Why Govt of India Isn’t Acting Like a Spender of the Last Resort

It’s 2019, and you are out watching an international cricket match.

You didn’t book tickets quickly enough and are sitting in one of the upper stands, pretty far away from where the action is.

Instead of sitting and watching the match, you stand up to get a better view. Of course, by doing this, you end up blocking the person behind you. He also has to get up to get a better view of the cricket.

When he does this, he ends up blocking the view of the person behind him. And so, it goes. Pretty soon, everyone in the rows behind you has also stood up to get a better view.

Economists have a term for a situation like this. They call it the fallacy of composition or the assumption that what’s good for a part (that’s you in this case) is good for the whole (the people sitting behind you) as well.

As economist Thomas Sowell writes in Basic Economics-A Common Sense Guide to the Economy: “In a sports stadium, any given individual can see the game better by standing up but if everybody stands up, everybody will not see better.”

So, why are we talking about cricket and sports here? What’s true about watching sports in a stadium is also true for the economy as a whole.

John Maynard Keynes, the most famous and influential economist of the twentieth century (and perhaps even the twenty first), came up with a concept called the paradox of thrift, where thrift refers to the entire idea of using money carefully.

Keynes studied the Great Depression of 1929. He concluded that during tough economic times, when the going is difficult, people become careful with spending money and try and save more of it. While this makes perfect sense at the individual level, it doesn’t make much sense at the societal level because ultimately one man’s spending is another man’s income.

If a substantial portion of the society starts saving, the paradox of thrift strikes, incomes fall, jobs are lost, businesses shutdown and the governments face a pressure on the tax front. The government also faces the pressure to do something about the prevailing economic situation.

This is precisely the situation playing out in India currently. The paradox of thrift is at work. Bank deposits between March 27 and September 25, the latest data that is available, have gone up by 5.1% or Rs 6.9 lakh crore to Rs 142.6 lakh crore. This is twice more than the increase that happened during the same period last year.

As far as loans are concerned, outstanding loans of banks have shrunk during this financial year. On the whole they haven’t given a single rupee of a new loan  (loans are again meant to be spent).

Keynes had suggested that during tough economic times, when the private sector, both individuals and corporations are not spending much money, the government needs to step in and act as the spender of the last resort. In fact, Keynes rhetorically even suggested that if nothing, the government should get workers to dig holes and fill them up, and pay them for it.

When the workers spend this money, it would start reviving the economy. Economists refer to the situation of the government spending money in order to get economic growth going again as a fiscal expansion or a fiscal stimulus.

Since the start of this financial year, everyone who is remotely connected to economics in India in anyway, be it journalists, economists, analysts, corporates, fund managers and even politicians, have been demanding a bigger fiscal stimulus from the government to get economic growth going again.

The government has responded in fits and starts. Last week the central government came up with a few more steps including the LTC cash voucher scheme, special festival advance scheme, loans to states for capital expenditure and an additional capital expenditure of Rs 25,000 crore.

The fact that one week later one’s not hearing much about these moves, tells us they have already fizzled out. They didn’t have much legs to stand on in the first place. Let’s look at these moves pointwise before we get into greater fiscal stimulus as a strategy, in detail.

1) The government announced last week that in lieu of leave travel concession (LTC) and leave encashment, the central government employees can opt for a cash payment. This money has to be used to take make purchases.

LTC is a part of the salaries of central government employees. Instead of traveling in these difficult times in order to avail the LTC, the employees can opt for a cash payment. But this cash payment comes with certain terms and conditions.

Employees who opt for an encashment need to buy goods/services which are worth thrice the fare and one time the leave encashment. Only the actual fare of travelling can be claimed as a tax exemption. Tax has to be paid on the money spent on other expenses during travelling, like hotel and restaurant bills.

This money will have to be spent on buying stuff which attract a minimum 12% goods and services tax (GST), by paying through the digital route to a GST-registered vendor. It is expected that the scheme will cost the government Rs 5,675 crore. Over and above this, it will cost the public sector banks and public sector units another Rs 1,900 crore. This works out to a total of Rs 7,575 crore.

The question is will people opt for this scheme or not, given that they need to spend money out of their own pocket (i.e. their savings) in order to get a tax deduction. It needs to be mentioned here that the increase in dearness allowance of central government employees has been postponed until July 1, 2021. This will act against the idea of spending. Also, there is paperwork involved here (always a bad idea if you want people to spend money).

2) Over and above this, all central government employees can get an interest-free advance of Rs 10,000, in the form of a prepaid RuPay Card, to be spent by March 31, 2021. This is expected to cost the central government Rs 4,000 crore. It’s not clear from the reading of the press release accompanying this announcement, whether it’s compulsory for central government employees to take this card, given that this money will have to ultimately be repaid.

Also, this is not fiscal expansion in the strictest sense of the term given that LTC is already a part of the employee pay and has been budgeted for. As far as the Rs 10,000 being given as an advance is concerned, it is an interest free advance. The government will bear the interest cost on this, which will be an extremely small amount. The employees will have to repay the advance.

3) The central government is also ready to give state governments Rs 12,000 crore for capital expenditure. These loans will be interest free and need to be repaid over a period of 50 years. This money needs to be spent by March 31, 2021. A state government will be given an amount of 50% of what it is eligible for first. The second half will be given after the first half has been spent.

One can’t really question the logic behind this move. But the question that arises here is, are state governments in a position to spend this money in the next five and a half months?

4) Finally, the government has decided to spend an additional Rs 25,000 crore (over and above Rs 4.12 lakh crore allocated in the budget) on roads, defence, water supply, urban development and domestically produced capital equipment. Again, one can’t question the basic idea but one does need to ask here whether this is yet another attempt to manage the narrative.

The total capital expenditure that the government has budgeted for this financial year is Rs 4,12,009 crore. In the first five months of the financial year (April to August 2020), the government has managed to spend Rs 1,34,447 crore or around a third of what it has budgeted for. Last year, in the first five months, the government had spent around 40.6% of what it had budgeted for.

In this scenario, it is more than likely that the government will not get around to spending the extra Rs 25,000 crore. The government systems can only do a certain amount of work in a given period of time, their scale cannot be suddenly increased.

If one doesn’t nit-pick with the four above points, it needs to be said that the amounts involved are too small to even make a dent into the economic contraction expected this year. The economy is expected to contract by 10% this financial year. This means destruction of Rs 20 lakh crore of economic value, given that the nominal GDP in 2019-20, not adjusted for inflation, was Rs 203.4 lakh crore.

The government expects the moves announced last week to boost the expenditure in the economy by Rs 1 lakh crore. The mathematics of this Rs 1 lakh crore is similar to the mathematics of the Rs 20 lakh crore stimulus package (which actually added up to Rs 20.97 lakh crore) earlier in the year. As we saw earlier, the chances that the government ending up spending the Rs 4.12 lakh crore originally allocated for capital expenditure is difficult. Hence, how will it end up spending the newly allocated Rs 25,000 crore?

The government also expects the private sector spending to avail of the LTC tax benefit to be at least Rs 28,000 crore. What no one has talked about here is the fact that while there is an income tax benefit available, one also needs to pay a GST. Net net, there isn’t much benefit left after this. For someone in the marginal bracket of 20% income tax, after paying a GST of 18% to make these purchases, there isn’t much of a saving. Also, to spend three times the amount to avail of tax benefits, isn’t the smartest personal finance idea going around.

