OPTIONS FOR RESTRUCTURING THE INDIAN WHEAT MARKET. Steve McCorriston (University of Exeter, UK) Donald MacLaren (University of Melbourne, Australia)

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1 OPTIONS FOR RESTRUCTURING THE INDIAN WHEAT MARKET Steve McCorriston (University of Exeter, UK) Donald MacLaren (University of Melbourne, Australia) THIS VERSION: 10 th FEBRUARY, 2011 Paper presented at the Final International Workshop on Facilitating Efficient Agricultural Markets in India: An Assessment of Competition and Regulatory Reform New Delhi, India, 15 th February, 2011 This research has been sponsored by the Australian Centre for International Agricultural Research (ACIAR)

2 OPTIONS FOR RESTRUCTURING THE INDIAN WHEAT MARKET Abstract In this paper, we consider the role of the Food Corporation of India currently plays in meeting the objectives of government policy via the procurement and distribution of wheat. We provide a quantitative analysis of current arrangements and consider alternatives whereby the role of the Food Corporation is reduced and the procurement and management of wheat is increasingly accounted for by the private sector. These issues are evaluated according to the degree of competitiveness in the private sector and where the government uses alternative policy instruments to meet its twin objectives of maintaining farm-level prices at a guaranteed level and where the provision of low-cost food to the most vulnerable is met through a food stamp programme. The results show that when the role of the Food Corporation is limited to only procurement for the buffer stock, there are considerable welfare improvements and both farmers and consumers benefit more when the marketing system becomes more competitive. This finding underlines that, to capture the full benefits from reform of the Food Corporation, a regulatory environment that encourages competition will become increasingly important.

3 OPTIONS FOR RESTRUCTURING THE INDIAN WHEAT MARKET 1. Introduction Pressures to reform government policy towards the Indian wheat and rice sectors have increased in recent years. Low productivity growth, a slowdown in investment, inefficient targeting of poor and vulnerable consumers, and the increasing cost of surplus stocks, have exposed the need for a re-evaluation of the effectiveness of agricultural policy aims and instruments currently employed in these key sectors. 1 Avoiding reform at this time will have consequences not only for poor farmers and vulnerable consumers directly affected by the inadequacies of the current arrangements but also for India s future growth prospects more generally. To sustain and support India s growth potential which has become apparent in recent years, policy reform that increases productivity and investment in agriculture while, at the same time, ensuring food security for the large proportion of the population that lies below the poverty line is a crucial combination that the Government of India needs to address. Notable in this regard is that while reform of the current policy arrangements is a key requisite for improving performance in the wheat and rice sectors and more effectively providing safety nets for the most vulnerable, success of the reform process will require complementary policies. These are required to ensure that these sectors are appropriately regulated and create an environment in which competition can develop while, at the same time, identifying the appropriate role for government in correcting market failures that cannot be appropriately resolved by the market. Key to addressing reforms in the Indian wheat and rice sectors is the role and functioning of the Food Corporation of India (FCI) which is the principal means 1 For a recent critique of India's food-grain policy, see Basu (2010). 2

4 through which the Government of India s management of these sectors is effected. Yet the functioning of the FCI is characterised by inefficiency. By being charged with dealing with various aspects of government policy, which are potentially conflicting, its very presence as a principal participant in the wheat and rice sectors stifles the role that private firms may play in these sectors. The purpose of this paper is to directly assess the role of the FCI in the Indian wheat market by considering possible reform options that may be used to meet the objectives of ensuring food security while, at the same time, permitting a more prominent role to be played by the private sector in the procurement and marketing of wheat. We do this in the context of a formal modelling framework that allows us to assess a range of alternatives and to evaluate the costs and benefits of current and alternative marketing arrangements across a variety of metrics relating to economic welfare and food security. The paper is organised as follows. In Section 2, we provide some background to the recent pressures for reform in the Indian wheat sector and comment on the role currently played by the FCI. In Section 3, we summarise the modelling exercise that is reported in this paper by comparing an environment in which private firms alone account for procurement (with respect to both domestic production and imports) and distribution to consumers with the case where the government agency alone fulfils these roles. Although this analysis is modelled using data from the Indian wheat sector, it is not intended to comprehensively represent the actual situation (as we at this stage omit other pertinent features of government policy in the wheat sector) but rather the intention is to fix in one s mind what the key issues are with respect to the debate on the private sector versus state marketing and procurement and to employ a range of different metrics against which to assess these issues. This forms the basis 3

