Sunday, May 11, 2008

Steel market parable

Econ 101 teaches us that in an open global economy, if there are world-wide supply side constraints on commodities and rising demand, their prices should rise. As prices go up, consumers will cut down their consumption and look for substitutes, while producers will look to increasing their production. Over time, the twin effects of these two actions will shift the supply curve up and the demand curve down, thereby lowering prices. This is all the more true in markets with multiple suppliers, where monopoly behaviour is less likely. We are told that there is little that governments can do with monetary or other policy levers to lower prices. And so the story goes.

Now consider this sequence of events. First, led by high global iron ore and commodity prices, domestic steel prices rise to historic highs, touching Rs 58000 per tonne in April. Second, inflation figures touch an all-time high of 7.6%, threatening India's economic growth. Third, the Government of India intervenes with a slew of measures, including export bans and reduction in import duties, so as to ease supply side constraints and lower prices. Fourth, steel prices continue to remain up, as producers refrain from lowering prices, citing high global prices. In fact, the steel producers increase prices in two phases in April by including a raw material surcharge of Rs 5000 per tonne.

Fifth, though the Government had talked tough all the while, producers refuse to back down. Sixth, then the Prime Minister of India holds a meeting with all the major steel producers. Finally, an agreement is announced wherein, the steel producers agree to slash prices of flat steel by Rs 4000 per tonne, with immediate effect.

What prompted the steel producers to lower prices? I will not buy the arguement that the steel producers agreed to lower prices because Government agreed to keep export duties in abeyance for two reasons - exports form a small share of the total production and not all steel producers benefit from the non-imposition of export duties. In any case, the total revenues foregone by steel producers by way of lowering prices is much more than the marginal incomes gained by the postponement of export duties.

I cannot agree with the contention that high global commodity prices are behind high steel prices and therefore prices cannot be lowered without a fall in global prices. If that were so, then steel and commodity prices have not changed much in recent days to merit a reconsideration in prices now. Further, there are enough producers in India (I could count atleast 14 of them) for our steel market to be classified as competitive. Also, it strains credulity to hope that our steel producers would give in and lower prices even if it meant unacceptably large hits on their bottom-lines.

Where did the Econ 101 story go wrong? What is to be inferred from the aforementioned sequence of events? Did the steel producers indulge in cartel behaviour in the first instance? Did they lower the prices out of altruism (public interest) or in response arm-twisting by the Government? If it were the former, would the producers have lowered prices without any Government intervention? If they lowered prices in reponse to Government arm-twisting, will it not adversely affect the bottom-lines of these companies? Did Government intervention succeed where the market mechanism failed? Will the steel producers have lowered prices if there was no Government intervention?

I am inclined to believe that national Governments continue to have an important role in such crisis situations, in bargaining and wresting out concessions from producers, especially in more organized markets like that for steel and cement. This is despite the emergence of an increasingly integrated global market place. Fiscal and monetary policy measures which are not supplemented by government guidance (read hard talk) is less likely to have the desired impact, especially in very tight market conditions.

No comments: