The real cause of food inflation

Aug 18, 2014

In this issue:
» Do firms with pledged shares manipulate earnings?
» Why the business matters more than the management
» New weapons of mass destructions invented by Wall Street!
» What to expect from the Jackson Hole meeting...
» And more!

If we were to conduct a poll about the most important problem facing the common man; we are quite sure that food inflation would be the top issue on most people's minds. It affects us all and there is no escaping it. We have already highlighted the reason for India's structural inflation problem. Now let us have a look at food inflation in particular.

Agri products are different from other commodities, like metals, in two important ways. Firstly, they are consumed quickly and cannot be stored for long periods. Secondly, demand keeps growing at a steady pace with the growth in population. Thus, food prices are vulnerable to spikes whenever there is a disruption in supply. This is why the monsoons and hoarding are always blamed whenever there is a sharp rise in food prices. But this is not the entire story. Hoarders can have a limited impact on prices, for a few months at most and their influence varies across regions and different types of agri commodities. The monsoons will cause a rise in prices only when it is deficient in any particular year. So what explains the continuous rise in prices year after year?

Many people have blamed NREGA. The employment guarantee scheme has been much criticised for driving up rural wages and thereby causing food inflation. However, the RBI governor, Raghuram Rajan, may have hinted at the real cause of food inflation. Rajan recently defended NREGA. He stated that honest studies have shown its effect on rural wages was just about 10%. The remaining 90% can be attributed to factors like higher Minimum Support Prices (MSP), the shift of labor to the construction sector and the gradual withdrawal of women from agricultural labour. We believe that the RBI governor has hit the nail on the head. After all, rural folk would not have spent the higher income they received from NREGA entirely on food.

Thus the real cause of food inflation in India must be due to factors like MSPs for various crops. The government sets minimum support price (MSP) for various products every season. State agri agencies or the Food Corporation of India (FCI) then purchases the agri produce from farmers at this price. The idea behind the MSP is to give the farmer an idea of how much he should expect to earn when he sells his produce. In reality, this is not an economic issue. MSPs have been misused by politicians for decades. MSPs have been increased for political reasons without any consideration about the consequences. This has led to the present situation where no party will dare reduce MSPs for fear of a backlash from rural voters. Does this mean that high food prices are here to stay? If so, then the RBI may not reduce interest rates anytime soon. This could have serious implications for the markets.

We will not like to be so pessimistic. Food inflation can be tackled by prudent policies. The government will have to allow farmers to sell their produce directly to retailers by cutting out the middlemen. In this regard, the APMC Act will need further amendments. A nation-wide cold storage chain will help to transport produce across the country with minimum losses. Also, bringing the entire arable land in the country under irrigation will rid the agricultural sector's dependence on the monsoons. If these steps are taken, they will go a long way to make the whole idea of MSPs redundant. In such a situation, food prices will be driven by real demand and supply factors. It would result in fall in food inflation. This will give enough room to the RBI to reduce interest rates, thereby giving a boost to the Indian economy.

Do you think Minimum Support Prices are the number one factor for high food inflation? Let us know in the Equitymaster Club or share your comments below.

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 Chart of the day
Not only investors but even promoters seem to have benefited from the current bull-run. A rise in stock price is being used as an opportunity to release their pledged shares. As can be seen in today's chart, promoters of JP Associates have released 225 m shares of JP Power Ventures, constituting about 7.7% of the equity capital of the company since April 01. Various other companies have also queued up to release their pledged shares.

First, let us understand why promoters pledge shares. Then we will see how a rise in price helps in un-pledging shares. Promoters typically pledge shares as a security whenever they take a loan which is to be infused in the company. These shares are released once they repay their loan. Until then, these shares act as a security to the lender. However, a rise in price also helps promoter's un-pledge their shares. As the value of the share price increases the total amount of security lying with the lender also increases. For instance let's assume on pledging shares worth Rs 100 promoters got a loan of Rs 80. The pledge amount is generally high than the loan given as share price is highly volatile. Now let's assume that share price rises subsequently. In that event, the value of the security lying with the lender also rises. This allows the promoter to free up few of his shares. The lender is also willing to release the shares as he has adequate security cover. This is precisely what has happened now. However, the risk lies when share prices decline. It is during that time the security cover falls and lender may sell shares to cover his losses if the promoter is unable to repay. As such, companies with high promoter pledge are risky in that sense. Hence, investors should be extremely careful and analyze the pledge percentage before buying shares of any company.

Will these stocks see better days?

It would not be wrong in saying that ever since SEBI made it mandatory for companies to disclose their pledged shares information, such data has often spooked investors. Nevertheless, there seems to be a positive side to this development as well. Given that the lending firms tend to closely monitor the financial position of companies that avail such a facility, it does tend to lead to less accounting manipulations of the borrowing companies; if one were to go by the findings of a particular research paper. As reported in the Business Standard, promoters were less likely to manipulate earnings after pledging. It is believed that 142 companies out of the BSE-500 companies have pledged shares, with the largest percentage coming from the infrastructure, real estate, shipping and power sectors.

While the data revealed through such disclosures may make investors worried in bear periods, the same may not hold true when markets are booming as the possibility of this percentage coming down is higher. We would nevertheless suggest that investors stay away from companies that rely on this facility too often. Regarding the earning manipulation aspect of it, the fact of the matter is that it is widespread in the country; the motivation behind the same is to meet earnings targets. This only indicates the need for better and stricter regulation.

What do you think happens when a management with a good reputation meets a bad business? Buffett was quite clear on this and opined that it is the reputation of the business that usually prevails. In other words, no matter how good the management, chances are very strong that when they take over a bad business, they will not be able to turn it around. Need a real life example of this? How about the whole Vijay Mallya and his Kingfisher Airlines saga? Before Mallya decided to take Kingfisher to the skies, he was widely touted as some sort of a maverick. A man who could do no wrong as far as marketing and branding exploits are concerned.

But then Kingfisher Airlines happened and it was not difficult to conclude that Mallya flourished earlier more due to the solid economics of the liquor business and not because he had some sort of a magic wand. So much so that the airlines has punched a hole so big that it may not fall alone but also take Mallya's crown jewel, its liquor business, down with it. Of course, as a leading business daily writes, for now, Mallya has found a much needed backer in Diageo. But there's really a huge question mark over how long the arrangement can continue. Well, what is the investing lesson one can learn? It is to always give the business fundamentals more weightage than the quality of management. And we cannot emphasise this enough we believe.

They were called weapons of mass destruction! But that was back in 2008. Six years hence Wall Street seems to have found its lost love for derivatives. And the too big to fail banks are once again at the forefront of creating new toxic products. Names like JP Morgan and Goldman Sachs were associated with toxic instruments like CDOs post Lehman bankruptcy. It seems these firms have learnt no lesson and are back to their notorious tactics putting the global financial system at risk! As per Bloomberg, Goldman Sachs is planning as much as 10 billion Euros (US$ 13.4 billion) of structured investments that bundle debt into top-rated securities. J P Morgan Chase is offering a swap contract that makes it easier for investors to wager on the debt. Thus while the big banks are back to vetting investors' risk appetite, the regulators are hardly prepared to avert another 2008 like crash. One can only hope that Western central banks, including the US Fed, take the RBI's warning signals more seriously!

An important economic event is scheduled this week. The world's top economists and central bankers and Fed officials will come together at Jackson Hole, Wyoming for the annual meeting to discuss the monetary and economic policies. Few years back, QE2 - an event that moved the markets and changed the global economy for the worse was announced in one such meeting.

Events like these are keenly eyed by the markets for directions. Now that the US economy is showing some signs of a recovery, there is a lot of curiosity regarding when the Fed will go ahead with the first rate hike. However, this particular event, while it may offer some clues, is unlikely to give a clear signal. Going by the title of the meeting, the focus is more likely to be on the labour markets than monetary policy this time. Already we are familiar with Ms Janet Yellen's stance. She claims to be adding to 'demand' by keeping interest rates at their lowest level ever. Hence, we will not be surprised to if the meeting creates no waves in the financial markets across the world.

The Indian stock markets continued to trade firm in the afternoon trading session. At the time of writing, the BSE-Sensex was trading up by 209 points (+0.75%). Barring IT sector, all the sectoral indices were trading in the green. capital goods sector and oil and gas sector were witnessing maximum buying interest. Asian markets were trading mixed with the markets in Taiwan and Korea trading in the red. However, the Japanese market is trading in the green. European markets have opened the day on a firm note.

 Today's investing mantra
"We want to be right on something that will work right now, not something that might work in the future." - Warren Buffett

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Equitymaster requests your view! Post a comment on "The real cause of food inflation". Click here!

14 Responses to "The real cause of food inflation"

Parin Thacker

Aug 20, 2014

I am not an expert on Food Inflation, but I can understand that arbitrarily determined MSP (fixed) must be replaced by profitability based MSP. I am referring to what BJP has in its manifesto for LS 2014 elections.

