The much-awaited announcement on summer crop Minimum Support Prices (MSP) came through this week. The prices are in line with the budget announcement of 1.5 times cost. Most commentary post the release is understandably hazy since, while the numbers on paper look alarming in terms of impact on CPI, it is yet unclear how effective and comprehensive the implementation is likely to be. Direct CPI impact is largely expected in the 30 – 90 bps band, with the impact rising towards the higher end of this range the more efficient the procurement becomes. The other important aspect is the fiscal cost of this implementation. Government ministers seem to have pegged the fiscal cost at around INR 15,000 crores. It has been confirmed that the costs are already built into the expanded food subsidy bill in the budget (an increase of INR 29,000 crores over last year is budgeted in overall food subsidy bill) and that fiscal deficit target will not be breached. Others in the government have also expressed confidence with respect to CPI post the release of MSP.
There are two broad ways that the implementation can work:
1. There can be direct procurement at an expanded scale through central / state / mandated private sector agencies. This involves an actual purchase of produce from the farmer. This will set a higher effective floor to prices thereby benefitting the farmer and will impact prices (and hence CPI) more than it does the fiscal.
2. The government can choose to compensate farmers for the difference between MSP and market prices (if market prices are lower), without actually expanding procurement. The compensation may be capped at a certain amount and may be shared between centre and states via a pre-determined formula. This will impact the fiscal much more and most of the CPI impact will largely only feed in from the second round effect of better incomes.
However, it is to be noted that if both price and fiscal effects are subdued then one can conclude that the whole exercise hasn’t had the desired welfare effect; which isn’t the intent at all.
Also, as seen in the chart below, buffer stocks in paddy are very large. This is alongside a material rise in production as well. Further aggressive procurement may only swell these stocks more and may be quite counterproductive in the medium term.
The scenario on pulses has also changed dramatically over the past couple of years – from shortage to over production, as seen in the charts. The point here is that in some cases, establishing a sustainable higher market price via widespread procurement may not be a very practical idea. Reasons of import price distortion and adverse terms of trade may be other considerations as well. These lend support to the view that the actual impact on CPI may be much more muted than the on-paper calculations suggest.
Source: CEIC. Note: FY18 numbers are based on the 3rd advance estimates of food grain production released by the Ministry of Agriculture
The Big Picture
It is important not to lose sight of the big picture view in this micro discussion on MSP. As the chart below shows, food prices have been declining almost secularly over the past few years with the cause-effect circularity flowing among lower MSPs, lower real rural wages and lower food prices.
Source: CEIC, PIB. Note: 1) Real rural wage is nominal rural wage deflated by CPI-rural. 2) There is a break in data from November 2013 to October 2014.
This trend is likely now starting to change. While the current quantum of MSP hikes may not get repeated now that the cost plus formula has been implemented, it is likely that policy focus remains conclusively on the farm situation for the foreseeable future. All of this argues for a higher steady state food CPI and hence a higher steady state overall CPI. The non-food basket could compensate in the time ahead, largely in two ways: 1> further rationalization in GST rates once revenue buoyancy stabilizes 2> the non-food basket itself changing at some point in the future to incorporate newer consumption patterns. However, this compensation may still be some time away.
It is also noteworthy from the chart above, that this new regime on food inflation has almost exactly coincided with the regime of CPI targeting framework of the RBI. In that sense, the framework ‘has had it easy’ thus far. If food inflation were to sustainably find a higher floor, it is quite likely that RBI / MPC focus on 4% CPI target will get challenged. This is because it may require a disproportionately large rate increases (and corresponding loss of output) to dis-inflate the residual part of CPI basket.
Rather, we think that the RBI / MPC will eventually adopt a pragmatic approach and focus on their controllable: the real policy rate buffer over average forecasted CPI. This in turn will be a function of local growth prospects and financial stability concerns. In our current view, local growth will likely begin slowing from its current pace over the second half of this financial year. This leads us to believe that this will be a shallow rate cycle. At this juncture, we are looking for another 50 bps of hikes by March of 2019. The risk to the view may come from financial stability concerns. Should global volatility escalate then the RBI / MPC will likely settle for a larger real rate buffer.
Conclusion
The CPI impact of the new MSP announcements remains ambiguous for now. A lot depends upon effective procurement as well as the starting availability dynamics for the crops. However, it is very likely that average CPI for the year gets pushed comfortably beyond 5%. This is particularly unhelpful given the already adverse macro dynamics currently underway. The RBI / MPC will be decidedly worried with these dynamics. For that reason, it is prudent to believe that the residual rate hikes in this cycle will come front loaded. We would think August policy is very much in play for the next one, to be followed by one more before the end of the fiscal year.
Given these CPI dynamics, one can potentially argue for a steeper rate hike cycle. However, we think that the RBI / MPC is currently too sanguine on growth dynamics. In our view, there is strong likelihood of a sequential slowdown in growth over October – March. This is especially true in light of the significant recent tightening in local financial conditions. Assuming no further escalation in global financial volatility, these dynamics should keep this rate hike cycle shallow.
Bond yields at the front end (up to 4 – 5 years) seem to be more than fully pricing in a shallow cycle. This has been our preferred overweight segment for some time. The larger issue has been demand – supply. While selling by foreign investors over the past few months has further made demand versus supply adverse, there are potential green-shoots on the horizon:
1. Public sector (PSU) banks seem to be nibbling in the market again for the past few weeks. This is evident both in primary auction clearance as well as secondary market activity to some extent.
2. Around INR 20,000 crore odd of government bonds in the 2020 and 2021 segment have been taken out from trader books by ALMs, PSU banks and RBI open market operations (OMO). This has reduced float in the segment thereby lending some element of incremental stability.
Apart from these, should foreign investor selling ease on relative stabilization of the global environment it would be positive. However, the biggest potential positive is the resumption of OMOs from RBI. While they are likely to be sporadic over April – September, we expect them to become fairly regular over the second half of the financial year. This will constitute the biggest support to bond prices.
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