The Narendra Modi government last week announced sharp increases in minimum support prices (MSPs) for a variety of farm products. The move itself is not unexpected. The first sign that the Modi government would shift away from its earlier strategy of minimal hikes to douse the inflation fire it inherited was evident in the February budget announced by finance minister Arun Jaitley, when there was a steep increase in the money kept aside for food subsidies as well as an explicit commitment to accept the advice given by M.S. Swaminathan that farmers should be paid 50% more than the cost of production. Rural distress is also a growing political concern as the country moves closer to the next general election.

The economics of the hike in farm support prices is more ambiguous than the politics. Higher prices are usually offered as an incentive for farmers to grow more. India currently has overflowing granaries—and Harish Damodaran has argued in The Indian Express that we are now in a new era of structural agricultural surpluses. The optimal policy response to such a structural surplus cannot be higher procurement prices—unless there are export opportunities to be harvested. The alternative is a massive food mountain.

The exact procurement plan is not yet clear, so assessing what it will mean for the rest of the economy is naturally uncertain. However, the immediate impact of the decision to hike minimum support prices could be milder than most people believe. There are three key issues to be considered.

First, a support price does not come with a commitment to buy whatever farmers offer. Actual procurement will be limited by the fiscal room available, especially at a time when a significantly higher fiscal deficit could lead to further pressure on the rupee. The actual incremental cost is likely to be between 15,000-30,000 crore, or between 0.07- 0.14% of gross domestic product for financial year 2019.

Second, minimum support prices in some cases continue to be lower than market prices, so farmers would rather sell to traders than government agencies. In this context, it is also worthwhile for the government to allow agro trading companies to buy more in the Indian market, especially given the limitations of the Food Corporation of India.

Third, much of the immediate inflation impact will depend on rice, which has the highest weightage in the consumer price index. It is significant that the increase in the support price for paddy is lower than the average increase announced for this year’s kharif crop. However, there is no doubt that headline inflation will inch closer to the upper limit of the official inflation band.

The Reserve Bank of India has a good case to respond to higher farm support prices with another hike in interest rates. The monetary policy committee will have to take into account not only the primary but also the secondary impact of the price increases. The experience of the previous years shows that higher food prices lead to higher rural wages as well as higher inflation expectations, albeit with a lag. The latter will be especially important in the months ahead. High food inflation spilled over to the general price level during the United Progressive Alliance regime because inflation expectations were not anchored. It remains to be seen whether the new inflation-targeting framework has created enough confidence in monetary policy for participants in the economy to look past this hike in farm support prices.

Food price policy has been a Catch-22 for policymakers. A sharp increase in farm support prices spills over into generalized inflation. A commitment to cap food prices in a bid to control inflation leads to rural distress. India has seen both these situations over the past decade. This newspaper has often written about the impossible fiscal trinity: It is impossible for India to simultaneously attain the three goals of keeping farm prices high, retail food prices low, and overall inflation under control through a tight fiscal policy.

Some states such as Madhya Pradesh and Telangana have come up with innovative policy options to protect the profitability of farmers. These too will be inadequate in the long run. The answer to the deep structural problem in agriculture has to be, by definition, structural as well. India needs to radically liberalize its farm economy on the one hand and create jobs in the industrial sector on the other. The best way to double the real incomes of Indian farmers would be to halve their numbers through job creation in other parts of the economy.

What will be the impact of recent increases in minimum support prices? Tell us at views@livemint.com

Close