India: Food Inflation Risks Rising Again

Inflation concerns building up again

Headline inflation (WPI) has risen to 3.5% during the week ended December 22, from the low of 3% during the week ended November 10, 2007. Core inflation (non-oil non-global commodities) has also accelerated to 5.2% during the week ended December 22 from the low of 4.4% during the week ended November 24, 2007. We believe that with a 2-3-month lag, consumer price inflation is also likely to start rising again. The recent rise in global food and energy prices has increased the risk of a further rise in inflation, in our view.

Recent rise in global food prices a key concern
After remaining stable for a period of five months, the CRB foodstuff index has shot up again. The index has increased by 4.5% in the last six weeks, taking the pace of year-on-year rise to 23.7% as of December 2007. Global wheat, rice and soybean prices have increased to new highs. Except edible oil for most other major agricultural items, India is largely self-sufficient, though it has again started importing wheat. However, healthy buffer stock and the government’s efforts to restrict exports have helped in keeping domestic food prices (especially of grains and pulses) insulated so far. Despite this, we believe that, with a lag, some amount of pass-through of higher international prices in domestic food prices would be inevitable.

With the domestic demand/supply balance being relatively tight, we believe that the adverse impact on output for any staple agricultural commodities could potentially push up domestic food inflation sharply. To that extent, the recent data on sowing for wheat are a cause for concern. As of January 4, 2008, the area under coverage for wheat for winter crop (bi-annual cropping season) has declined by 3.3% compared to the same period last year. Similarly, for oil seeds, the area under coverage has declined by 12%Y as of January 4, 2008. Typically, most of the sowing for the winter season is completed by end-December.

In our view, the root cause of an increasing risk of food inflation is the domestic structural demand/supply imbalance. There has been a clear deceleration in supply growth over the last few years due to a host of problems facing the farm sector, most being deep-rooted issues. For instance, food grain output has declined at an average rate of 0.1% over the last five years compared with 1.3% growth in the five years ending March 2002 and 3.4% during the five years ending March 1997. Indeed, in the last five years, the average growth in agricultural production has been below the country’s population growth. Food imports have increased by 56.5%Y during the 12-month period ended July 2007 (last data point available) – a key contributor to this acceleration has been wheat and pulses imports. Productivity growth has stagnated. On a trailing five-year basis, yield per hectare for major crops such as rice has increased by only 0.1%, while for wheat, it has declined at an average rate of 1.1%.

First, the most important factor behind the current state has been low spending by the government on agriculture-related infrastructure services. Public investment in agriculture has only recently picked up to 0.5% of GDP in F2006 after averaging 0.4% of GDP in the preceding three years. Spending on irrigation has also been negligible. Only 40.3% of the farming land is irrigated. The average growth in land brought under irrigation decelerated to 1.5% during F1991-04 compared with 2.4% in the 1980s and 2.7% during the 1970s.

Second, agricultural land holdings are highly fragmented. About 60% of the farm land area is with marginal, small and semi-medium farmers (about 107 million land-holdings). The average land size per farmer is only 0.005 square miles (1.4 hectares). As pointed out in the Fifth Report of the National Commission on Farmers, these resource-poor farmers are unable to benefit from the power of scale at either the production or post-harvest phases of farming. These farmers are also more vulnerable to adverse weather conditions and high levels of indebtedness. Hence, they are unable to increase investments to improve productivity and growth.

Third, the government’s fertilizer policy has distorted the trend in fertilizer consumption and therefore the mix of soil nutrients, resulting in low productivity. The ideal usage ratio of nitrogen, phosphorus and potassium (NPK) is 4:2:1. According to the Planning Commission of India, this is one of the proven and well-documented reasons for stagnation in the productivity and production growth rate since the early 1990s.

There is little hope for a quick solution to the international price rise problem either, in our view. Rising per capita incomes, reducing poverty and increased urbanization are supporting the acceleration in demand for some basic food items. In many countries (with a higher proportion of non-vegetarians), as the United Nations points out in its report 1, as incomes increase, people tend to eat more food and meat, and this in turn requires relatively higher amounts of grain to feed the livestock. Global corn prices have also moved up significantly owing to increased demand from ethanol producers. This is also driving up wheat and soybean pricing, albeit to a lesser degree, as acreage is lost to corn.

