Hoarding and inefficient supply chain management leads to price volatility, price escalation and food inflation

The Financial Express has been carrying some interesting articles commenting about the plausible cause of food price inflation (?Procurement price inflation bogey?, March 28; ?Wages, waste and WPI?, April 1; ?Don?t blame MSP alone?, April 2; ?Let?s not piss away agriculture?, April 17). Among the important factors attributed are widening fiscal deficit, rise in farm wages, global food price hikes and increase in MSP. It is also argued that the growing demand due to rising national incomes, decreasing arable land and stagnating yields may also have contributed to food inflation. Influence of each one of these factors on food inflation has been tested in the empirical literature. But what has not been examined in the Indian context is to understand the cause of cyclical fluctuation in agricultural output; whether it is driven by demand-side or supply-side shocks. We are defining shocks as exogenous, something outside policymakers? control. Understanding the source of fluctuation in agricultural output is important to decipher the story of food price inflation, and more importantly what type of demand management policy should be undertaken.

From a layman?s perspective, inflation happens when there is a mismatch between demand and supply of output. Managing inflation is to manage demand-side factors, supply-side factors, or a combination of both, affecting availability of output (GDP). Demand management policy refers to use of fiscal and monetary policy when there is inflation characterised by a positive output gap (difference between demand and supply).

Agricultural output gap or the cause of food price inflation can happen because of increase in demand-side factors. Increase in income has contributed to consumption of high protein items such as meat, milk and eggs. In general, consumption of these high protein items increases with income. Advocates of demand-side factors causing inflation believe in this story?increase in food price inflation is because of demand-side factors or higher income resulting from the India growth story, and increased payment through MGNREGA and MSP. But consumption of food items cannot move beyond steady-state level of consumption. This is particularly true for basic cereals and vegetables. Interestingly, weights of these basic food items are more than high protein items in the WPI.

Agricultural output gap can also increase if for a given demand the supply of output falls below the trend level?which refers to the supply side, what the economy can produce for a given level of factor endowments (labour and capital), and technology. It takes time to develop better technology that will improve agricultural productivity. Policymakers have little or no control as to how much an economy can produce in the short run. On the contrary, supply of agricultural output in India can fall below the trend level because of drought and capacity constraint such as lack of physical infrastructure leading to inefficient supply chain management.

Given this information that supply-side shocks (such as rainfall) may affect agricultural output gap, it makes sense to examine whether there is any association between agricultural output gap and rainfall. Inadequate rainfall can be treated as supply-side shock, especially because 55% of agricultural produce depends upon rainfall. It is expected that rainfall during the previous year may effect this year?s agricultural output gap. We did a simple statistical exercise, regressing present year?s agricultural output gap over last year?s rainfall*. As heavy rainfall (flood) without proper irrigation facilities may harm crop production, we have taken into consideration rainfall square as an additional explanatory variable. We considered agricultural GDP data for four states?Bihar, Punjab, UP and West Bengal?only as we did not have matching rainfall data for other states. The agricultural output data consisted of 46 annual observations from 1960-61 to 2005-06 measured in 1993-94 prices. Since it takes time to build rural infrastructure, especially irrigation facilities, we believe our results will not change much. And though allocation towards agri-infrastructure went up during the 11th Plan, most part of it was used for rural electrification.

We find evidence in favour of association between agricultural output gap and rainfall data. The results are robust for Bihar, UP and West Bengal. This is also congruent with the fact that these states lack basic irrigation facilities?the agricultural output in these states is more dependent upon rainfall than Punjab with a relatively better irrigation framework.

To check robustness of our result we did a counter-factual experiment by surveying market managers employed with the wholesale food and vegetable association in Chennai. Survey points out, in the event of poor harvest and bad rainfall, the number of trucks bringing vegetables to the city wholesale market falls drastically. There is a high correlation between the bad harvest/poor rainfall year and the number of trucks bringing produce to the market. According to these managers, the demand for vegetables and cereals remains stable throughout the year, with prices becoming more volatile during summers. Poor rainfall during the previous year means lesser produce available during this summer. There is evidence that number of trucks bringing agricultural produce from Kerala and Karnataka to Chennai falling drastically if there is inadequate rainfall during the previous year. In fact, there are instances of hoarding by big retailers and middlemen during bad harvest years. Hoarding and inefficient supply chain management leads to price volatility, price escalation and food price inflation.

In the presence of supply-side shock, it does not make sense to follow a contractionary demand management policy to control food inflation. Contractionary policy such as through monetary policy can become successful during the time of expansion or demand-side shock. For instance, to control inflation during economic expansion during 2005 lasting until 2007, RBI followed a contractionary monetary policy. The tighter credit policy of April 2007 was influential in reducing inflation rates from 6.7% to 3.5% within the next four months. But contractionary demand management policy may not be a good idea to control inflation especially when the cause of food price inflation is supply-side factors. What is required is the use of supply management policies like investment in suitable infrastructure, developing new technology to improve agricultural productivity and efficient supply chain management.

* N Banik and B Biswas (2013), ?Food price inflation and the weather god? The Empirical Economics Letter, 12:2, Feb.

The author is professor, Institute for Financial Management and Research, Chennai. nilbanik@gmail.com