Monday, October 3, 2011

Impact of cash transfers in an economy with large fiscal transfers

For its extraordinary, almost global size, India's flagship National Employment Guarantee Scheme (NREGS) remains one of the least evaluated of anti-poverty programs anywhere in the world. For example, how has the massive NREGS cash transfers to rural consumers affected wages and local price levels? More generally, what is NREGS contribution to India's persistent food inflation? Or more specifically, how is the additional disposable income generated by NREGS being spent?

Unfortunately, there is no rigorus enough empirical study of the impact of world's largest cash transfer program on rural wages and resultant inflation. In a related context, Jesse M. Cunha, Giacomo De Giorgi, and Seema Jayachandran compared the relative local price effects of cash and in-kind transfers by studying a large food assistance program in Mexico that randomly assigned villages to receive boxes of food (trucked into the village), equivalently-valued cash transfers, or no transfers and found,

"Both types of transfers increase the demand for normal goods, but only in-kind transfers also increase supply. Hence, in-kind transfers should lead to lower prices than cash transfers, which helps consumers at the expense of local producers...

The price increase caused by cash transfers, based on the point estimates, offsets the direct transfer by 6 percent for recipients who are consumers of these goods. Meanwhile, for in-kind transfers, the price effects represent an indirect benefit to consumers equal to 5 percent of the direct benefit. Thus, choosing in-kind rather than cash transfers in this setting generates extra indirect transfers to the poor equal to 11 percent of the direct transfer. Of course, the welfare implications are reversed if transfers recipients are producers rather than consumers.

We also find that agricultural profits increase in cash villages, where food prices rose, more so than in in-kind villages where prices fell. These effects are due both to the change in the price of goods sold, but also to households responding by producing more (less) when the price of what they produce increases (decreases)."

The study also finds that price effects were particularly pronounced for very geographically isolcated villages, where the most impoverished people live. This is consistent with the fact that these villages are less open to trade and have less market competition, and are therefore more likely to be supply constrained in case of cash transfers. In these cases, the in-kind transfers actually increases supply and lowers prices.

The authors point to two issues that needs to be factored in while calculating the price benefits. One, their study does not look into what kind of effect is generated in the long-term, when the higher prices would signal to increase local production, thereby easing supply constraints. In fact, its long-term benefits are far more than that arising from external in-kind supply.

More importantly, there is the issue of how much does in-kind transfers constrain households' choices or conversely how much does cash transfers increase households' choices. As the authors point out, it is quite possible that an efficient private sector would create more surplus than if the inefficient government were the supplier. So they suggest that the best alternative would a mixture of cash transfers and policies to ease supply-side constraints.

Extending this analysis to NREGS and India will yield interesting possibilities. In India, we currently have a deeply supply constrained market where inflation expectations are on the rise. In such markets, any cash transfer would do little to increase supply. It increases the cash available with consumers, without doing much to boost supply, atleast in the short- to medium-term. Increased prices are inevitable. This increase in prices affect both the specific commodity being subsidized and the general price level.

Consider a cash transfer in place of rice supply through the Public Distribution System (PDS). Assume a family requires 60 kg of rice per month and gets cash equivalent of 35 kg of rice. Let us also assume that the subsidies are calibrated to price variability. Let us assume that there is only one variant of rice available in these remote markets and its price is Rs 15 per kg before the new cash transfer scheme is introduced. In supply-constrained markets (and remote interiors are classic examples of supply-constrained markets), which also experience government fiscal spending, prices generally increase and the following two effects are observed.

1. The beneficiary gets only a portion of his rice through the PDS. He has to purchase the rest from the market at market prices. In this case, he purchases 25 kg from the open market. After the cash transfer scheme is introduced, the price of rice increases to Rs 20 per kg (since the PDS supplies, which is not an insignficant share of total supply in such small markets, is now not available and has to come from the general market supply). He still continues to get cash equivalent to 35 kg. But now he has to shell out an extra Rs 125 per month for the same amount of rice the family was consuming before the program was introduced.

In contrast, with in-kind transfer, let us assume that the price falls (or it could remain the same) by say Rs 2 per kg after its introduction. This in turn leaves the farmer with a savings of Rs 50 per month. The difference between the two programs, with these assumptions, is therefore Rs 175.

2. There is also the likely spill-over effect on the general price level due to the increase in the price of rice. Further, the additional disposable incomes generated by way of NREGS and the resultant higher rural wages, will increase the demand for other items, mainly meat and other protein foods. Econ 101 would tells us that, when supply remains the same (which is likely to be the case with most products, atleast in the medium term), additional incomes (or higher aggregate demand) will have the effect of increasing the general price level.

All this in turn increases the burden on the family by say, Rs 100. Taken together, both these effects have the effect of reducing the real income of rural household by Rs 225 per month. The combined effect of cash transfers in an NREGS context is captured in the graph below. Note that it is possible that even the actual aggregate consumption could fall, rather than increase, especially if inflationary pressures get out of hand.

This highlights the importance of easing supply-side constraints in ensuring the effectiveness of any cash transfer scheme. In fact, taken together with NREGS, cash transfers could, without policies to increase supply, exacerbate inflationary pressures. Whatever the analysis, India's biggest obstacle to growth and successful implementation of process reforms that can increase growth, is a deeply supply-constrained economy. Its inflation problems too are just a symptom of supply bottlenecks.


Yasser said...

Thank you, it was informative. I was wondering what would happen to electricty markets in India when direct cash transfers are introduced and there is no ease on the supply side.

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