5 for the discussion of the more specific role played by the FCI and the costs and benefits of reform of the current marketing arrangements as the private sector is allowed to play an increasing role in procurement and distribution with the proviso that food security to the most vulnerable is maintained. In Section 4, we consider a range of additional issues that relate to the role of the private sector and the potential costs of alternative policy instruments that could replace the functions currently carried out by the FCI including a policy of deficiency payments instead of procurement to maintain the Minimum Support Price and a food stamp programme as an alternative to the Targeted Public Distribution System. This analysis, therefore, ties in market reforms with the Government of India providing safety-net measures by other means, while reducing the dominance of the FCI in the market and the reliance on the FCI to meet three objectives. 2 In Section 5, we summarise the main insights from this research and the implications for the future path for reform in the Indian wheat sector. 2. Pressures for Reform in the Indian Wheat Sector The key feature of agricultural policy in India is to provide access to low-price staples such as wheat and rice especially to the poorest sections of society while, at the same time, supporting agricultural prices and promoting price stabilisation through the procurement and management of stocks of key commodities. These objectives are potentially incompatible especially when there is a single intermediary charged with implementing these policies, i.e., the Food Corporation of India. Furthermore, the 2 The objectives of the FCI are: (i) effective price support operations for safeguarding the interests of the farmers; (2) distribution of food-grains throughout the country for public distribution system; and (3) maintaining satisfactory level of operational and buffer stocks of food-grains to ensure National Food Security (FCI, 2011a). 4

6 combination of high support prices, coupled with the slower growth in demand and the inability to appropriately target poor consumers has led to the build up of excess stocks which have to be managed by the FCI. As a consequence, the food subsidy (the combined cost of the agricultural price support, the cost of distributing food to the poor and the costs of stockholding) has increased substantially in recent years and has placed considerable pressure on public expenditure. Specifically, by 2006, the food subsidy amounted to Rs.155 billion which was up from Rs.135 billion in 2000, and from Rs.130 billion in 1996 (Jha et al.,2007). The high and growing costs of the food subsidy, together with the annual loss of millions of tonnes of food-grains through inadequate storage, are the most evident signs of the pressure for policy reform. In more detail, farm prices are supported by the Minimum Support Price (MSP) which is aimed at providing income support to farmers. To effect the use of the MSP, the Government of India through the FCI will procure grain of fair-to-medium quality in surplus areas during harvest, with the support price for wheat being paid directly to farmers in the markets in which they sell their grain. The private sector which coexists with the FCI in the procurement of wheat tends to purchase grain of higher quality thus leaving the FCI to procure lower quality wheat. The wheat that is procured via the MSP is distributed as subsidised food to the poor, occasionally as exports or held as stocks. Though the MSP for wheat in real terms has declined since the 1970s (Jha et al., 2007), supporting prices at the farm-gate is one of the main mechanisms by which the Government of India can influence prices in agricultural markets and meet its objectives of farm price support and price stabilisation. 5

7 Ensuring access to low-priced food for the most vulnerable was the function of the Public Distribution System (PDS) which was the system for distributing subsidised staple foods through (approximately 500,000) fair price outlets. This system was reformed as the Targeted Public Distribution System (TPDS) in 1998/99 which increased the subsidy component of low-price food to consumers below the poverty line and with a higher price to those consumers above the poverty line. The cost of distributing subsidised food is considerable; Jha et al. note that prices for below-thepoverty-line consumers were per cent below the previous PDS prices and covered approximately one-third of the costs of the FCI subsidised distribution while prices to consumers above the poverty line covered around 60 per cent of the FCI s costs of distributing wheat. Other mechanisms by which the poor are targeted include food-for-work programmes and school lunches (see FCI (2011b) for a list of other welfare programmes involving subsidised food grains). International trade has been largely managed by the FCI. Traditionally, India has been a net importer of wheat but, with the increase in domestic production, it has become an occasional exporter to world markets. In more recent years, India has again faced a moderate wheat deficit and relied on imports from the world market. The principal mechanism for managing trade is the FCI which traditionally has maintained exclusive rights over exports and imports, thus maintaining a dominant role over all traded staple commodities. Even when private traders have been permitted to engage in trade, the FCI has retained its dominant role. The potential trade distorting effect of state trading enterprises such as the FCI in wheat and rice trade has been explored by McCorriston and MacLaren (2006) where they highlighted that managing trade in this way would be equivalent to an import tariff/export subsidy beyond the bound tariff 6