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In the recently released OTT series Scam 1992 – The Harshad Mehta Story, there is a scene in the second episode, in which a newsreader is seen saying that this year’s budget has a deficit of Rs 3,650 crore for which no arrangements have been made (or as the newsreader in the series said, jiske liye koi vyawastha nahi ki gayi hai).

Given that the makers of the series have stuck to details of that era as closely as possible, I was left wondering if the Rs 3,650 crore number was correct or made up. I went looking for the budget speech of 1986-87 made by the then finance minister Vishwanath Pratap Singh, and found it.

This is what Singh said on page 32 (and point 168) of the speech: “The proposed tax measures, taken together with reliefs, are estimated to yield net additional revenue of Rs 445 crores to the Centre. This will leave an uncovered deficit of Rs 3650 crores. In relation to the size of our economy and the stock of money, the deficit is reasonable and non-inflationary [emphasis added].”

The number used in the series is absolutely correct. Hence, the makers of the Scam 1992, have gone into this level of detailing.

Dear Reader, you must be wondering by now, why have I suddenly started talking about the budget speech of 1986-87. This random point in the OTT series made me realise something. At that point of time, the government could get the Reserve Bank of India to monetise away the fiscal deficit or the difference between what it earned and what it spent.

This meant that the RBI could simply print money and hand it over to the government to spend it. Of course, money printing could lead to a higher amount of money chasing a similar number of goods and services, and hence, higher inflation. This explains why Singh in his budget speech emphasises that the uncovered deficit of Rs 3,650 crore will be non-inflationary. Not that he knew this with any certainty, but there are somethings that need to be said as a politician and this was one of those things.

As a result of two agreements signed between the RBI and the government (in 1994 and 1997) and the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, the automatic monetisation of government deficit was stopped.

The government funds its deficit by selling bonds to raise debt. The FRBM Act prevented the RBI from subscribing to primary issuances of government bonds from April 1, 2006. In simple terms, this meant that it couldn’t print money and hand it over directly to the government by buying government bonds.

Now why I have gone into great detail in explaining this will soon become clear.

As I wrote at the beginning of this piece, many journalists, economists, analysts, corporates, fund managers and even politicians, have been demanding a greater fiscal stimulus from the government. In short, they have been wanting the government to spend more money than it currently does.

The International Monetary Fund  recently said that India needs a greater fiscal stimulus. Former Chief Statistician of India Pronab Sen has gone on record to say that India needs a fiscal stimulus of Rs 10 lakh crore. Business lobbies have demanded stimulus along similar levels.

The question is why is the government not going in for a bigger stimulus? The answer lies in the fact it simply doesn’t have the money to do so. The gross tax revenue of the government has fallen by 23.9% this year. Hence, it doesn’t even have enough money to finance the expenditure it has budgeted for. So, where is the question of spending more?

Of course, people who have been recommending a larger fiscal stimulus understand this. They simply want the RBI to print money and finance the government expenditure. Well, the RBI has been indirectly doing so. Take a look at the following table.

RBI –The Rupee Machine.

Source: Monetary Policy Report, October 2020.

What does the table tell us? It tells us that between early February and end September, the RBI has pumped in Rs 11.1 lakh crore into the financial system. How has it done so? Simply, by printing money in most cases. This does not apply to the cash reserve ratio cut, which meant banks having to maintain a lower amount of money with the RBI and hence, leading to an increase in the money available in the financial system to be lent out.

Here is the thing. The RBI prints money and buys bonds to introduce money into the financial system. Of course, it does not buy these bonds directly from the government. Nevertheless, even this indirect buying ends up financing  the government  fiscal deficit.

How? Let’s say the government sells bonds to finance its fiscal deficit. The financial institutions (banks, insurance companies, provident funds, mutual funds etc.) buy these bonds directly from the government (actually through primary dealers, but let’s keep this simple because the concept is more important here).

When they do this, they have handed over money to the government and have that much lesser money to lend. By printing money and pumping it into the financial system, the RBI ensures that the money that banks have available for lending doesn’t really go down or doesn’t go down as much, because of lending to the government.

Hence, in that sense, the RBI is actually indirectly financing the government. (It’s just buying older bonds and not newer ones).

The point being that despite the 1994 and 1997 agreements and the FRBM Act of 2003, the RBI is already financing the government fiscal deficit, albeit in an indirect way.

Of course, this financing is only enough to meet the current budgeted expenditure of the government. The thing is that the journalists, economists, analysts, corporates, fund managers and even politicians, want the government to spend more.

In fact, people in favour of a larger fiscal stimulus are okay with the RBI financing the government directly instead of this roundabout way. It seems that might be possible as well. As Viral Acharya, a former deputy governor of the RBI, writes in Quest for Restoring Financial Stability in India, published in July earlier this year:

“A recent amendment of the RBI Act allows the central bank to re-enter the primary market for government debt under certain conditions, annulling the reform of 2003 and recreating investor expectations of deficit monetization.”

Hence, the RBI can directly finance the government fiscal stimulus by printing money, buying government bonds and giving the government the money required to spend.

The question is why has the government not gone down this route? The fear of an even higher inflation seems to  be the answer. If there is one thing in economics that the current government is bothered about, it is inflation, in particular food inflation. The food inflation in September 2020 stood at 10.7%. During this financial year, it has been at a very high level of 9.8%.

The money supply in the economy (as measured by M3) has gone up at a pace greater than 12% since June, thanks to the RBI printing and pumping money into the financial system. For fiscal expansion more money will have to be printed and pumped into the financial system, hence, there is the risk of inflation rising even further.

A few experts have said that in a situation like this growth is more important than inflation. Some others have said that inflation is not a real danger currently.

A government focussed on narrative and perception 24 x 7 would not want to take the risk of inflation at any point of time, especially when food inflation is already close to 11% and there is grave danger of it seeping into overall retail inflation (as measured by the consumer price index).

There are other risks to printing money directly and the country’s public debt going up. Foreign investors can leave India. The rating agencies can cut the ratings. (You can read about it here). This stems from the fact that investors are not as comfortable holding investment assets in a currency like the Indian rupee vis a vis a currency like the American dollar or the British pound or the currency of any other developed country.

As L Randall Wray writes in Modern Monetary Theory: “There is little doubt that US dollar-denominated assets are highly desirable around the globe… To a lesser degree, the financial assets denominated in UK pounds, Japanese yen, European euros, and Canadian and Australian dollars are also highly desired.” This allows these countries to print money in a way that India cannot even dream of.

Also, if the government wanted to go the fiscal stimulus route, it should have done so at the very beginning. But instead it chose monetary expansion, with the RBI printing money and pumping it into the financial system, cutting the repo rate or the interest rate at which it lends to banks and getting banks to lend to certain sectors.

All this, in particular money printing by the RBI to drive down interest rates, has already led to the money supply going up. A larger fiscal stimulus will lead to the money supply going up even further increasing the possibility of a higher inflation.

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There is a new theory going around especially among the stock market wallahs who think they understand economics.