Inflation pressure from other commodities – an additional challenge
Apart from rising global food prices, there are two other factors posing risks to the inflation outlook:

(a) Rise in domestic oil products prices: Our estimates indicate that the current weighted average realization of oil products in the domestic market implies an average crude oil price of US$63/bbl (WTI), versus the current international market price of US$100/bbl. This widening gap between domestic and international prices is pushing the fiscal burden up sharply. If oil prices stay at current levels and domestic prices are kept unchanged for the next 12 months, the oil subsidy burden would increase to 2.1% of GDP, on our estimates. We believe that the government is likely to increase domestic oil product prices by 5-10% in the near term. If the government increases crude prices by 10%, it would result in increasing wholesale price inflation by 60-70bp.

(b) Acceleration in the pace of price rise for other commodity products: Domestic steel, coal and iron ore have witnessed highs. Recently, the Coal India Ltd (CIL) increased coal prices by 10% across all grades of coal and all coalfields and 15% for coal produced by North Eastern Coalfields Ltd (NECL) effective December 12, 2007. Similarly, the domestic steel companies also raised their product prices in the range of 2-4% of late. We believe that there will be a cascading effect of higher coal, oil and other commodities input cost prices in sectors such as cement, construction, electricity and other related areas over the next 3-4 months.

Fiscal policy implications
The burden of addressing this food price problem has largely been on fiscal policy. The government is responding with short and long-term measures due to its implications on inflation and farmers.

Short-term measures: Recently, the government has announced a number of short-term measures to address the risk of food inflation:

(a) Wheat: The demand/supply imbalance in domestic wheat production is clearly stretched, in our view. The procurement of wheat by the government from the farmers has been declining every year on account of lower minimum support prices offered and higher private trade offering. The government has been taking steps to stabilize domestic wheat prices by augmenting the domestic availability with imports from the international market through State Trading Corporation (STC). In 2007, the government imported 1.8 million tonnes of wheat (against a target of 2.3 million tonnes) compared to 5.5 million tonnes imported during the previous year. However, the sharp increase in international wheat prices has nudged up the average landing cost of imported wheat in each successive quarter. In December 2007, the STC received offers for importing wheat that were 40-50% higher compared to those fixed a fortnight ago. In October 2007, the government announced a ban on wheat exports for an indefinite period. Similarly, to keep domestic wheat prices low, the government also scrapped the import duty on wheat flour on January 2, 2008, as against the normal applicable duty of 36%.

(b) Rice: In October 2007, the government announced a ban on exports of all non-basmati rice to ensure greater procurement of rice and increase domestic supply. Although this ban was relaxed later, the government gradually increased the minimum free-on-board export price three times between October and December 2007 to discourage exports. Similarly, to increase the domestic procurement of rice stocks, the government issued a notification in December 2007, seeking disclosure of rice stock by private rice purchasers above 10,000 tonnes during the Kharif marketing season (October 2007 to September 2008).

(c) Edible oil: In July 2007, the government reduced import duty on edible oils by about 5-10% to control domestic prices. The measures included a reduction in customs duty on crude palm oil to 45% from 50%. Duty on crude soyabean oil was also reduced to 40% from 45%, while on crude sunflower oil it was lowered to 40% from 50%. The tariff on refined sunflower oil was reduced to 50% from 60%. These measures have helped in reducing to some extent the impact of higher international prices.

(d) Pulses: With effect from June 2006, the government permitted the import of pulses at zero duty and stopped exports.

Long-term measures: The political implications of the poor growth in the farm sector and risk of inflation have forced the government to take some long-term measures too. The adverse conditions have driven thousands of farmers to suicide each year – with the official number pegged at an annual average rate of 3,800 suicides per year for the past nine years. The government has focused on three sets of measures to improve agricultural output: (a) increasing credit access and restructuring old loans; (b) increasing infrastructure spending; and (c) deregulation of the sector, allowing increased private corporate participation.

