Looking like a recovery

Financial Express, 20th December 2013

There are a few signs of recovery in the Indian business cycle. These include an improvement in sales and profits of non-oil, non-financial companies and increase in the dollar value of exports. The growth in dollar value of exports has slowed down in the latest available data but now that the rupee is more competitive and the US economy is recovering, if firms have the needed business environment and infrastructure, we can see further improvements and a pick up in the business cycle.

One measure of business cycle conditions in India is to look at the quarterly GDP data. Figure 1 shows the seasonally-adjusted qoq growth of real GDP at factor cost. This data shows that the last quarter (July-September 2013) is showing an upturn.

Figure 1:

However, this data includes agriculture and government spending. Agriculture has many fluctuations, but these are related to weather rather than business-cycle conditions. If an upturn in seen in agriculture then, while it does influence demand and therefore non-agricutural output, the direct effect of the monsoon on crops is not part of the cyclical upturn. If the government spends more, say because of a hike in government salaries due to the implementation of pay commission recommendations, GDP due to government services goes up. This component also can have an indirect effect on demand and cyclical conditions, but the additional spending by the government should not constitute a reason to believe that the cycle has turned. We, therefore, look at non-agricultural, non-government GDP (figure 2). This shows an upturn in the last quarter.

Figure 2:

We then look at business cycle conditions by aggregating the performance of firms. Figure 3 shows aggregate sales of all non-oil, non-finance listed firms in India. The data showed qoq growth of seasonally-adjusted nominal sales. Oil companies are kept out as the administered price of diesel and kerosene will affect their nominal sales values. Finance is kept out as the definition of sales is not fully compatible with that of other services and goods. Since the figure is nominal its interpretation should be mindful of inflation. But if the WPI is not rising, then looking at these growth rates is meaningful. The figure shows that the growth rate of sales has now been rising for four quarters in a row. This is in contrast to the situation in the last two years when sales growth continued to decline quarter after quarter.

Figure 3:

We next look at profit margins, or, the net profit (after tax) as a ratio of net sales of non-oil, non-finance listed firms

(figure 4). Conditions for investment are created only after firms see an increase in their profit margins. Here we see that in the last two quarters, profit margins have stopped declining. The data suggests that it is still too soon to say if profit margins have started recovering. We should wait and watch what happens to margins for at least two more quarters before drawing such a conclusion.

Figure 4:

What might have driven these improvements in the firm indicators? While investment indicators have stopped worsening, they are still to show a steady improvement that would be enough to push up sales. Many project clearances have been given, but most of those do not appear to have translated into action on the ground yet. It seems that a serious driver of the improvement is the improvement in exports. Figure 5 shows yoy and the three-month centered moving average of annualised month-on-month change in seasonally-adjusted merchandise exports measured in dollars. This showed a sharp increase and then a sudden slump in export growth.

Figure 5:

Looking forward, can we expect the recovery to continue? The latest US jobs data is further indicating an improvement in business cycle conditions in the US. In the period before the financial crisis, Indian business cycles were highly correlated with global ones. After the crisis, it was felt that the two had decoupled as India continued to grow when the world was slowing down. The same happened with many other emerging economies. However, lately, we have come to understand that the fiscal and monetary stimulus that was able to keep growth from falling in emerging economies has now lost most of its impact. Now that these economies have slowed down and large deficits and inflation have started hurting these economies, the question of decoupling is being revisited. So if the US economy recovers and Indian exports do well, we may expect to see the upturn continuing.

However, there are three caveats. First, infrastructure such as power can pose a constraint to further growth. While textile and leather exports have picked up they could, at some point, hit constraints posed by power availability and port capacity. This suggests that if exports growth has to continue then infrastructure issues would need to be solved. In the immediate future, there may be space capacity and we might see a sudden pick up in exports, but it may become difficult to sustain these unless those constraints are addressed.

Second, if the real exchange rate appreciates, Indian exports could lose competitiveness. This could happen because of an appreciation of the rupee or an increase in the inflation rate. Indeed, very roughly, if the inflation differential between India and the US is 8%, then an annual depreciation of the rupee of about 8% would keep the real exchange rate between the rupee and the dollar where it is today.

Third, finance may pose a constraint as many companies, especially infrastructure companies have damaged balance sheets. Banks have rising NPAs and until the financial health of companies and banks improves, fast recovery will be difficult.

In summary, we are seeing small signs of an improvement in business cycle conditions in India. Looking ahead at the next quarter, these are likely to continue. At the same time, if some of the projects that have obtained clearances start operations, there may be further signs of a cyclical upturn.

Cereal offenders

Indian Express, 17th December 2013

Food inflation owes largely to agricultural markets being regulated by outdated laws.