8 rates typically reported in publicly available documents. In other words, managing trade through the FCI acted as another distortion to trade beyond more standard trade policy instruments. Setting aside the issue of whether using support prices to raise farm incomes and subsidised prices to ensure access to food to the poorest are compatible aims of policy, especially when carried out by a single agency as the FCI, one of the features of the current operations of policy has been the inefficiency associated with the FCI in carrying out its principal functions. Despite the widespread coverage of the TPDS, most of the poor still rely on the commercial market for purchasing staples (Jha et al., 2007). Moreover, operating the TPDS is costly; Jha et al. report that, to transfer Rs.1.00 to the poor costs Rs3.14 in the State of Andhra Pradesh and Rs4.00 to transfer the same amount in the State of Maharashtra. Breaking down the costs of transferring subsidised food, per cent was due to high costs of grain transport, handling and storage, per cent was accounted for by transfers to non-poor households, and per cent due to so-called leakages where subsidised food finds its way back onto the commercial market. Ramaswami (2002) reports that only 32 per cent of subsidy expenditure reached the targeted groups in the State of Maharashtra. Persaud and Rosen (2003) also report comparable levels of costly distribution in the functioning of the PDS. More recently, Khera (2010) reports that 67 per cent of wheat aimed at the poor missed its target group. This brief overview of the Government of India s policy in the wheat sector clearly shows that current policy arrangements are both costly and ineffective. Further, the role of the FCI is the main mechanism by which wheat is procured, stored and 7

9 distributed and is the main means via which current policy objectives are met. The current failures of policy in the Indian wheat sector need to be addressed and other instruments by which the aims of government policy can be met need to be considered. These issues arise against a background of low productivity growth and weak investment in agriculture both in comparison with growth and productivity in the rest of the economy and also in relation to the performance witnessed in other BRIC countries. Specifically, the growth rate in gross domestic product in agriculture between 1997 and 2004 averaged 1.8 per cent per annum compared with growth in the economy of 5.8 per cent per annum over the same period (Landes, 2008). Similarly, over the period investment in agriculture also lagged behind the general economy with the growth in investment being 3.9 per cent per annum in the agricultural sector compared with 11.3 per cent per annum for the whole economy. Compared with other BRIC countries, investment in Indian agriculture as a percentage of GDP was 6.6 per cent for the period which is considerably lower than the 48 per cent for Brazil ( average), and 9.6 per cent for China ( average) (Landes, 2008). Addressing the potential for reform of the current functioning of policy in the wheat sector can be seen, therefore, as a requirement for providing the basis of a more productive agricultural sector and one that is more efficient in marketing food products to consumers while, at the same time, ensuring that the mainstays of the government s objectives of ensuring food security and providing a floor price to vulnerable farmers are met. Central to this package of reforms is the role of the Food Corporation and raises the question whether the role of this state enterprise inhibits the performance of agricultural policy and whether a marketing system with a greater 8

10 role played by private firms together with a diminishing the role of the FCI, can improve welfare and food security. To do this, the potential role of the private sector has to be considered in the context of using alternative policy instruments to ensure floor prices at the farm gate and access to cheap food by the poorest consumers. These are the issues that we consider in the remainder of this report. However, encouraging the development of private sector competition will require a broader menu of reforms and policy initiatives. There is a wide range of regulations and restrictions that currently exist that inhibit private sector investment in the food supply chain and the entry of new firms. These include taxes on processed food, insufficient investment in infrastructure, restrictions on the size of firms in the agribusiness sector, restrictions on transportation and storage and on foreign investment in the food retailing sector, as well as the lack of effective and appropriate grading and inspection systems (Landes, 2008). Thus, in considering the overall development in the food sector in the absence of the FCI, it is also relevant to identify issues that will determine the overall effectiveness of competition throughout the marketing chain and, more generally, the broader regulatory environment in which private firms will compete. We analyse these issues indirectly, by comparing the policy options with regard to the role currently played by the FCI against alternative characterisations of the overall competitiveness when private firms alone characterise the wheat marketing chain. 3. State Procurement and Distribution versus the Private Sector Key to addressing policy reform options in the Indian wheat sector and the overall effectiveness of marketing arrangements is the role of the Food Corporation of India. 9

