While procurement prices have been rising along with expanding procurement, the unit value of grain held by the government has been stagnant. In their paper, which was presented to the Governor of the RBI, Raghuram Rajan, and the Chief Economic Advisor to the Government of India, Arvind Subramanian, authors Bharat Ramaswami (Professor at the Indian Statistical Institute, Delhi), Sridhar Seshadri (Professor of Operations Management, Deputy Dean Operations and Area Leader, Operations Management at the Indian School of Business) and Krishnamurthy V Subramanian (Associate Professor of Finance at the Indian School of Business) develop a model to analyse the welfare loss from this increasing divergence. According to their estimates, in 2010, such welfare losses amounted to about 40% of the food subsidy.
Ranking at the 55th position in the global hunger index (GHI), India’s agricultural policies aimed at enhancing food security, and protecting farmers seem understandable. The government intervenes by keeping procurement prices high to support farmers and at the same time ensures low prices for the consumers by paying for the difference. However, continuing to spend on food subsidies despite changes in the country’s economic and political scenario appears to be a costly decision that has important repercussions on India’s other critical development needs. Such intervention has also resulted in accumulating buffer stocks over time. Besides adding substantially to costs, this policy support has also led to distortions in the crop mix. The administration of these subsidies has also come under criticism.
Through their recent research, the authors highlight the costs and benefits of such government interventions. Evaluating 40 years of food procurement related data, the researchers have obtained some key insights with respect to minimum support prices (MSP). Some of the trends they observed are as follows. The MSP for India’s key staples, rice and wheat, has been steadily increasing. Inflating food prices have been increasingly contributing to overall inflation, which anyway continues to be high. Buffer stocks of cereals have been burgeoning. The government’s food subsidy bill has increased significantly over the last decade. Is the steadily increasing MSP responsible for these trends? The authors, based on their analysis, attempt to answer this question and explain the role of MSP as the key underlying factor behind these trends.
The real price to pay
Simply put, minimum support prices are guaranteed prices announced by the government at the beginning of the sowing season to protect producers from any fall in prices due to excess production. By acting like an insurance mechanism, the MSP acts as a signal for farmers to plan their production. At the same time, the MSP serves to discourage farmers from shifting to other crops which would end up causing shortages of some essential commodities.
While on the one hand the government sets the support price, on the other hand it also procures produce for selling a fixed quantity at a subsidised price through the public distribution system. As long as the market price is above the MSP, the government procurement is limited to what is required for public distribution. However, if the market price falls below the MSP, the government would have to intervene and procure beyond its requirement for the PDS so that the market price becomes the support price. Observing prices in major mandis in India, and given the open-ended procurement system in prevalence, the authors find that the MSP has become the de facto procurement price. Thus, any increase in the MSP increases the likelihood of the government intervening to bring up the market price of food grains, thereby contributing to food price inflation. Further, increasing support price leads farmers to over invest in MSP supported crops at the expense of other non-supported crops. The reduced production of such crops and the resultant supply-demand mismatch pushes up the prices of non-MSP supported crops as well, which in turn contributes to food price inflation and overall inflation.
Another implication of increase in MSP, the authors explain, is the increase in buffer stocks. Every time the government intervenes to stabilise the market price to the MSP, it ends up procuring more than the PDS requirement. Thus, increase in the MSP results in high levels of buffer stock.
In addition to the above, government intervention to combat an increase in MSP comes at a high cost – while the farmers need to be paid at the higher MSP, the sale through the PDS takes place at heavily subsidised prices. Also, buffer stocks resulting from such intervention incur depreciation during storage. Consistent with their hypotheses, the authors find that an increase in the MSP ultimately adds to the government subsidy bill.
The government intervenes by keeping procurement prices high to support farmers and at the same time ensures low prices for the consumers by paying for the difference. However, continuing to spend on food subsidies despite changes in the country’s economic and political scenario appears to be a costly decision that has important repercussions on India’s other critical development needs.
So what should the price be?
Given the government’s budget constraint, the authors propose a model to derive the optimal MSP, framing the problem from the perspective of a social planner with the objective of maximising the overall welfare of producers and consumers. As explained above, the government ends up with excess stock as a result of intervention. If these buffer stocks were to be exported, the Food Corporation of India would be able to sell them at the expected world market price. On the other hand, if these stocks were maintained for domestic use in future years, then the price that could be realised would equal the expected future domestic price. Thus, the authors propose that the marginal cost of government intervention, which is the price paid for every unit of excess procurement in the form of MSP, should equal the marginal benefit that comes from selling that unit of excess stock (either in the world market or the domestic market in future years).
Applying this framework, they calculate the welfare losses incurred by the inefficient setting of MSP for rice and wheat over the years. By taking the weighted average of the value that the Food Corporation of India was able to obtain by open market sales, welfare schemes such as school feeding programmes and the depreciation of unutilised stocks, the authors estimate the welfare losses for inefficient setting of MSP for rice and wheat to be about 33%-40% of the food subsidy bill.
The authors predict that over time, as issue prices to the PDS remain fixed, these losses would only grow. On the contrary, if issue prices are revised then demand from PDS is likely to fall resulting in increasing excess stocks once again. This is a dilemma that the government faces.
About the Researchers
Bharat Ramaswami, Professor, Economics and Planning Unit, Indian Statistical Institute
Sridhar Seshadri, Professor of Operations Management, Deputy Dean Operations and Area Leader Operations Management at the Indian School of Business (ISB).
Krishnamurthy V. Subramanian, Associate Professor of Finance at the Indian School of Business (ISB).
About the Research
“A Framework for Analysing Food Policy in India” – Paper presented to the Governor of the RBI, Raghuram Rajan, and the Chief Economic Advisor to the Government of India, Arvind Subramanian
About the writer
Geetika Shah, Associate Director – Content Development and Training, Centre for Learning and Management Practice at the Indian School of Business (ISB).