Increasing credit access and restructuring old loans: In September 2006, the central government announced a Rs170 billion (US$4.1 billion) rehabilitation package for farmers in four states that had witnessed a spate of suicides. The package, to be implemented over a period of three years, would be spread among 16 districts in Andhra Pradesh, six in Karnataka, three in Kerala and six in Maharashtra. The package also included a US$0.7 billion interest waiver for farmers in these states. However, the project has been lagging on the implementation front, with slow progress achieved so far in rescheduling loans, offering low interest rates on farm loans, funding watershed development and other irrigation projects. In fact, the Radhakrishna Committee Report on rural indebtedness has called for “urgent corrections” over the implementation of this package. The government has announced that a coordinated approach on agricultural indebtedness will be finalized in the near term to help the farming population and avert a further rural debt crisis in the country. According to Times of India, the government is likely to initiate a mega-farm loan-restructuring package covering bad and doubtful debt of about Rs300 billion (or US$7.5 billion) in the upcoming Union Budget to be announced in February 2008.

Increasing infrastructure spending: In the Union Budget (February 2007), the central government announced that it would increase spending on irrigation by 54% and on the Bharat Nirman programme (which covers power, roads, telecom and housing in the rural areas) by 38%. These measures would cumulatively result in additional capex of US$2.2 billion (0.14% of GDP) in F2008. In addition, the government is targeting a net disbursement of US$7.8 billion (or 0.4% of GDP) in farm credit by the end of next year. The government announced additional measures to train farmers and also launched a subsidized insurance scheme for rural landless households. In May 2007, the Prime Minister announced a Rs250 billion (US$6.3 billion) plan for the farm sector by addressing the needs at a grass roots level over the next four years. The package will have state-specific plans for overall development of the farm sector and aims to give incentives to states to invest more in the agriculture sector.

Attracting private corporate sector investments: The government is relaxing regulations for the private corporate sector to participate in farm-related activities. Many states have recently amended the Agricultural Produce Marketing Committee (APMC) Act, which in effect was restricting the private sector from directly transacting with farmers. Sixteen states and five union territories have amended the APMC Act, allowing private sector participation in direct purchases of agricultural produce from farmers. We believe that this, coupled with the emergence of the organized sector retailing, could prove to be a significant catalyst for the growth environment in the sector. Indeed, private corporate entities are influencing the government policy to improve the business environment for the sector.

Exchange rate and monetary policy implications
We believe that incrementally the exchange rate policy is unlikely to play a supportive role in managing food price inflation. The RBI had opted for sharper appreciation in the exchange rate in 2007 to offset the increase in the global prices of commodities, including those of agri-products. However, we believe that there is little scope for allowing further major appreciation in the currency, considering its implications on goods exports by small and medium enterprises.

The risk of higher food prices is constraining monetary policy management. Even as consumption growth has slowed meaningfully, the RBI is deferring policy rate cuts. It is concerned about higher food and energy prices weighing on inflationary expectations.

Conclusion

The rise in international food prices, in addition to the rise in oil prices, has revived inflation concerns. Higher food prices are resulting in: (a) the RBI pursuing a conservative monetary policy. Even as consumption growth has slowed down significantly, we believe that the central bank is unlikely to cut policy rates until there is a clear sign of a decline in global commodities prices, including agri-products; and (b) the government initiating a number of short-term fiscal measures restricting exports and encouraging imports to contain the rise in domestic food prices. The government is also implementing long-term measures to accelerate food output growth by improving credit access to farmers, increasing rural infrastructure spending and encouraging private corporate sector participation in farm-related activities. We believe that these macro policy responses should ensure that headline inflation remains under the RBI’s comfort range of 5% as long as there is no major crop failure. In this context, the recent data on wheat sowing for winter crop are a cause for concern.

By Chetan Ahya Singapore
Morgan Stanley
January 7, 2008