11 As noted above, the FCI currently plays a key role in the procurement and distribution of wheat and has the remit of implementing the key instruments of agricultural policy. While we consider alternative policy instruments below, we also need to consider the possibility that if the FCI does not exist (or at least that its obligations change), private firms will increasingly play a part in the overall marketing arrangements in the wheat sector. In this section, we therefore focus on two broad issues. First, as noted above, the FCI is characterised by inefficiency and we consider the case where the FCI s costs reflect various degrees of inefficiency associated with procurement and distribution. Second, we compare the state enterprise scenario with private firms coexisting with the FCI but with no agricultural policy instruments in place. While this is not realistic given the Government of India s stated concerns of income support at the farm level and ensuring access to food by poor consumers, it does provide a benchmark against which the various policy options can be compared, where the role of the FCI is constrained and where private firms increasingly feature in procurement and distribution in the Indian wheat sector. The basis of the analysis provided here is a theoretical open-economy model which can be calibrated with data which then forms the basis for considering alternative reform scenarios including alternative roles for the FCI co-existing with (varying numbers of) private firms in all or limited segments of the wheat market. To expedite the discussion and to focus on the principal insights from this outcome, we refer the interested reader to our related work on partial reforms of state trading in McCorriston and MacLaren (2011) which details the theoretical framework employed. To provide some detail, the theoretical model that we develop for this analysis is calibrated with data in 2008/09 for the Indian wheat sector. In this way, the formal framework 10

12 underpinning the analysis to scenarios that directly relate to the main reform issues in the Indian wheat market and therefore they give a detailed insight into the potential costs and benefits of policy reform. We conduct the analysis in two steps. In the first step, we consider the potential effect of a competitive private sector replacing state procurement and marketing but where other government policy instruments are absent from the market. This allows us to focus on the potential impact of de-regulation of the FCI with private firms becoming an increasingly important feature of the marketing regime for wheat; second, we go on to consider not only the significance of the FCI in procurement and distribution, but limiting the role of the FCI while using alternative policy instruments to meet safety net objectives of government policy. In this context, the quantitative results should be interpreted as the relative impact that may arise from different reform configurations. 3 The focus of the comparison of alternative policy options will be across various metrics which reflect different perspectives on the role and purpose of government policy. These metrics are: (i) net social welfare; (ii) producer and consumer surplus, the latter being associated with purchases on the commercial market only, these measures reflecting the distributional aspects of policy; (iii) food availability as measured by the level of self-sufficiency (domestic production/domestic production plus imports) and total availability (domestic production plus imports) and (iv) the impact of any reforms with reference to farm-gate and consumer prices 4. 3 In comparing results, we therefore benchmark the base scenarios in each case at 100 to focus on the relative changes that may arise rather the exact quantitative impact that may be expected. 4 As noted above, much of the concerns of many countries regarding food security issues in the context of exogenous shocks has related to the price spike. In the analysis conducted here, we could focus on shocks emanating from the domestic agricultural sector. The reason for this is that, with the data used for the model calibration, the level of trade in wheat was minimal and therefore it would be more appropriate to gauge the price transmission effects associated with shocks in the domestic sector. However, we do not evaluate the effect of production shocks on prices because we are not directly 11

13 We start by measuring the potential effect of a welfare maximising state enterprise; as noted above, one of the key criticism levelled at the FCI is its inefficiency and we assess what potential impact inefficiency of a state enterprise has on the distributional and net welfare effects. The inefficiency aspects of the state enterprise are associated with its costs being higher than what may be expected with a private firm benchmark. We consider two levels of inefficiency; one where the state enterprise s costs are 25 per cent higher than would be expected and the other where the costs are 50 per cent higher. The effects of this are reported in Figure 1. As can be clearly seen, inefficiency in the procurement and distribution of wheat reduces net welfare significantly: with the degree of relative inefficiency being 25 per cent, social welfare arising from the use of a welfare maximising FCI is reduced by 11 per cent. Increasing the degree of relative inefficiency to 50 per cent reduces social welfare by around 21 per cent. In terms of the effects on the distribution of welfare, both farmers and consumers are negatively affected by state inefficiency; with relative inefficiency at 25 (50) per cent, producer surplus is reduced by 10 (18) per cent while consumer surplus is reduced by 8 (15) per cent respectively. The other component of welfare (not reported in the figure) is that when the state enterprise is efficient, it runs a small operating profit on importing (its profit on domestic procurement and sales is zero because it is welfare maximising) but inefficiency turns overall profit into a substantial loss. modelling the effects of variability, except to the extent that we incorporate a guaranteed price as way of moderating down-side producer price risk.. 12

