On June 9, the union cabinet approved Minimum Support Prices (MSP) for the 2021-22 kharif marketing season. MSP for paddy, the most important kharif crop as far as procurement is concerned, will be ₹1940 per quintal, compared to ₹1868 last year. The press release issued by the Cabinet Committee on Economic Affairs (CCEA) says that the latest MSP offers a 50% mark-up over the projected cost of cultivation in 2021-22.
The cost measure which has been used in calculating this mark-up is the A2+FL category. This has been described, in the CCEA release, as a “comprehensive cost which includes all paid out costs such as those incurred on account of hired human labour, bullock labour, machine labour, rent paid for leased in land, expenses incurred on use of material inputs like seeds, fertilizers, manures, irrigation charges, depreciation on implements and farm buildings, interest on working capital, diesel/electricity for operation of pump sets etc., miscellaneous expenses and imputed value of family labour”.
To be sure, many farmer organisations have been demanding that the government use the C2 measure of cost of cultivation — this includes the imputed rental value of owned land and interest on value of owned fixed capital, thereby including the opportunity cost of practising agriculture — in making sure that MSP offers 50% returns.
This A2+FL versus C2 controversy notwithstanding, a more important question is worth our engagement. How useful is MSP when it comes to boosting rural demand for the economy at large? An HT analysis shows that the answer is complicated.
Nominal growth in MSPs has been low in recent years
Although the government claims that latest MSP announcements fulfil the 50% mark-up over A2+FL criteria, the increase in nominal terms is not much. Paddy and wheat MSPs for the 2021-22 kharif and rabi marketing seasons have increased by 3.9% and 2.6% respectively. A long-term analysis of MSP for paddy and wheat, the two most important crops which are procured, shows that nominal growth in MSP has been declining under the second Narendra Modi government.
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While the first Modi government increased nominal MSPs at a slower pace than the rate of increase in most years under the first and second United Progressive Alliance (UPA) governments, it announced a big hike in the 2018-19 marketing season, which could have been tactically aligned with the 2019 elections.
Chart 1 here
Nominal MSPs are not enough to access the demand impact
To be sure, nominal MSP growth numbers could be misleading as far as its impact on farm incomes and hence rural demand is concerned. Here is why. MSPs, directly or indirectly (in terms of creating a price floor), affect the prices received by farmers, and hence their nominal incomes. Demand, on the other hand, is a function of purchasing power, which is determined by relative prices.
An example can make this clear. A wheat growing farmer sells his wheat and expects to use his earnings to buy other things. Let us assume that the farmer in question wants to buy a fertiliser, motorcycle and tractor with his earnings. If wheat prices double in a year and motorcycle, fertiliser and tractor prices increase by only one-and-a-half times, then the farmer is in an advantageous position. However, if wheat prices increase at a slower rate than other commodities, then the farmer is at a disadvantage.
The best way to capture this dynamic is to look at the terms of trade — ratio of prices received and prices paid — for agriculture. The ministry of agriculture publishes this data. This is better than a simplistic retail inflation (as measured by the Consumer Price Index for rural areas) comparison because farmers are both consumers and producers at the same time. As is obvious from the list of commodities given above, the motorcycle, fertiliser and tractor capture spending by the farmer on consumption, intermediate and capital goods. A typical CPI index is not meant to capture prices of intermediate or capital goods.
Unfortunately, terms of trade data are available with a time-lag and the latest numbers are for 2018-19. The statistics show that terms of trade were improving for farmers from 2004-05 to 2010-11, stagnated at unfavourable levels till 2016-17, and started declining after that. A worsening of terms of trade for farmers entails a decline in their purchasing power and therefore rural demand.
Chart 2 here
Disaggregating the terms of trade deterioration
Because the headline terms of trade number is contingent on what is happening to prices of consumption, intermediate and capital goods, it is important to find out the relative contribution of these items.
The ministry of agriculture data actually gives the index of prices paid for these three categories and their respective weights in a farmers’ spending basket. Intermediate consumption has the highest share of 43.4%, followed by final consumption (38.2%) and capital formation (18.4%). Calculation of individual terms of trade — the ratio of prices received and paid — for each of these categories shows that headline terms of trade have deteriorated despite an improvement in terms of trade for intermediate consumption.
Chart 3 here
The rural wage factor in intermediate consumption terms of trade
What explains the improvement in intermediate consumption terms of trade while the other two heads have deteriorated? A rural wage squeeze could be the answer.
Wages account for more than 60% and almost one-third of A2+FL cost of cultivation for paddy and wheat. Rural wages, which were rising at a fast pace until 2014-15, have stagnated in the recent past. This is bound to have generated headwinds for intermediate costs for farmers and hence overall cost of cultivation.
However, this is likely to have generated a second order squeeze on rural demand. If agricultural labour and farmers experience a squeeze on income (rural wages and imputed value of wages), this will put a pressure on purchasing power and therefore rural component of aggregate demand, including that for farmers. Large parts of India’s rural poor are also net buyers of food items.
Chart 4 here
The chicken-egg connection between terms of trade for agriculture and aggregate demand
The discussion so far underlines an interesting paradox in the Indian economy. Even though the government is offering remunerative MSPs year after year, this might not have generated strong tailwinds for overall demand because the terms of trade for farmers have been deteriorating leading to a squeeze on their purchasing power. Of course, the situation would be worse if MSPs did not exist.
Two factors might further worsen the terms of trade for farmers going forward. The profit-led nature of recovery and poor labour market conditions in the post-pandemic phase will further squeeze mass incomes and hence demand for food items, putting downward pressure on prices. A rise in the cost of items such as diesel and some fertilisers (the government has announced a hike in subsidies for urea) could lead to the actual cost of cultivation being higher than the projected costs used for calculating the latest MSPs, which only started rising after May 2021.
“It is unrealistic to think that the farm economy will keep delivering even though the non-farm part is in crisis. Farm sector is the shock absorber in terms of the labour market and the longer it takes for the non-farm labour market to recover, the more difficult the farm sector will find to cushion incomes”, said Himanshu, an associate professor of economics at Jawaharlal Nehru University. “This is why it is important that the government provides a fiscal stimulus to both the labour-intensive component of both farm and non-farm sectors”, he added.