The foreign currency reserves with the RBI have gone up from $440 billion towards the end of March to around $509 billion as of October 9. What if a part of this can be converted into rupees and the money can be handed over to the government to spend, is the crux of the new theory going around.

Only someone who does not understand how these foreign currency reserves ended up with the RBI in the first place, would suggest something like this. The RBI buys foreign currency (particularly the American dollar) in order to intervene in the foreign exchange market.

Let’s say a lot of foreign money is coming into India. This increases the demand for the rupee and it leads to the appreciation of the rupee. The appreciation of the rupee makes imports more competitive, hurting domestic producers (not good for atmanirbharta). It also makes exports uncompetitive. In this scenario, the RBI intervenes. It sells rupees and buys dollars (Of course, these rupees have to be printed or rather created digitally these days).

The point being that the dollars end up on the balance sheet of the RBI, only after it has introduced rupees against them into the financial system. So, where is the question of printing and introducing more rupees against the same set of dollars?  (Which is why I keep saying that stock market wallahs should stick to earnings growth and not make a fool of themselves by coming up with such silly theories).

One way of raising money against these foreign exchange reserves is to borrow against them. But that would make India look very desperate and weak on the international as well as the domestic front. Do we really want to do that?

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Does all this mean that the government can’t do anything? Not really. I had written about lots of solutions a few weeks back.

One thing that the government needs to pursue seriously is an asset monetisation programme. This involves selling its stake in public sector units which are in a position to be sold. Even public sector units that cannot be sold have a lot of land lying idle.

This land needs to be monetised. This will take time. Nevertheless, the thing is that the Indian economy will need massive government support even in 2022-23. And if the government starts the monetising process now, it will be prepared in 2022-23 to help the economy.

10 Things You Need to Know About India’s High-Inflation

In September, inflation as measured by the consumer price index continued to remain in elevated territory at 7.34%. Inflation is the rate of price rise in comparison to the same period last year.

Let’s take a look at this relatively high inflation of 7.34%, pointwise.

1) Only twice in the last five years has the monthly inflation figure been higher than that in September 2020. This was in January 2020 and December 2019, at 7.59% and 7.35%, respectively. The December 2019 inflation figure was more or less similar to the September 2020 number.

2) Interestingly, eight out of the ten highest inflation months in the last five years have been in 2020. What this clearly tells us is that 2020 has been a year of high inflation. Alongside this consumer demand has collapsed and there is stagnation in the economy. Hence, 2020 has been the year of stagflation (stagnation + inflation) as well. While, this wasn’t clear at the beginning of 2020 when covid hadn’t made an appearance (and I had said so), it is very clear by now (and I am saying so).

3) In an environment where consumer demand has collapsed, prices should be falling and not going up. What’s the logic here? When consumer demand collapses, firms in order to get people to consume, cut prices. This leads to lower inflation or even deflation (in worst cases, when prices fall).

But that hasn’t happened in the Indian context. The question is why? The following chart plots food inflation (using data from the consumer price index) over the last five years and possibly has the answer.

High food inflation

Source: Centre for Monitoring Indian Economy.

 Food inflation in India has been rising since early 2019 and it has continued to remain high in the post-covid environment. The inflation of vegetables, pulses, oils and fats and egg, meat and fish, was in double digits in September. Vegetable prices led the way and rose at the rate of 20.73% during the course of the month, with potato prices rising 101.98%.

4) Food carries a weight of 39.06% in the overall consumer price index. In the rural part, it carries a weight of 47.25%. Hence, elevated food inflation pushes up overall inflation. Also, the thing to notice here is that food prices were high even before the covid-pandemic struck. This was due to weather disruptions among other things. The trend of high food prices has continued post-covid.

5) Take a look at the following chart. It plots the difference in food inflation as measured by the consumer price index and as measured by the wholesale price index.

The Farmer Doesn’t Benefit 

 Source: Author calculations on data from Centre for Monitoring Indian Economy.

What does this chart tell us? It tells us that post-covid, the food prices at the consumer level have been growing at a much faster rate than food prices at the wholesale level. The average difference between April and August was 610 basis points. One basis point is one hundredth of a percentage. The wholesale price index data for September is yet to come in (It will be published tomorrow).

What this means is that, despite the end consumers of food paying a higher price, the farmers are largely not benefitting from this rise in food prices, given that they sell their produce at the wholesale level.
This difference can be because of a few reasons.

a) A collapse in supply chains has led to what is being sold at the wholesale level not reaching the consumers at the retail level, thus, leading to higher prices for the consumer.

b) This could also mean those running the supply chains hoarding stuff, in order to increase their profit.

Having said that, the former reason makes more sense given that stuff like vegetables, egg, fish and meat, etc., cannot really be hoarded. Also, hoarding stuff like pulses, needs a specialized storage environment which India largely lacks.

6) The difference in food inflation as measured by the consumer price index and as measured by the wholesale price index peaked in April at 790 basis points. This makes complete sense given the lockdown was at its peak during the month. As the economy has opened up, the difference has come down.

Nevertheless, in August the difference was at 521 basis points. This is still high given that the average of the difference over the last five years is 38 basis points. Also, with the food inflation as measured by the consumer price index going up by 163 basis points to 10.68% in September 2020, in comparison to August 2020, chances are that the difference in food inflation as measured by the consumer price index and as measured by the wholesale price index, might go up in September.

7) So, what does this mean for food inflation in the second half of this financial year? The monetary policy committee of the RBI projects that the inflation will be between 4.5-5.4% during the second half of this financial year. This can only be if food inflation comes down and also, it does not seep into overall inflation.

In the past, high food inflation has seeped into wage inflation and overall food inflation. It remains to be seen whether this happens this time around as well. The monetary policy committee doesn’t think so, but then it has as much control over food prices as it has over the finance ministry.

Interestingly, in the monetary policy report released a few days back, the RBI says in this context:

“Food inflation has remained elevated in recent months driven by price pressures in vegetables, cereals and protein items such as pulses, eggs and meat. The normal south-west monsoon, increased sowing of kharif crops, moderate MSP hikes, and high reservoir storage are expected to soften food inflation going forward.”

It goes on to say:

“However, a delayed normalisation of supply chains, heavy rains and floods in some states and demand-supply imbalances in key items such as pulses could exert further upward pressure on the headline inflation and keep it higher by around 50 basis points. On the other hand, an accelerated softening of food inflation due to an early restoration of supply chains, ample buffer stocks and efficient food stock management by the Government could bring headline inflation below the baseline by up to 50 basis points.”

So, the RBI in the monetary policy report is basically saying it could go either ways. In the process, it has hedged itself well, either ways.

8) Until the dynamic of whether food inflation is seeping into overall inflation becomes clear, it will be very difficult for the RBI to cut the repo rate any further than 4%, where it currently stands. The repo rate is the interest rate at which the RBI lends to banks.

Also, if the food inflation starts seeping into the overall inflation, the easy money policy of the RBI, where it has been printing and pumping money into the economy to drive down the interest rates, will have to take a backseat.

The RBI has pumped a lot of money into the financial system since February. Some of it has been done by buying bonds from financial institutions. But a lot of it has been done by defending the rupee.  When a lot of foreign money comes into India, the demand for rupee increases and it tends to appreciate against the dollar. This hurts exporters as well as domestic producers.