Like (2)


Aug 19, 2014

I am an agri-businessman. I own cold storages, FCI godowns and trade in agri-commodities.
NREGA has definitely caused food inflation as this has resulted in higher operations cost in most rural based production/warehousing facilities. The contract labour cost has risen by 100% in the last 4years. However the real cause of inflation is the erratic weather & floods over the past few years.e.g we had a bumper potato harvest this year however due to floods in Orissa & crop failure in Bihar the prices have shot up. It’s basically demand & supply. Currently, in West Bengal the market price of potatoes is Rs. 20/- a kg because of greater demand from neighbouring states but the Govt. has set-up a MSP of Rs. 12/- and thereby controlling on price rise, the purchase price during harvest was Rs. 9/-per kg. I think the real solution lies in govt active participation in crop production/management and supply chain infrastructure (pre-cooling, efficient transport but not cold storage) from farm to fork.

P.S: The govt is selling rice at Rs. 2 per kg at ration outlets. The paddy MSP to farmer is Rs. 13/- per Kg and to rice miller is Rs. 20/- per kg!

Like (4)

vinod mahajan

Aug 19, 2014

Further I would like to add that the very purpose of FCI is defeated as I understand that the purpose was to intervene in the market if it heats up.But FCI continues to sit on huge stocks of food grains and letting them rot and then sell to big companies for making alcohol.They do not pay fair rent to the private people who make go downs and that is why people do not come forward to build storage go downs.They must encourage people to build go downs so that the wastage is eliminated

Like (2)

vinod mahajan

Aug 19, 2014

I believe that the biggest factor is the inadequate storage space for food grains and again inadequate arrangement for storage of perishable goods.Food corporation of India has become the biggest hoarder of food grains.The whole attention is directed towards procurement without taking into consideration the available storage space.Over the years FCI has ousted the private trade from procurement of food grains.This has resulted in non utilization of the storage space owned by the private traders.It is a known fact that a lot of grains stored by FCI are spoiled during storage,whereas a private trader does not allow any damage during storage.It is this colossal wastage which is responsible for steep rise in prices of food items

Like (2)

sundar rangan

Aug 19, 2014

Much has been said about need for nation-wide cold storage chain. But does anyone supervise or regulate how these cold storages function. During the recent onion scarcity, I came to know of a Gujarat based cold storage unit, which made huge profit at the cost of common man, by procuring large quantities of onion at throwaway prices from the farmers and hoarding in cold storage for days together and releasing when the prices crossed Rs 80. So unscrupulous businessmen are also a main cause of food inflation.

Like (2)

krishna murthy

Aug 19, 2014

PLEASE read Sunday Herald article by doorothy victor, dated 16.08.2014. We have created and practicing the theory like, Earlier Govt servants hardly works, now this got encompassed the entire nation. Nearly 65% of our population does not do any productive works which contributes to the national growth. Dole out money like minority, reservation, temple, politicians looting in different forms are the culprit and ills of the nation.

Like (3)

Rasikbhai Gandhi

Aug 18, 2014

2nd big reason for food and spices price rising is the steep rise in Dollar rate. As a result our exports have become cheaper for importers abroad and our own imports have become costlier. Even necessary food articles become costlier at this rate of Dollar.

Like (2)

K K Mehta

Aug 18, 2014

I think it is wrong to blame MSP as a bad idea. It is dichotomy, If we want to improve the life of poor people in agriculture and also provide some kind of assured returns as they can't afford swings in prices. If there is no MSP, yes food prices may come down a bit but that would amount to subsidising urban middle class at the cost of rural population. Right answer is improvement in supply-chain.

Like (2)


Aug 18, 2014

farmers get better than MSPin open marketfor all items except sugar cane.Price rise in vegetables is entirely due ti manipulative APMCs. you can see APMCs formed to maintain neatness in marketyards never do that duty.All our markets
stink.price fixation is to be done by auction as in grain markets.
Why these manipulative merchants should get low interest loans while savers get interest much below inflation.Till
inflation is brought down to zero levels,interest rate sholdnot be reduced

Like (2)

Rameshwar Gagrani

Aug 18, 2014

It is true that MSP is the real reason of food inflation. Government support the minimum price then how one can expect the price to go down ?
It is just like the guide line price of land and buildings fixed by government in cities. The government would not accept the registration of properties below the guideline prices. This causes inflation in property market. For the sake of revenue government is adamant on this issue. However government does not assure to buy the property at guideline price itself.

Like (2)
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