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24.08.2009

The Threat of Drought-driven Inflation

With just a few weeks to go before the Southwest monsoon retreats, it seems almost certain that the deficiency in rainfall would be such as to constitute a drought. In its press release dated August 21, 2009, the Indian Meteorological Department declared that rainfall deficiency relative to the long period average was 26 per cent over the June 1 to August 19 period (Chart 1). Northwest India with a deficiency of 37 per cent leads, followed by Northeast India, Central India and the Southern Peninsula, in that order. With deficiency having been high throughout the season in Northwest India and very high in Central India in the period up to the first week of July (Table 1), sowing has been delayed or has not occurred at all. Agricultural output is thus bound to fall this year.

India last experienced a drought in 2002. The fortuitous record of six years of normal or good monsoons after that is now being broken. This is bound to test the ability of the government to deal with shocks other than those transmitted through the world of finance.

As a result of the early drought-like conditions, on August 13, 2009, area sown under rice was reported at 247 lakh hectares which is 63 per cent of normal levels and 19 per cent short of the previous year's levels. The shortfall relative to the normal was 24 per cent for coarse cereals, 21 per cent for pulses and 10 per cent for oilseeds. This will obviously affect aggregate production. The effect is likely to be significant because kharif production accounts for around 57 per cent of total crop production.

One crop that is expected to be particularly affected is rice, which is the most important food crop during the kharif season. And the impact could be severe on the marketed surplus of the crop, because some ''surplus states'' have been particularly adversely affected. The deficiency in rainfall has been high in those states which contributed a substantial share of total rice procurement during the marketing season 2007-08. Punjab, Andhra Pradesh, Uttar Pradesh and Chattisgarh, which contributed close to three-fourths of all rice procured during the 2007-08 marketing year, have thus far experienced a deficiency in rainfall varying from 30 to 60 per cent (Table 2).

With the fall in output likely to push up market prices it can be expected that farmers would prefer to sell in the market, where prices are likely to be higher than the floor set by the minimum support price. In the event, procurement is likely to be low, while demand from the public distribution system is likely to rise in the wake of an increase in market prices. If stocks with the government deplete, this could trigger speculation based on inflationary price expectations, setting off a price spiral.

Table 1: Week by week progress of cumulative seasonal rainfall
Period ending	Country as a whole	Northwest India		Central India	South Peninsula		North East India
03.06.09	-32	-40		-50	-14		-32
10.06.09	-39	-31		-56	-15		-44
17.06.09	-45	-26		-72	-21		-46
24.06.09	-54	-49		-73	-38		-55
01.07.09	-46	-45		-59	-31		-41
08.07.09	-36	-50		-40	-18		-34
15.07.09	-27	-43		-15	-12		-40
22.07.09	-19	-38		3	-6		-43
29.07.09	-19	-33		1	-15		-39
05.08.09	-25	-40		-13	-18		-36
12.08.09	-29	-43		-19	-23		-36
19.08.09	-26	-37		-22	-20		-27

There are three additional reasons why the evidence of an unfolding drought is a matter for serious concern. To start with, during the previous drought in 2002, rainfall was around 81 per cent of the long period average, as compared with the 74 per cent figure recorded thus far for this season. Rice production in 2002-03 fell by 23 per cent from its 2001-02 high of 93.34 million tonnes to 71.82 million tonnes. Things could be much worse this time around. Second, if previous experience is the basis for prediction, droughts tend to cluster across time. Thus 2000, 2001 and 2002 all had below normal monsoon, as did 1985, 1986 and 1987. If this cycle repeats this could be the beginning of bad times for the medium term.

Table 2: Share in 2007-08 Rice Procurement and Rainfall Deficiency Range by State
	Share in Procurement (Oct-Sep) (%)	Rainfall Deficiency Range
Punjab	27.7	36
Andhra Pradesh	26	31-59
Uttar Pradesh	10.1	40-46
Chhattisgarh	9.6	30
Orissa	8.2	4
Haryana	5.5	63
West Bengal	5.3	25
Tamil Nadu	3.4	5
Kerala	0.6	14
Maharashtra	0.6	20-50

Finally, the evidence of drought occurs at a time when food prices are already high and rising. Going by annual point-to-point changes in the WPI (relative to values prevailing a year back), prices on average have been falling in recent times. After touching a high peak level in August 2008, largely because of increases in the prices of oil and other primary commodities, inflation turned negative in June 2009 and has remained so since then. The figure as on 1 August 2009 stood at a comforting minus 1.74 per cent. This, of course, is misleading. The annual point-to-point increase in the monthly CPI for Industrial Workers stood at 9.29 per cent in June 2009, which is way beyond the negative 1.2 per cent figure for July yielded by the WPI. Moreover, the month-on-month inflation rate as measured by the CPI has been above the August 2008 level in seven of the subsequent ten months.