To prevent this from happening the RBI intervenes in the foreign exchange market by selling rupees and buying dollars. When the RBI sells rupees the money supply in the economy goes up. The RBI has an option of sterilising this rupee inflow by selling government bonds and sucking out the excess money. But it has chosen not to do this, which is in line with its easy money policy.

In the recent past, the RBI has allowed the rupee to appreciate against the dollar, by not buying dollars, and not adding rupees to the money supply through this route. This is primarily because there is already too much easy money floating around in the financial system.

This easy money hasn’t led to inflation because banks are going slow on lending and borrowers are being very careful before borrowing. This has ensured that the dynamic of too much money following the same amount of goods and services hasn’t played out and hasn’t created an even higher inflation.

Nevertheless, as the economy continues to recover there is a chance of this happening. Hence, the RBI needs to be careful with its easy money policy, especially if food inflation starts seeping into the overall inflation.

In the latest monetary policy, the monetary policy committee had said: “The MPC also decided to continue with the accommodative stance as long as necessary – at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward [italics added].”

In simple English, this means that the RBI will keep driving lower interest rates to create growth. Up until now it doesn’t seem to be worried about its inflation mandate (to maintain the inflation as measured by the consumer price index between the range of 2-6%). But if food inflation remains high and seeps into overall inflation, the RBI will have a major problem at its hand, with all the liquidity it has pumped into the financial system.

9) Even if inflation falls to 4.5-5.4% as the RBI expects it to, the real return on fixed deposits after adjusting for inflation and taxes paid on the interest earned, will continue to remain in negative territory. And that’s not good news for savers as their savings will lose purchasing power. It’s great news for borrowers because inflation means they are repaying their loans in money which is worth less than it was at the time it was borrowed.

10) As much as economists might want us to believe, economics is no science. There are too many ifs and buts and maybes to the predictions that are made. And this is something that every reader needs to be aware of. This is true as much of this situation as it is of others.

Has RBI Lost Control of Monetary Policy?

On August 31, 2020, the Reserve Bank of India (RBI), published an innocuously titled press release RBI Announces Measures to Foster Orderly Market Conditions. The third paragraph and the fourth line of the release said this: “The recent appreciation of the rupee is working towards containing imported inflationary pressures [emphasis added].”

What did this line mean? Take a look at the following chart. As of June 18, one dollar was worth Rs 76.55. By August 31, one dollar was worth Rs 73.13. The rupee had gained value or appreciated against the dollar.


Rupee Up, Dollar Down

 
Source: Yahoo Finance.

What has this got to do with inflation? When the value of the rupee appreciates against the dollar, the imports become cheaper.

Let’s say the price of a product being imported into India is $10. If the dollar is worth Rs 76, it costs Rs 760. If the dollar is worth Rs 73, it costs Rs 730. Hence, if the rupee appreciates, imports become cheaper and in the process the inflation (or the rate of price rise) that we import from abroad, comes down as well.

The trouble is that if imports become cheaper, things become difficult for the home-grown products. Hence, an appreciating rupee goes against the government’s pet idea of atmanirbhartha or producing goods locally.

Given that the current dispensation at the RBI is more or less in line with what the government wants, this move to allow the rupee to appreciate, so that it reduces imported inflation, is even more surprising. (On a different note, I am all for consumers getting to buy things cheaper than in the past. The point of all economic activity, at the end of the day, is consumption. But most people don’t think like that).

Also, RBI’s Monetary Policy Report released in April, suggests that the impact of the appreciation of rupee on inflation is at best marginal: “An appreciation of the Indian Rupee by 5 per cent could moderate inflation by around 20 basis points.” One basis point is one hundredth of a percentage.

The trilemma

So what’s happening here? The RBI has basically hit the trilemma, something which it can’t admit to. Trilemma is a concept which was originally expounded by the Canadian economist Robert Mundell. Basically, a central bank cannot have free international movement of capital, a fixed exchange rate and an independent monetary policy, all at the same time. It can only choose two out of these three objectives. Monetary policy refers to the process of setting of interest rates in an economy, carried out by the central bank of the country.

Of course, this is economic theory and in practice things are slightly different. The more a central bank allows free international movement of capital (i.e. money) and has a tendency to continuously intervene in the foreign exchange market and not allow free movement in the price of the local currency against the dollar, the lesser control it has over its monetary policy.

Let’s try and understand this through an example. Let’s consider the central bank of a country which allows for a reasonable movement of capital. At the same time, it wants to ensure that the value of its currency against the US dollar doesn’t move much.

This is to ensure that its exporters don’t face much volatility on the exchange rate front. Over and above this, the central bank does not want its currency to appreciate because that would hurt the exporters and make them less competitive.

In this scenario, let’s say the central bank sets interest rates at a higher rate than the rates in the United States and other parts of the world. What will happen is given that reasonably free movement of capital is allowed money from other parts of the world will come flooding in to cash in on the higher interest.

When the foreign capital comes into the country in the form of dollars and other currencies, it will have to be converted into the local currency. This will lead to the demand of the local currency going up and the local currency will appreciate against the dollar. Of course, when this happens, the value of the local currency will no longer remain fixed against the US dollar.

This is where the trilemma comes to the fore. If the country wants monetary independence and free movement of capital, it cannot have a fixed exchange rate. If it wants a fixed exchange rate then it has to set interest rates around the interest rate set by the Federal Reserve, so that it doesn’t attract capital because of a higher interest rate. In the process, it loses control of monetary policy.

In the Indian case, in the recent past, the RBI has tried to pursue all the three objectives, reasonably free movement of capital, a currency (the rupee) which doesn’t appreciate against the dollar and an independent monetary policy.

The repo rate, or the rate at which the RBI lends to banks, was cut from 5.15% to 4%, in the aftermath of the covid-pandemic. The RBI has also flooded the financial system with money by buying government bonds.

Between February 24 and April 23, the RBI lent a lot of money to banks through long-term repo operations, targeted long-term repo operations and targeted long-term repo operations 2.0. These schemes have essentially lent money to banks at the repo rate for the long term. On February 24, the RBI lent Rs 25,021 crore to banks for a period of 365 days at the prevailing repo rate of 5.15%. The repo rate is the interest at which RBI lends to banks, typically for the short-term.

After this, the RBI has lent around Rs 2.13 lakh crore for a period of around three years at the prevailing repo rate. Around Rs 1 lakh crore out of this was lent at 5.15%. In late March, the RBI cut the repo rate by 75 basis points to 4.4%. The remaining Rs 1.13 lakh crore has been lent at this rate. The idea here was to encourage to lend money to banks at a low interest rate and then encourage them to lend further, under certain conditions. There has been more bond buying over and above this.

The idea was to drive down interest rates to lower levels, so that companies borrow and expand, people borrow and consume. In the process, the economy starts to recover. Also, with the government borrowing more this year, lower interest rates would help it as well.

Along with this, the reasonably free movement of capital that India allows has continued. The RBI has also intervened in the currency markets trying to ensure that the rupee doesn’t appreciate against the dollar.

What’s happening here? In the aftermath of covid, Western central banks have gone on a money printing spree, some to drive down interest rates and to get businesses to expand and people to consume, and some others to finance the expenditure of their government. Take the case of the Federal Reserve of the United States. Between February end and early June, it printed a close to $3 trillion and expanded its balance sheet by three-fourths in the process.

