Much like an offseason spell of showers, this may come as a surprise. Most of what you've been made to believe about the monsoon and its effect on inflation has been misleading. At least, this is what a study of official data indicates. The rain gods play a small role, if any, in influencing the prices of food items. In fact, there has been little correlation between poor monsoons and food prices in India, despite what market commentators, economists and policymakers would have us believe. Official data for the past 17 years indicates that insufficient monsoons have not had a parallel or lagged impact on production of food grains in the country.
On the contrary, production has been rising steadily owing to the improved irrigation system and better farm yield. It must also be considered that statistical models and sophisticated technology have not been able to predict the rains accurately. Between 2001 and 2009, monsoon predictions have been accurate only twice.
The Indian Meteorological Department seems to be throwing darts but rarely hitting the target (see Predicting the Rains). Now, following the recent rains, commentators will claim that the year-onyear inflation is likely to cool down, reinforcing the myth that inflation depends on monsoons. What they don't say, but should, is that the base effect will play a role in inflation mathematics and the figure will look better than expected. Politicians, central bankers and economists will be commended for reining in inflation even though the prices are the same as those in the previous week. A low year-on-year inflation only means that prices have not gone up as fast as they did in the same period last year, not that they have been brought down. The graphs on the following pages clearly demonstrate that food prices have only gone up.
Even when the production of food grains increased from 191 million tonnes to 232 million tonnes, a rate similar to the growth in population, the Primary Inflation Index went up by 162% from 115 to 302. The data also indicates that the production of foodgrains is not solely dependent on the monsoon, or the extent of its deviation from the long period average (LPA). In fact, the LPA itself has come down over the past seven years due to deficient rains. Statistics show that a rise in the inflation rate in India is rarely dependent on the monsoon or a result of lack of rains (see Impact of Rainfall on Inflation).
In the first half of the current decade, despite deficient rainfall in four years, the year-on-year primary inflation was benign. The meteoric food price inflation during the past five years is despite the record food grain production during this period. In October 2009, the economic advisory council to the prime minister projected a 2% decline in food grain production in 2009-10.
But the estimates were revised to a 0.2% growth despite a 23% deficiency in rainfall during the period. A careful study of statistics reveals the true determinants of food price inflation. They are land and oil prices, exchange rates of the domestic currency, the opportunity cost that farmers have to incur and the prevalent interest rates. For any production unit, the land value and transportation cost are the two major components in pricing farm produce.
As the land's price goes up, the farmer's equity value (or capital) in the farm increases, forcing him to raise the selling price so as to retain his return on capital. If the industry has the right to raise the selling price when the cost of raw materials goes up, so does the farmer when his nominal capital cost, in the form of land, increases. Land values in most parts of India have gone up over the past decade, which naturally translates into a higher selling price for farm produce.
Among the many reasons for the increase in land prices are increasing urbanisation and the government's industrialisation policy, popularly known as the special economic zones (SEZs). Another factor that influences the prices of assets - land in this case - is the exchange value of the domestic currency. The Indian rupee has depreciated against the US dollar by about 20% over the past four years and 96% against gold, the real hard currency. This implies that the land prices in India have gone up during this period.
We must also consider as an important factor the transportation cost, which contributes 15-20% to the prices of agricultural products at the final selling point. This cost depends on international oil prices. Crude oil, at $80 a barrel, is currently trading at over six times from a decade ago. More importantly, retail auto fuel prices are at their highest, more than what they were when crude oil prices in the global markets hit $147 a barrel in mid-2008. Opportunity cost is another variable determining the price of farm produce.
The difference in earnings, based on a farmer's choice to continue ploughing the field and not to cash out, sell his land and put the money in bank, will be reflected in the cost of the product. After a steep rise in land prices, if a farmer were to sell his land and convert it into cash, the interest it would have earned wouldn't have been substantially less than the earnings from farming. Agricultural prices tend to rise as farmers demand a fair compensation for continuing to remain in the profession. So, understand that rain gods have little control over the factors that actually lie in the domain of central bankers and politicians.
The writer is Vice-President, Research & Market Strategy, Khandwala Securities