14 Figure 1: Welfare Impact of an Inefficient, Welfare Maximising State Enterprise 0-5 % Change in Social Welfare % Change in Producer Surplus % Change in Consumer Surplus % Change % less efficient 50% less efficient The food security implications are reported in Figure 2. The inefficiency of the state enterprise has, most notably, a strong impact on the total availability of wheat; while there is little noticeable effect on self-sufficiency (largely because inefficiency negatively impacts on domestic procurement and imports and the marketing of both), the total wheat available decreases by as much as 8 per cent with 50 per cent relative inefficiency. Consumer prices rise by as much as 11 (20) per cent when the state enterprise is 25 (50) per cent inefficient and farm-gate prices fall by 8 (14) per cent under the same scenarios. 13

15 Figure 2: Food Security Implications of an Inefficient, Welfare Maximising, State Enterprise % Change Change in Total Availability (%) Change in Consumer Prices (%) Change in Farm Gate Prices (%) 25% less efficient 50% less efficient Consider the alternative to a welfare maximising but inefficient state enterprise with a marketing system characterised by competition between private firms. Remember that, at the present time, we are comparing alternative structures to the wheat marketing system in the absence of any agricultural policy instruments, so the comparison for the present is solely between a state-dominated system and a private firm environment. In addressing the role of competition, including concerns that a (welfare maximising) state enterprise system may be replaced by private firms exercising market power, we consider a range of scenarios where we vary the number of firms competing in the market. Three alternatives are considered: one where the market is characterised by oligopoly/oligopsony for this, we set the number of firms equal to 4; another scenario where the market is reasonably competitive here the number of competing firms is set to 20; and finally a more competitive environment where the number of competing firms equals 100. For the sake of our evaluation, we 14

16 compare the private sector outcome with the state enterprise that is 50 per cent less efficient than the private firms. With this set-up, there are therefore two principal differences when comparing these alternative market structures: first, that the objective function of the state enterprise differs from that of private firms (welfare maximising versus profit maximising); second, the state enterprise s costs are 50 per cent higher than the private firms costs. The results from comparing the private firm market structure with the inefficient state enterprise on welfare are reported in Figure 3. With a moderately competitive private firm environment (n=20), social welfare is 25 per cent higher than in the inefficient, state-dominated case; with a more competitive environment, social welfare increases by 26 per cent. With a small number of firms (n=4), social welfare increases by 18 per cent. Both farmers and consumers potentially gain in the private firm case when there are a reasonable number of firms competing in the market, when there are no additional government policies in place and in comparison with where the state enterprise is explicitly concerned about producer and consumer welfare. For example, with n=20, producer surplus is 8 per cent higher in the n=20 firm scenario, while consumer surplus is 7 per cent higher. The losses of the state enterprise are turned into considerable profits, with the marketing margin between retail and farm-gate prices being 15 per cent in the 20-firm scenario, though this decreases to 9 per cent in the more competitive (100 firm) case. Note from Figure 3 that, while the results suggest an increase in social welfare in all cases, producers and consumers lose in the case with a small number of private firms (n=4). This seeming disparity between this case and the other two where producer and 15

17 consumer surplus increase is due to the fact that in the small numbers case, the large marketing margin is reflected in high profits for the private firms. This underlies a central point in the policy implications in the analysis conducted here; the gains from encouraging competition in the wheat sector require that there is a regulatory framework that ensures competition is effective so that the potential gains to consumers and producers actually materialise. Figure 3: Welfare Implications of Private Firm Scenarios with Welfare Maximising, Inefficient State Enterprise n=4 % Change 0-10 % Change in Social Welfare % Change in Producer Surplus % Change in Consumer Surplus n=20 n= Figure 4 reports the results relating to the food security implications from this comparison. There is a negligible effect on self-sufficiency (largely because, as we noted above, the effect of changing market structure impacts on both domestic procurement and imports) though total availability of wheat available increases by 8 per cent in the 100-firm case when compared with the inefficient state enterprise and by 4 per cent in the less competitive (n=20) case. Reflecting these changes, retail food 16