To cut a long story short, interest rates have been driven down globally and there is a lot of money going around looking for some extra return. Some of this money has been coming to the Indian stock market.

In 2020-21, the current financial year, the foreign institutional investors (FIIs) have net invested $7.62 billion in the Indian stock and bond market. A good amount of this, $6.66 billion, came in August, when FII investment turned into a deluge. Of course, there were months like April and May, when the FIIs net sold. Between June and August, the FIIs net invested $10.54 billion in the Indian stock and bond markets.

The foreign direct investment (FDI) coming into India between April and July stood at $5.86 billion, with $4.01 billion coming just in July. The outward FDI (Indians investing abroad) in the first four months, stood at $3.17 billion. This means that the net FDI number (foreign investments made by Indians deducted from investments in India by foreigners) has been in positive territory. Net-net dollars have come into India on the FDI front.

Over and above this, the net receipts from services (i.e. services exports minus services imports) stood at around $28 billion between April and July.

Other than this, the demand for dollars, from within India, has come down. The import of crude oil and petroleum products between April and August 2020 has fallen by 53.7% to $26.02 billion. This has been both on account of fall in price of oil as well as lower consumption. In fact, on the whole, the goods exports have fallen at a lesser pace than goods imports, again implying a reduced demand for dollars within India.

Internal remittances, the money sent by Indians working abroad back to India, must have definitely fallen this year (I say must because the data for this isn’t currently available). Nevertheless, at the same time, outward remittances, everything from money spent on health, education and travel, has also come down, given that barely anyone is travelling abroad.

What does this basically mean? It means more dollars are coming into India than leaving India. When dollars come into India they need to be converted into rupees. This increases the demand for rupees and the rupee then appreciates against the dollar. This, as I have explained above, hurts atmanirbharta, domestic producers of goods and exporters, all at once.

Preventing the appreciation of the rupee

To prevent the rupee from appreciating against the dollar, the RBI buys dollars by selling rupees. In fact, that is precisely what the RBI has done between April and July this year. It has net purchased $29 billion, the highest in this period in the last five years. The August press release suggests that the RBI stopped trying to defend the rupee from appreciating sometime during the month or at least didn’t try as hard as it did in the past.

If we look at the foreign currency assets of the RBI they have barely moved between August 28 (three days before the press release) and September 18 (the latest data available), barely increasing from $498.36 billion to $501.46 billion. This tells us that the RBI isn’t really intervening much in the foreign exchange market in the recent past. But that might also be because of the fact that in September (up to September 29), the FIIs have net sold stocks and bonds worth just $4 million. Net net, FIIs didn’t bring any dollars into India in September.

By buying dollars, the RBI releases rupees into the Indian financial system and thus increases the money supply. In the normal scheme of things, the RBI can sterilise this by selling bonds and sucking out this money. But that would have gone against the easy money policy that the Indian central bank has been running through this financial year.

The excess liquidity (or the money that the banks deposit with the RBI) in the financial system suggests that the RBI hasn’t really been sterilising the rupees it has put into the system to prevent the appreciation of the rupee. On the whole, the bond buying by the RBI in order to release money into the financial system, has been in the positive territory. The following chart plots this excess liquidity in the system.

Easy Money


Source: Centre for Monitoring Indian Economy.

 

The excess liquidity in the system, money which banks had no use for and parked with the RBI, even crossed Rs 6 lakh crore in early May. It has since fallen but is still at a very high Rs 2.72 lakh crore.

So, what does all this mean?

The inflation between April and August, as measured by the consumer price index, has been at 6.63%. The inflation in August was at 6.69%. As per the RBI’s agreement with the government the inflation should be 4% within a band of +/- 2%.

This means that the current inflation is way beyond range. A major reason for this is high food inflation which between April and August has been at 9.58%. The food inflation in August was at 9.05%.

If we look at the core inflation (which leaves out food, fuel and light), it is at 5.16%. If we add fuel inflation to this (thanks to the government increasing the excise duty on petrol and diesel), the inflation is higher.

Where does this leave the RBI? All the liquidity in the financial system hasn’t led to even higher inflation primarily because there has been an economic collapse and people are not spending money as fast as they were in the past.

Food inflation has primarily been on account of supply chains breaking down thanks to the spread of the covid-pandemic. The trouble is that covid is now spreading across rural India. As Crisil Research put it in a recent report: “Of all the districts with 1,000+ cases, almost half were rural as on August 31, up from 20% in June.” This basically means that the supply chain issues when it comes to movement of food are likely to stay, during the second half of the year as well.

Food on its own makes up for 39.06% of the overall index and 47.25% of the index in rural India. As the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel Committee) said:

“High inflation in food and energy items is generally reflected in elevated inflation expectations. With a lag, this gets manifested in the inflation of other items, particularly services. Shocks to food inflation and fuel inflation also have a much larger and more persistent impact on inflation expectations than shocks to non-food non-fuel inflation.”

An IMF Working Paper titled Food Inflation in India: The Role for Monetary Policy suggests the same thing: “Food inflation [feeds] quickly into wages and core inflation.” This is something that the country saw in the five-year period before 2014, when food inflation seeped into overall inflation.

What this means is that if covid continues to spread through rural India and food supply chains continue to remain broken, food inflation will persist and this will seep through into overall inflation, which is anyway on the high side.

In this situation what will the RBI do in the months to come? As mentioned earlier, all the money that the RBI has pumped into the Indian financial system hasn’t led to an even higher inflation simply because the consumer demand has collapsed. But as the economy continues to open up and the demand picks up, there is bound to be some amount of excess money chasing the same amount of goods and services, leading to higher inflation.

In this scenario what will the RBI do to prevent the appreciation of the rupee against the dollar, especially if foreign capital continues to come to India and the demand for the rupee continues to remain high?

As mentioned earlier, if the RBI buys dollars and sells rupees to prevent appreciation, it will continue to add to money supply. Interestingly, the money supply (as measured by M3 or broad money) has been growing at a pace greater than 12% (year on year) since June. This kind of rise in money supply was previously seen only before 2014, a high inflation era.

If RBI keeps trying to intervene in the foreign exchange market to prevent the appreciation of the rupee against the dollar, it will keep adding to the money supply and that creates the risk of even higher inflation. To counter this risk of higher inflation, the RBI will need to raise the repo rate or the interest rate at which it lends to banks.

This goes against what the Indian economy or for that matter any economy, needs, when it is going through an economic contraction. This in a way suggests that the RBI has lost control over the monetary policy. In fact, even if the monetary policy committee (MPC) of the RBI, whenever it meets next, keeps the repo rate constant, it suggests a lack of control over monetary policy. This also explains why the RBI hasn’t made any inflation projections since February this year.

Of course, the RBI has the option of sterilising the extra rupees it releases into the financial system by buying dollars coming into India. In order to sterilise the extra rupees being released into the financial system, the RBI needs to sell government bonds. The RBI needs to pay a certain rate of interest on these bonds. These bonds are a liability for the RBI.

As far as assets of the RBI go, a significant portion is invested in bonds issued by the American and other Western governments and the International Monetary Fund. These assets pay a much lower rate of interest than the interest that the RBI needs to pay on bonds it sells to sterilise excess rupees in the financial system. This is referred to as the quasi fiscal cost and needs to be kept in mind.