The RBI governor, Raghuram Rajan, has a difficult task this week. He has to decide whether to keep interest rates constant or raise them - bearing in mind the possible taper of the US Fed's bond buying programme, a decline in industrial production and a rise in inflation. The sharp increase in consumer price-based inflation, to more than 11 per cent, has significantly added to the RBI's headache. The increase in inflation is mainly due to the nearly 15 per cent increase in food prices. This has been led by a 61 per cent increase in the price of vegetables. There are structural problems in agricultural markets, which continue to be regulated by old laws and require licences. Entry into these markets is not free and they remain uncompetitive. The rising demand for food has been met not by an increased supply but by a rise in prices instead.

The demand for vegetables, meat, milk, fish and other food items has been rising with rapid GDP growth and a rise in incomes. Rural demand has increased since 2008 as a result of the MGNREGA and rising rural wages. As income levels increase, the first change in people's consumption basket is in food items. Indian households start consuming more high protein products and fresh vegetables. This phenomenon is discernible in household consumption data. The share of cereals in total food consumption has declined as incomes have increased.

At the same time, after the global financial crisis, world commodity price inflation has decreased. Inflation in tradables, mainly manufactured goods, has been low. Consequently, households have to spend a smaller share of their income on non-food items. Relatively cheaper non-food items means that the share of disposable income available for the purchase of food has gone up. This has further increased the demand for food.

As we know, Indian agriculture is entirely private. If there was free entry into markets and they were competitive, we could expect a better supply response to the increase in demand. In cereals, some of the food inflation is due to higher minimum support prices. MSPs have risen faster than before because the export of cereals is now allowed and, since 2011, world prices are taken into account in their determination. But this does not explain the rise in the prices of vegetables, meat, etc, which are outside the purview of MSPs.

A second explanation is that the MSP system for cereals creates a pro-cereal bias in policy and production. The price system as well as the subsidies for inputs focus on cereals. This reduces the relative risk of growing them. Even though the price for non-cereals - cash crops, vegetables, etc - may be higher, their risk-adjusted returns are lower.

A third explanation often heard for the high food inflation is hoarding. It is argued that traders hoard food to push up prices. But this only explains the rise in the prices of non-perishables. Products like meat and fish, whose prices have also been rising, cannot be stored without cold storage facilities. They are more likely to go bad than see an increase in prices if they are hoarded. Also, hoarding may cause some price volatility but it cannot explain the persistently high inflation for five to seven years in a row.

The lack of a supply response can also be explained by the absence of free and competitive markets, and by laws that do not allow a customer to buy directly from the farmer without a licenced mandi trader as the go-between. On one hand, the Essential Commodities Act does not allow private persons to hold inventories of agricultural goods that are on the list of essential commodities because it assumes traders are speculators, black-marketeers and hoarders. On the other, the agricultural produce marketing committee acts do not allow people to transact without them.

The APMC acts were created in the Sixties and Seventies by various states to promote agricultural marketing. But these and the Essential Commodities Act created several barriers to the development of free and competitive agricultural markets. A licence for trade in agricultural products requires owning a shop/ godown. This has led to the monopoly of licenced traders. It is a major entry barrier for new entrepreneurs who, attracted by the high returns, may want to enter the market. But the licensing system prevents entry and thus competition. Some market yards were established many years ago and these do not have the space for the construction of new shops and godowns. No new licences are available in such a situation. Traders, commission agents and other functionaries organise themselves into associations, which generally do not easily allow the entry of new players. The law hinders both food processing and direct organised retail tie-ups with farmers.

Though the question of agricultural marketing reform has been under discussion for nearly a decade, no action has been taken. In 2003, the Central government, after holding consultations with state governments, and trade and industry representatives, formulated a model APMC act. This was circulated among the states. But until January 2013, only 16 states had amended their acts, and only six had notified the amended rules.

The lack of cold storage capacities and strong supply chains are a serious cause for concern. To be rectified, investment is required. But the inadequacy of public infrastructure such as roads, power supply, etc constrain profitable investment. The thousands of crores that are spent on food storage in India actually go towards storing cereals and building warehouses for the Food Corporation of India or for the public distribution system. Even according to the most lenient estimates, the leakages here are more than 50 per cent.

Central legislation dealing with essential commodities has been liberalised to remove the controls on the movement, storage and marketing of agricultural goods and abolish the licensing system. The number of commodities covered under the act has been reduced from 54 to seven. However, in order to contain the inflationary pressure on the prices of essential commodities, the government has been imposing stock limits on paddy, rice, pulses, sugar, edible oils, edible oil seeds as and when required. At times, as we saw recently, when Mamata Banerjee announced restrictions on the trade of potatoes, even state governments have been imposing restrictions. The ad-hoc approach to the imposition of controls on stock limits and the movement of produce goes against the spirit of reforms, and hinders investment and free trade in the country.