The principal reason for the difference between the WPI and CPI is that prices of different sets of commodities in the Indian economy have been moving very differently. Globally, oil prices, though rising, are below the peak levels they reached sometime back. The prices of many manufactured goods have also been falling because of the global recession. On the other hand the prices of food articles have been rising in recent times. Thus the Reserve Bank of India's recently released quarterly review of economic trends had this to say: ''Notwithstanding the negative WPI inflation, food articles inflation (i.e. primary as well as manufactured) remains high at 8.9 per cent (as on July 11, 2009). Inflation as per Consumer Price Indices (CPIs) also continues at elevated levels (in the range of 8.6 per cent to 11.5 per cent for different consumer price indices in May/June 2009).''

This raises the question as to the factors behind the price increase. Production has not fallen. Most recent estimates place the total food grain production during 2008-09 at a record 233.9 million tonnes. Stocks with the government are comfortable. There are enough foreign exchange reserves in the economy to import food. And, if anything, demand expansion must have been dampened by the slowdown in growth in the economy. To quote the RBI: ''Weakening aggregate demand emerged as a major constraint to growth in 2008-09.''

However, the dampening effects of the recession on demand seem to have affected only the prices of non-food articles and not so much those of food and certain other essentials. The implications are clear. Speculators are playing a role in ensuring that prices not only remain high but continue to rise in a period when normally they should be in decline. And the fact that for some time now the wholesale price index has conveyed the impression that inflation is low and even negative has rendered the government complacent. There has been no concerted effort at reining in food prices, and all attention has been focused on reviving growth. And monetary policy aimed at responding to the slowdown in growth is ensuring that speculators are able to access liquidity quite easily. The danger of high inflation driven by speculation is only increasing.

Given this context, evidence of a drought is disconcerting because it can result in an acceleration of food price inflation with economy-wide consequences, and extremely adverse implications for the poor. The government is attempting to talk down inflation and the speculative surge by pointing to the huge stocks it has at hand and the country's strong foreign exchange reserve position that can be used to import commodities in short supply to hold the price level. But this ignores the fact that prices of food articles have already been rising.

It is indeed true that on April 1, 2009 the stocks of rice and wheat with the government stood at 21.6 and 13.4 million tonnes respectively, as compared with the official buffer stock requirement of 12.2 and 4 million tonnes respectively for that date. On May 1 stocks were at an even more comfortable, with 21.4 and 29.8 million tonnes of rice and wheat. Moreover procurement this season promises to be better than the last. As on 13 August 2009, procurement of rice during the 2008-09 marketing season was at 32.5 million tonnes much higher than the 27.1 million tonnes recorded during the same period last year.

However, there is the larger question of how the government would be able to reach this food to areas where it is most needed, given the woefully inadequate coverage of the public distribution system in most states. Since the movement of foodgrains across states and regions has been liberalised for many years now, this would affect prices not only in the deficit areas but elsewhere as well, with traders seeking the best prices. The government appears to be banking on its open market sales scheme, or the sale in the open market at predetermined prices, to dampen prices.

But liberalisation has also increased the role of private traders including big private players in the foodgrain market. It is they who would corner these stocks and hold them till prices do rise. The centre is attempting to shift the burden of dealing with the price rise on to state governments. Besides accusing them of not doing enough to dishoard private stocks, it is requiring them to organise the distribution of food. In his speech to a 19th August, 2009 meeting of Ministers of Food and Civil Supplies of the state governments, Sharad Pawar, the Minister for Consumer Affairs, Food and Public Distribution said: ''If required, Government would not hesitate to undertake open market intervention and release of wheat and rice under Open Market Sale Scheme to State Governments. State Governments should in turn gear up and put in place appropriate mechanism to sell wheat and rice to consumers and ensure these releases check inflationary trends in the food economy.''

The Centre, in its effort to hold State governments more responsible, is also pressing them to impose a 50 per cent or more levy on rice millers. With states not all being in a position to create the necessary network and handle the distribution process, it is inevitable that the private sector would be called in. It is at that stage that the effects of speculation could intensify necessitating strong action if inflation is to be reined in.

If that happens, the option that would be resorted to is that of imports. But the situation is not too favourable in global markets either. The Food and Agriculture Organisation's Crop Prospects and Food Situation Report released recently, estimates world cereal production in 2009 at 2208 million tonnes, or 3.4 percent down from last year's record harvest. This is not all bad, since the high base implies that this would be the second largest crop ever. However, the situation is less optimistic on the price front. To consider the case of rice for example, the FAO Rice Price Index which is based on 16 global rice price quotations indicates that while prices have declined from their peak levels of around a year ago, they are still close to their 2008 high and well above levels that prevailed in 2007 and earlier (Chart 3). This, together with the possibility of rupee depreciation and the difficulty of reaching imported rice to the final consumer, could imply that even if the government offers a subsidy, imports may not serve to control the price level. That may be the cost to be paid for failing to ensure universal coverage of the PDS, remaining obsessed with targeting in order to limit food subsidies and liberalising trade of essentials like food grains.