The second problem with sterilisation is that it might lead to a situation where interest rates might go up, creating further problems. As an RBI research paper titled Forex Market Operations and Liquidity Management published in August 2018 points out:

“For example, when a central bank undertakes open market sale of government securities to absorb the surplus liquidity as a part of the sterilised intervention strategy, it could harden sovereign yields, which, in turn, could attract further debt inflows driven by higher interest rate differentials.”

What does this mean in simple English? When the RBI sells government bonds to carry out sterilisation, it sucks out excess rupees from the market. This might lead to interest rates going up. If interest rates go up more foreign money will come into India looking to earn that higher interest rate. And this will create the same problem all over again, with the demand for rupee going up and the RBI having to intervene in the foreign exchange market.

Any increase in interest rates will not go down well with the government which will end up borrowing a lot of money this year, thanks to a collapse in tax revenues. Take a look at the following chart which plots the 10-year government bond yield from the beginning of 2020. The 10-year government bond-yield is the return an investor can expect per year, if they continue owning the bond until maturity.

Down and then slightly up

Source: https://in.investing.com/rates-bonds/india-10-year-bond-yield-historical-data

Thanks to all the easy money created by the RBI there has been excess money in the Indian financial system, since the beginning of this year. This has helped drive down bond yields from around 6.5% at the beginning of the year to a low of 5.76% in July and to around 6.04% currently. Hence, the Indian government has been able to borrow at a lower rate thanks to the excess liquidity created by the RBI and it wouldn’t want that to change. Also, the yields have been rising gradually since July, making sterilising even more difficult.

If the RBI keeps intervening it creates the risk of increasing money supply and that leading to the risk of even higher inflation. A high inflation in a poor country is never a good idea. If the RBI does not intervene that leads to the rupee appreciating and in the process creating problems for the domestic industry as well as the atmabnirbhar strategy. The exporters suffer as well.

What’s the RBI’s best strategy here? It can pray that foreign inflows slow down for a while, like they have in September. But that was basically the FIIs reacting to the Indian economy contracting by nearly a fourth between April to June. This data point was published on August 31. Also, as the economy keeps opening up more and more, imports and other spending pick up, the demand for the dollar will go up as well. All this will help the RBI. Nevertheless, if Western central banks unleash even more money printing, then all this will go for a toss.

The RBI ended up in this position by abandoning its main goal of managing price inflation. The agreement between the government and the RBI states clearly that “the objective of monetary policy is to primarily maintain price stability [emphasis added], while keeping in mind the objective of growth.”

Instead of managing inflation, the RBI chose its role as the debt manager of the government to outshine everything. This led to all the excess liquidity in the system so that interest rates were driven down and the government could borrow at lower interest rates. The Times of India reports on October 1, 2020: “The weighted cost of borrowing [for the government] during the first half was 5.8%, the lowest in 15 years.”

While the government has borrowed more, the overall non-food credit given by banks has shrunk between March 27 and September 11, from Rs 103.2 lakh crore to Rs 101.6 lakh crore. The banks lend money to the Food Corporation of India and other state procurement agencies to primarily buy rice and wheat (and some oilseeds and pulses in the recent past) directly from the farmers. Once this credit is subtracted from overall credit of banks what remains is non-food credit.

What this tells us is that despite lower interest rates overall lending by banks has shrunk. This might primarily be because of people and firms prepaying loans as well as a general slowdown in loan disbursal. Of course, the fall in interest rates has hurt savers and nobody seems to be talking about them.

To conclude, the RBI abandoned its main goal and is now stuck because of that. As economists Raghuram Rajan and Eswar Prasad wrote in a 2008 article : “The central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”

By trying to do too many things at the same time, RBI ends up being neither here nor there. As Rajan and Prasad put it: “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.” This was a mistake the RBI used to make pre-2015, before the agreement with the government was signed. It has gone back to making the same mistake again.

As Rajan wrote in the 2008 Report of the Committee on Financial Sector Reforms“The Reserve Bank of India (RBI) can best serve the cause of growth by focusing on controlling inflation.”

But that’s not to be, given that politicians, bureaucrats and even economists, expect monetary policy to perform miracles it really can’t.

I would like to thank Chintan Patel for research assistance. 

 

Are Acche Din Here for Onion Farmers and Consumers?

Yesterday (September 22, 2020), the Rajya Sabha passed the Essential Commodities (Amendment) Bill, 2020. The Lok Sabha had passed the Bill a week back on September 15. The passage of this Bill essentially dropped cereals, pulses, oilseeds, edible oils, potatoes and onions, from the definition of essential commodities.

The government may regulate the supply of food items only under extraordinary circumstances like war, famine, extraordinary price rise and a natural calamity of grave nature.

In this piece we will concentrate on what this change means in the context of onions.

India grows 10% of the world’s onions. It is the second largest producer of onions in the world, after China. In 2019-20, the total onion production across the country stood at 251.46 lakh tonnes. But despite being the second largest producer in the world, the price fluctuations of onions within the country are huge.

In fact, on more than a few occasions in the past, the price of onions has crossed Rs 100 per kg, causing a lot of pain across households, with the onion being an important ingredient in different kinds of food all across the country. Elections have been lost on the price of onions going up, making it a politically sensitive vegetable.

Take a look at the following chart, which basically plots the inflation of onions as measured by the consumer price index. Inflation is the rate of price rise.

Up and Down


Source: Centre for Monitoring Indian Economy.

(The curve is broken towards the end because data for a couple of months wasn’t available due to the covid-pandemic).

The inflation of onions is all over the place. It just tells us how volatile onion prices are at the consumer level. It’s not just the consumers who face this volatility, even the farmers face volatility in the price they get for the onions that they grow.

All over the place

Source: Centre for Monitoring Indian Economy.

The above chart shows the volatility of onion prices at the wholesale level. And the way the curve goes up and down, tells us that onion prices move around quite a lot, even at the wholesale level.

What does this mean for the consumer and the farmer? The onion consumer doesn’t get to buy onions at a consistent price, the prices go up and down, quite a lot. On the other hand, the onion farmer doesn’t get to sell onions at a consistent price. There is always a chance that when the farmer goes out to sell the onions he has grown, there is a price crash. In that sense, growing onions for a living becomes a very risky profession.

The question is why are onion prices so volatile? This is where things get interesting. Take a look at the following chart (I know, I am throwing a lot charts at you, dear reader, but these are simple straightforward charts.) The chart plots the wholesale prices of onions through the months, over the years.

Rise in wholesale onion prices

Source: http://ficci.in/spdocument/23156/FICCI’s-paper-on-Onion-Crisis.pdf

What does the chart tell us? It tells us that the wholesale onion price start rising around May and they keep rising till around August-September. This is where the entire problem lies, both for consumers as well as farmers.

Why is that the case? The onion has three harvesting seasons; the Rabi season (March-May), the Kharif season (October-December) and late Kharif season (January-March). Close to 60% of the onion production happens during the Rabi season.

Also, the onions produced during the Rabi season are most amenable to storage. The supply of fresh onions hitting the market between May to September is simply not enough to meet the demand. Given this, a part of demand has to be met through stocks of Rabi onions maintained by traders and wholesalers.

