Will the price control strategy backfire?

DEBATE

Banning exports or commodity futures may help in the near term, but the impact of this on future investments needs to be kept in mind as well.

Pawan Kumar Bansal
Minister of State, Finance

Ideally, futures help stabilise farm prices and help farmers get appropriate prices, but it is equally important to check hoarding

The increase in prices of certain essential commodities being experienced today is because of the hardening of international prices and demand-supply mismatch. The government has taken a number of steps to curb inflation in essential commodities, as a result of which it has started coming down "" from 7.66 per cent in October 2006 to 5.34 per cent (provisional) in January 2007 and 4.44 per cent (provisional) in February 2007.

It is not that this is happening for the first time. The average inflation rate in 2000-01 was 7.13 per cent. In fact, during the NDA regime the inflation rate touched 7 per cent twice, whereas the average GDP growth remained merely 5.56 per cent. On the other hand, the last three years have registered a growth rate of 8.6 per cent and the projected target now is 9.2 per cent. Inflation is occuring because of an increase in money supply driven by this high growth.

To reduce liquidity in the system, on four occasions the Reserve Bank of India increased the Cash Reserve Ratio and repo rates and stepped up the Market Stabilisation Scheme. These measures were aimed at sucking excess liquidity.

Intervention by central bank to check inflation is a worldwide phenomenon. All that the RBI has done is to rebalance the portfolios without hitting the housing sector.

To contain volatility in futures prices of wheat, sugar, and pulses, the Forward Markets Commission imposed limits on open position, reduced limits on daily fluctuations and imposed additional margins. Futures trading in tur, urad and more recently, wheat and rice was banned. These are immediate, short-term measures.

Ideally speaking, futures markets help in the stabilisation of prices and are therefore, desirable. They also help farmers in getting appropriate prices. But what is important is to check hoarding. The role of the regulator is to strike a right balance. Ideally, futures trading must be permitted, but futures markets have to be mature and show discipline. The Abhijit Sen Committee will look into all these issues and then the government will take a final view on it.

The government has taken a number of other steps to contain inflation. Retail prices of petrol and diesel were reduced twice. Private traders were allowed to import wheat at zero duty from September last year. A ban on the export of wheat was imposed in February this year. The customs duty on the import of pulses was reduced to zero last June. The export of pulses was also banned.

But the major factor of demand and supply mismatch continues to be a source of trouble. The production of wheat, pulses and paddy has stagnated in the past few years, while demand has increased considerably due to an improvement in the standard of living, which has itself resulted from economic growth. For instance, many people who used to live on coarse grain have shifted to cereals now.

Finance Minister P Chidambaram has tried to address these issues in the present Budget. It is essential that our agricultural growth increase to 4 per cent. To this end there has to be greater emphasis on credit and infrastructure in this sector and this is what the finance minister has done in this Budget. Apart from increasing the credit target considerably, there is greater allocation for improvement of water bodies and irrigation facilities.

Two agriculture universities have been given additional grants for research. Emphasis has been laid on extension services in agriculture. The present Budget has focused on a target to increase agricultural production as also productivity, which is the only solution to the current demand-supply mismatch.

The government has already taken a number of measures including a few mentioned above to bring relief to the people immediately. We are sure these measures will further bring down the inflation rate soon.

Dharmakirti Joshi
Director and Principal Economist, CRISIL Ltd

Most measures will help relieve short run inflation pressures, but the absence of price signals lowers the incentive to raise long run capacity

Rising inflation is indeed a matter or concern, but some of the steps taken to tame it are equally worrying. Over the last few months, we have seen a broad strategy comprising a reduction in indirect taxes, monetary tightening and restriction of exports. Some of these measures, such as a reduction in customs and excise duties, will have a moderating impact on inflation in the short term and over a period of time reduce the distortionary effects of indirect taxes. Monetary tightening by the RBI is intended to check the demand side pressures on inflation.  Other measures like fixing cement prices, banning futures trading in rice and wheat are undesirable and can at best be characterised as a knee-jerk reaction to control inflation. It is true that cement and foodgrain prices have seen a sharp rise which is a reflection of supply not keeping pace with demand. Cement prices have increased over 25 per cent and foodgrains have seen double digit inflation in 2006.  The government response ""of fixing the cement prices""seems to push us back to the era when the government assumed that it had all the necessary information to decide the optimal price for a given commodity. This kind of arbitrary price setting blurs the signalling mechanism of the market. This move will cap cement prices, only temporarily though. It will depress capacity expansion and can eventually lead to supply shortages and put pressure on prices when the control is lifted. Governmental intervention in the process of price setting by dynamic market forces is, therefore, not such a good idea unless there is an established case of market failure.  Supply shortages in foodgrains, pulses and edible oils have pushed up their prices to perturbing levels. The Economic Survey 2006-07 clearly states that there are no short cuts to addressing this issue and a long term strategy aimed at rekindling Indian agriculture is needed. The Budget did take cognisance of this and announced some measures aimed at raising the irrigation potential and agricultural productivity. But alongwith these healthy measures, it also banned futures trading in rice and wheat.  The introduction of the commodity futures market was a step to reform Indian agriculture. Futures contracts involve an agreement for delivery of a given amount of goods at a specified time for an agreed price. It is well understood that efficient futures markets help in price discovery and also provide a hedge against risks and uncertainties. On the issue of futures trading, the Economic Survey opined, "Futures markets help in efficient price discovery of respective commodities and do not impair the long-run equilibrium price of commodities." And on its implications for agriculture, the Survey stated, "Agricultural commodities are expected to gain importance, helping their price discovery process and thereby providing opportunities for farmers, traders and consumers to obtain a reasonable price."  Apart from supply shortages, one of the reasons for the spurt in foodgrain prices was the inability to take a cue from futures markets elsewhere that global price tightening was underway. A timely reading of the signals combined with an assessment of the domestic supply situation would have prompted remedial measures such as opening up of imports/duty reduction on foodgrains earlier.  The reason behind the ban on trading in foodgrain futures is the fear that some manipulation is at the back of the spurt in their prices. Clearly markets are susceptible to fraud and manipulation, even in developed economies. But is imposing a ban on trading the right approach? The received wisdom is that strengthening regulation to avoid unfair trade practices would have been a better option. Government policy efforts should therefore focus on ensuring proper functioning of the markets. Fixing of prices as well as banning futures trade was aimed at supplementing the government's efforts at taming inflationary pressure: their unintended consequences do not augur well for the journey towards a free-market based system. I hope that these highly avoidable measures are temporary in nature and will be rolled back once inflation starts to moderate.

The views are personal