Monday, March 29, 2010

The challenges facing fertilizer subsidy reforms

I have blogged a few days back about how the Government of India proposes to reform the fertilizer subsidy regime by immediately migrating to a nutrient-based subsidy regime and then gradually moving to direct cash transfers into the farmer's UID-linked bank account.

Despite its apparent conceptual simplicity, especially given the possibility of a UID-linked beneficiary account in the coming months, there are several important challenges that will need to be addressed before such direct cash transfers and price decontrol can be successfully implemented. Here are a three problems that are certain to come in the way of any attempt to dispense off with the dual pricing system and transfer subsidies as direct cash support.

1. Beneficiary targeting - The fundamental requirement in delivering fertilizer subsidies as direct cash transfers is the accurate identification of its target group. In the Indian context, there is the important distinction to be made between farm land owners (mostly absentee) and actual cultivators (or tenants). However, since tenancy has been abolished across most parts of India, existing land regulations and records recognize only the land owner and does not acknowledge the rights of the tenant.

In the absence of any legally certified record that establishes the identity of the actual cultivator, it becomes impossible to administer a cash transfer scheme for fertilizer subsidies. It is for this reason that the largest beneficiaries of the recent loan waiver scheme were the absentee landlords (crop loans are given based on the existing land records which acknowledge only the landlords).

Further, even assuming the cultivator status is established, means-tested targeting would require identification of beneficiary farmers based on some objective farming-related parameter - say, the extent of land ownership or cultivation. However, given the abysmal shape of our land records, the veracity of any such identification will remain questionable.

In view of the problems in identification based on cultivation status, the most effective proxy for targeting farmers will be their income levels, established based on some relatively accurate database, like the PDS card issued. It can be mandated that only the Below Poverty Line (BPL) farmers will be eligible for fertilizer subsidies. The cash subsidy can then be delivered to their UID-linked account.

Another option to deliver the subsidy would be to use time-dated (so that it would not be used after the season) and UID-linked bar-coded vouchers. The vouchers could be issued to eligible farmers who would then pay the market price and get the subsidy redeemed to their UID-linked bank account when the bar-code is swiped. With appropriate controls to restrict the amounts that can be transferred to any UID-linked account, the extent of subsidy delivered to any one farmer can be restricted.

Though the accurate identification of the beneficiary farmers to be given the vouchers in the first place will remain a problem, any leakages arising from too liberal a coverage (of beneficiaries) can be substantially limited with the subsequent aforementioned controls.

2. Ensuring availability - As this Businessline story documents, the success or otherwise of the fully decontrolled regime will critically depend on curbing speculative tendencies in the market and thereby ensuring adequate availability of stocks. I have blogged about the strong incentives to game the market in the case of a similar strategy to deliver PDS through private shops by abolishing the dual-price system.

This is more so in the case of DAP and MoP, the two most consumed fertilizers after urea, due to their use-pattern and import dependency. Fertilizers prices are especially vulnerable to market manipulation given the limited number of manufacturers, large share of imports, and narrow consumption window. For example unlike urea which is applied throughout the crop cycle, DAP is a nutrient required for root establishment and which farmers apply primarily as a basal dressing just before sowing (for wheat DAP is to be applied only during planting in November-December). Given this, there is the strong possibility of demand spikes and price rises unless adequate and timely availability is ensured during such times. It also means that the bulk of Indian imports should be concentrated in October-December, when the demand in other major users/importers is low due to severe winter.

Further, while three-fourths of urea consumed is produced domestically, domestic output meets only 30-40% of demand of DAP and the entire annual consumption of 44-45 lt of MoP is imported. Further, underlining the sensitivity of global market prices to India's imports, India formed 40% of global DAP imports in 2009, 58% of phosphoric acid, and 31% of rock phosphate.

Even under the proposed NBS scheme, distribution and movement controls (not price controls) under the Essential Commodities Act, 1955 would remain on up to 20% of the production and imports of these products so as to ensure adequate supplies in under-served areas. The government should use this 20% quota available to ensure adequate availability of these fertilizers, especially during the planting seasons. This should be complemented with very firm efforts to crackdown on hoarding and other activities that cause scarcity.

3. Cushioning against price volatility - Decontrolled prices mean that the domestic farm-gate fertilizer prices will now be substantially determined by international markets, especially since many of these fertilizers are predominantly imported, one way or the other. Given the widespread political opposition to decontrolling the similarly global market dependent petroleum prices, the Union Government will face strong pressures to intervene especially during periods of oil price spikes.

Further, despite the generous subsidies to placate the powerful fertilizer companies and also discourage them from raising their MRP, the incentives to indulge in price gouging will continue to be strong.

However, in due course of time, a more closely integrated pan-national market for such products, as against the highly fragmented and localized existing markets, coupled with more easy access to market information for farmers, will limit/contain the possibilities for such price manipulation.

In order to off-set any volatility in global market prices, there have been calls to maintain a strategic reserve of DAP and MoP. While this may be politically attractive, it poses numerous problems of incentive distortions and administration challenges that bedevil existing programs like the PDS.

An effective alternative would be to help farmers access the forwards and futures market for fertilizer products and hedge for such volatility. This could be done either at the individual farmer level or more effectively at the level of farmers groups or co-operatives. Customized and user friendly financial market products, which are readily accessible, can dramatically expand the use of such hedging instruments.

By clearly defining the unit subsidies on each element for the full year, the proposed NBS regime removes all regulatory uncertainties for the producers and leaves them to address only the market risks. It is therefore important that they too hedge for input price volatility risks with futures and forwards contracts.

In any case, given the pervasive market failures, especially in markets with strong legacy of political interference and regulatory controls, all such perverse tendencies will continue to surface at some time or other at all levels. In order to deter such practices, governments, especially at the state level, will have to show the commitment to immediately crackdown on such practices with firmness.

Incidentally all the same problems will remain with the NBS regime too.

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