When the supply from the Rabi season starts to run out, the price of onions tends to rise. If there are any rains it makes the situation worse. The rains not only destroy the early Kharif crop which starts hitting the market in late September-early October, but they also destroy the Rabi crop that has been stored.

In fact, this is precisely what has happened in 2019 as well as 2020. As the Economic Survey for 2019-20 points out: “Due to heavy rains in August-September, 2019, the kharif crop of onions was adversely affected leading to lower market arrivals and upward pressure on onion prices. This kharif crop usually caters to the demand during the period from October to December till fresh produce from late kharif crop comes in the market.” Something similar has happened this year as well, with rains destroying the onion crop in Karnataka.

Hence, as an economist would put it, there is a structural problem at the heart of the onion trade in India. The government notices this only when there is a price rise and the media starts splashing it. Hence, there is always a knee-jerk reaction.

The government has a fixed way of reacting. It either invokes the Essential Commodities Act (ECA), 1955, or bans exports of onions (and if not that, it makes exports unviable by increasing the minimum export price).

Last year, on September 29, stocks limits under the ECA were imposed. Retail traders could stock up to 100 quintals of onions and wholesale traders could stock up to 500 quintals. (One quintal = 100 kgs. This was later reduced to 20 quintals and 250 quintals, respectively).

The idea here being that as soon as stock limits are imposed anyone who has onions stocked beyond the limit will have to sell them in the open market and that will push down wholesale prices and in the process retail prices (at least, that is what the government hopes).

This year on September 14, onion exports were banned under the Section 3 of the Foreign Trade (Development and Regulation) Act, 1992. The trigger was the more than doubling in the average price of onion arriving at India’s biggest onion market at Lasalgaon near Nashik, between end of March and September 14.

The modal price of onion as of March 30 was Rs 1,301 per quintal. By September 14, the modal price had jumped to Rs 2,801 per quintal. After the export ban on September 14, on September 15 the wholesale onion prices crashed to Rs 1,901 per quintal. Obviously, this did not go down well with the onion farmers.

The third option that the government resorts to is the import onions. This does not bring immediate consumer relief because imports carried out through government institutions take time. Even after onions have been imported, there is trouble is storing, distributing and selling them, because government institutions involved in this process, really don’t have the expertise for it. Also, in the past, the taste of imported onions hasn’t really gone down well with the Indian consumers.

So, what’s the way out of this mess? Let’s take a look at this pointwise.

1) The ECA is a remanent of an era when India had genuine food shortage. The idea was to restrict activities of some agents who were indulging in black marketing and hoarding at that point of time.

As a July 2018 report titled Review of Agricultural Policies in India published by the Organisation for Economic Co-operation and Development, points out: “Orders issued by the centre or the states regulate the production, storage, transport, distribution, disposal, acquisition, use or consumption of a commodity.”

While, we do have our share of problems with some food products where the price volatility is very high (pulses and onions in particular), the days of food shortage are long gone. Also, over the years, the fact that ECA exists has undermined investments in India’s agricultural supply chain infrastructure.

As the Economic Survey of 2019-20 points out:

“ECA interferes with this mechanism by disincentivising investments in warehousing and storage facilities due to frequent and unpredictable imposition of stock limits. As stockholding limits apply to the entire agriculture supply chain, including wholesalers, food processing industries and retail food chains, the Act does not distinguish between firms that genuinely need to hold stocks owing to the nature of their operations, and firms that might speculatively hoard stocks.”

This fear of stock holding limits essentially leads to entrepreneurs staying away from creating supply chain infrastructure.

2) The lack of storage facilities adds to the price volatility of onions. As per a report titled A Report on the study of Onion Value Chain, published by the College of Agricultural Banking, Reserve Bank of India, 20-25% of onion production is lost due to post-harvest damages. This is because of the lack of storage infrastructure.

As the report points out:

“Nearly, 60% of the onion produced in Maharashtra during Rabi/ summer is available for storage i.e. 27 lakh tonnes out of total 45 lakh tonnes. The storage capacity created in the state through different government schemes is 8 lakh tonnes. These are scientifically built onion storage structures. Farmers store 5 lakh tonnes of onion in traditionally built local storage structures. Thus the total storage capacity in the state is 13 lakh tonnes.”

What this means that as of 2018, there was a need to create onion storage structures of additional 14 lakh tonnes, just in Maharashtra. Both the ECA and the lack of bank finance come in the way.

3) The ECA also leads to a situation where traders aren’t able to store enough and this creates problems. Let’s take a look at what happened last year. The ECA was invoked in end September. The onion inflation in the coming months just went through the roof (you can take a look at the inflation charts earlier). The stock limits basically ensured that traders couldn’t store onions beyond a point.

As the Economic Survey pointed out:

“Most of the kharif crop, which itself was lower, would have had to be offloaded in the market in October itself [thanks to the stock limits under the ECA]. Absent government intervention through ECA, traders would store a part of their produce to ensure smooth availability of a product at stable prices throughout the year.”

Of course, this does not mean that onion prices wouldn’t have gone up post September. They still might have gone up because of the lower kharif production, but the prices would have risen in a smoother way.

4) The government also resorts to export bans or increases the minimum export price of onions (where you can still export as long as the customer at the other end is ready to pay the higher price). The idea as mentioned earlier is to increase the supply in the domestic market.

In 2018-19, India exported around 22 lakh tonnes of the onions it produced. This was worth around $500 million. The total onion production during the year had stood at 228.2 lakh tonnes. Hence, less than 10% of the onion produced was exported. Also, the value of onion exports isn’t very big in the overall scheme of things.

As per a FICCI document, India’s export policy towards onions was changed 14 times between 2014 and 2019. This does no good to India’s image globally on the export policy front. It makes us look terribly unreliable.

Also, while prices in the Lasalgaon market fell on September 15, a day after the export ban, they have risen since then, and on September 23, the modal price of onion stood at Rs 3,600 per tonne. So much for the policy benefiting the consumer.

So where does all this leave us? The government has removed onions from the list of essential commodities in the hope that it leads to the development of storage infrastructure.

As Minister of State for Consumer Affairs, Food and Public Distribution Danve Raosaheb Dadarao told the Rajya Sabha:

“The stock limit conditions imposed through the law were hindering investment in the agriculture infrastructure… The move will boost investment in the agriculture sector and will also create more storage capacities to reduce post-harvest loss of crops.”

The move is also expected to increase the income of farmers.

The question is will this work out in the way the government is projecting it to be? Let’s look at this pointwise.

1) While, the government has removed onion from the list of essential commodities, its export continues to be banned. So, what kind of signal is being sent out to anyone who is interested in building agriculture infrastructure, including onion storage?

2) Even though onion is no longer a part of essential commodities, the government can still intervene, under extraordinary circumstances like war, famine, extraordinary price rise and a natural calamity of grave nature.

How is extraordinary price rise defined as?

“Any action on imposing stock limit shall be based on price rise and an order for regulating stock limit of any agricultural produce may be issued under this Act only if there is— (i) hundred per cent increase in the retail price of horticultural produce; or (ii) fifty per cent, increase in the retail price of non-perishable agricultural foodstuffs, over the price prevailing immediately preceding twelve months, or average retail price of last five years, whichever is lower.”

In the last three years, retail onion inflation has been more than 100% in eight months. Clearly, there is a good chance of high onion inflation in the time to come, given that any onion storage infrastructure isn’t going to be built overnight. Will the government intervene? Or will it sit tight and let the end-consumer pay?

The larger point here is that what the government does on this front in the time to come will determine how many entrepreneurs get interested in building agricultural infrastructure.

Just because onion is out of the essential commodities list doesn’t mean that the government cannot intervene. Any prospective entrepreneurs will like to see more evidence on this front.

3) There is great fear (as has been the case with the two main Farm Bills) of big business taking over. The question is if private enterprise is not allowed to operate in this sector, then what’s the way out? The government doesn’t have the money or the wherewithal to do much here. Central planning has been failure the world over and that it is a failure here as well, isn’t surprising.

Big business has built a lot of things since 1991, which most of us use and enjoy. Of course, along the way there has been crony capitalism as well. And that’s the fear here in the minds of people as well. (I don’t have a clear answer for this and I am saying so).

To conclude, taking onion out of the essential commodities list is just the first step. Many other things need to be done before the consumer can pay the right price and the farmer can get the right price.

In an ideal world, these are things that should have started in May 2014, when Narendra Modi was elected the prime minister for the first time. It would have been best to carry out small experiments in states and see how they go, before a nationwide plan was unleashed. There is always a gap between theory and practice and it’s best to correct that gap at a smaller level.

I would like to thank Chintan Patel for research assistance.

CONFLATION (Contraction + Inflation) is Here. And It Will Stay This Year.

The British politician Ian Macleod is said to have first used the word stagflation in a 1965 speech he gave to the Parliament, where he said:

We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of “stagflation” situation. And history, in modern terms, is indeed being made.”

The words stagnation and inflation came together to create the new word stagflation. The economic growth in United Kingdom in 1965 was 2.1%, falling to 1.6% in 1966. Consumer prices inflation during the year was at 4.8%. While, this might not sound much, it was the highest in more than half a decade. Inflation in United Kingdom would touch a high of 24.2% a decade later in 1975.

Hence, stagflation became a term which referred to a situation of slow economic growth or stagnation and high inflation.

Many economists and analysts are asking if India has entered a stagflationary scenario now, just like the British had in the mid 1960s. The consumer prices inflation for August 2020 was at 6.7%. The consumer prices inflation for April to August in the current financial year has been at 6.6%, higher than the Reserve Bank of India’s comfort range of 2-6%.

What is worrying is the food inflation level. Food inflation in August was 9.1%, whereas food inflation during this financial year has been at 9.6%. Within this, the inflation in the price of vegetables was at 10.9%, oil and fats at 11.8%, pulses at 18.2% and that of egg, fish and meat at 15%.

At the same time, the Indian economy as measured by its gross domestic product (GDP) contracted by 23.9% during April to June 2020, in comparison to a year earlier. Things are expected to slightly improve during the period July to September 2020, but the Indian economy will contract in comparison to last year.

Hence, during the first six months of 2020-21, India will see the economy contracting and high inflation. Stagflation doesn’t quite represent this scenario, for the simple reason that stagnation represents slow economic growth and not an economic contraction as big as the one India is seeing.

As Macleod put it in the 1960s: “History, in modern terms, is indeed being made.” What was true in the 1960s Britain is also true about the 2020 India.

Given this, it’s time to coin a new word to represent this particular situation of economic contraction plus inflation and call it CONFLATION (I considered Contraflation as well but somehow Conflation just sounded better and the word anyway means the merging of ideas, so, works that way as well).

What does this conflation really mean in the overall scheme of things for India for the remaining part of the year? Let’s take a look at it pointwise.

1) A high inflation, especially food inflation, during a time when incomes are contracting is going to hurt the economy badly. People are having to pay more for food while their incomes are contracting. This means that spending on non-food items is going to come down. This will impact overall consumer demand right through the remaining part of the year. It is estimated that poor households allocate up to 50% of their expenditure towards food. So, conflation will hurt.

Lower consumer demand also leads to a fall in investments simply because there is no point in corporates expanding production, when people aren’t buying things like they used to. This again will negatively impact the economy. (A contraction in investments has been negatively impacting the economy for close to a decade now).

2) High food inflation has primarily been on account of supply-chains from rural to urban India, breaking down. This means that the farmers are not the ones benefitting from the high food prices. Basically, the traders, as usual, are cashing in on the shortage.

This can be gauged from the fact that food inflation as measured by the consumer price index during the year has stood at 9.6%.

Food inflation as measured by the wholesale price index has stood at 3.1%. This clearly tells us who is benefitting from food inflation. It’s clearly not the farmers. If farmers need to benefit, the terms of trade need to shift in their favour, something that hasn’t happened in many years.

3) Some economists have been of the view that food prices will slowdown in the second half of the year, thanks to a bumper agricultural output. Anagha Deodhar of ICICI Securities writes: “We expect vegetable and pulses inflation to start moderating from September 2020 and October 2020 respectively due to base effect. These two items together account for almost one-fifth of food basket and hence meaningful decline in their inflation rates could keep a lid on headline inflation as well.”

While this is true, what this view does not take into account is the fact that covid is now spreading to rural areas. As Crisil Research put it in a recent report: “Of all the districts with 1,000+ cases, almost half were rural as on August 31, up from 20% in June.” This basically means that the supply chain issues when it comes to movement of food are likely to stay, during the second half of the year as well.

Also, the spread of the pandemic could impact the harvesting and the marketing of agricultural products. Hence, overall agricultural production may not grow along expected lines. Given this, food inflation may not fall as much as it is expected to and might continue to remain elevated. Again, a sign of conflation hurting the economy.

4) The medical facilities in rural India are nowhere as good as the ones in urban India (This is not to say that medical facilities in urban India are excellent). The spread of covid pandemic will mean that people will have to spend money treating the disease.

This will lead to the cutting down on spending towards other items. Also, more importantly, the spread of the pandemic will even have an impact on the spending of people who haven’t been affected by it. People will save more for the rainy day. So, conflation will continue to hurt the Indian economy.

5) Another factor that needs to be taken into account is the fact that the money supply* has gone up by more than 11.7% consecutively for the last four months. This hasn’t happened since 2014. What this tells us is that the Reserve Bank of India is really pumping in money into the financial system. If all this money keeps floating around in the months to come, then there is a real danger of this leading to a further rise in prices. (A piece on how the RBI has botched up the monetary policy remains due).

6) But all this remains valid only for 2020-21. Come 2021-22, and India will be back in growth territory again and hence, conflation will be out of the picture. This, as I had explained in an earlier piece, will primarily be because of the base effect.

Basically, the GDP figure in 2020-21 will turn out to be so terrible that it will make the GDP growth in 2021-22, look fantastic. But this won’t mean much because only in 2022-23 are we likely to go past the GDP figure of 2019-20. This means the Indian economy is likely to go back by two years and that will be the cost of conflation.

To conclude, the Indian economy will contract during the second half of the financial year. There is a slim chance of growth being flat for the period January to March 2021. Inflation, even though it might come down a little, is likely to remain high due to the spread of the covid pandemic. Hence, India will see conflation through 2020-21.

* Money supply as measured by M3.