18 prices are 14 per cent lower and farm-gate prices 14 per cent higher in the most competitive case, the lower retail and higher farm-gate prices reflecting the decline in marketing margins in the more competitive case. Note, however, the outcome with a relatively low level of competition: total availability declines (by 13 per cent), consumer prices rise (by 25 per cent) and farm-gate prices fall by the same margin. As noted above, these results underpin the importance of effective competition if reform of the FCI is likely to be successful. Figure 4: Food Security Implications of Private Firm Scenarios with Welfare Maximising, Inefficient State Enterprise n=4 % Change 0-10 Change in Total Availability (%) Change in Consumer Prices (%) Change in Farm Gate Prices (%) n=20 n= A word of caution in interpreting these results should be noted at this point. Here we are comparing the private sector with a state enterprise which, though relatively inefficient, is nevertheless maximising both consumer and producer welfare. If we were to dilute this objective function of the state enterprise, then the evaluation will change. Assuming the state enterprise focussed on profits only (whether these were 17

19 positive or negative), the more competitive (n>1) outcomes would always dominate the state enterprise case. This therefore suggests that, in considering the impact of deregulation, there are factors that are potentially offsetting and this suggests that care has to be exercised in identifying closely what the ingredients of the reform package are. In the welfare-maximising case, the state enterprise is already charged with the aim of re-distribution even if other policy instruments are not being used and it has the potential to dominate the private firm outcome. But this need not always be guaranteed and any deviation from this welfare maximising case will cause the state enterprise scenario to be dominated by the private sector outcome (see McCorriston and MacLaren (2011) for further discussion of this). In the final comparison of alternative market structures of the wheat marketing chain, we consider the case where the state enterprise co-exists with private firms rather than comparing the polar opposites. This example is important since, across many countries (including India) where state enterprises are involved in procurement and distribution, this co-existence is likely to be the most typical market structure. However, it is often the case that when the state enterprise does co-exist with private firms, the government bestows exclusive rights to the state enterprise, i.e., the government determines in which markets private firms can operate, leaving the other segment of the market exclusively to the state enterprise. A common example of this would be where the state enterprise has exclusive rights over international trade. In this case then, we have three aspects of the potential asymmetry between the state enterprise and private firms: the objective functions may or may not differ; the state enterprise may be relatively less efficient than the private sector counterparts; the state enterprise may have sole rights in the procurement/distribution in specified segments 18

20 of the market. The results below relate to the case where the state enterprise has exclusive rights over the procurement of imports but competes with private firms in the procurement of domestic output and with private firms in the distribution of both. The comparison made is with the polar opposites reported above: i.e., with an inefficient state enterprise that exists alone and with a private firm benchmark comprising 20 firms. The welfare comparisons are reported in Figure 5. The welfare outcomes with the coexistence of the state enterprise and private firms lie between the state enterprise only case and the private firm only case with the net welfare effect being closest to the former scenario. Specifically, welfare is approximately 3 per cent higher compared to the inefficient state enterprise alone but 17 per cent lower than the private firm only case. Note, that in this comparison, in the case where both private firms and the state enterprise co-exist, we have the same number of market participants in both scenarios (i.e. 20 private firms or 19 private firms plus the state enterprise) but in the state enterprise case it has exclusive rights in the import market and we revert to the case where its objective function is to maximise welfare. This suggests that, while introducing private firms to compete with the state enterprise improves the overall welfare outcome, it still falls far short of the welfare improvement that could materialise if the state enterprise was privatised, it improved efficiency commensurate with the private sector and it maximises profit in competition with private firms. In terms of the effects on producer and consumer surplus, producers and consumers both lose relative to the welfare maximising state enterprise case and they also lose compared with the case where there are only private firms (n = 20). 19

21 Figure 5: Welfare Implications of Private Firms Co-existing with Welfare Maximising, Inefficient State Enterprise % Change in Social Welfare % Change in Producer Surplus % Change in Consumer Surplus -10 % Change Inefficient SE n= Interesting effects arise when the focus turns to food security metrics which are reported in Figure 6. In the case with the welfare maximising, state enterprise coexisting with private firms, while self-sufficiency remains largely unaffected, total availability of wheat is less than in the two cases; relative to the inefficient, state-only case, total availability is 11 per cent lower and, with respect to the private firm case, approximately 14 per cent lower. Consumer prices are higher in this joint case by approximately 29 per cent relative to the private firm only case and 21 per cent higher compared with the state enterprise only case. Farm-gate prices are 20 per cent lower relative to the state only case and 25 per cent lower compared with the private firm only case. 20

22 Figure 6: Food Security Implications of Private Firms Co-existing with Welfare Maximising, Inefficient State Enterprise % Change 0-10 Change in Total Availability (%) Change in Consumer Prices (%) Change in Farm Gate Prices (%) Inefficient SE n= We can summarise the main insights from the above analysis as follows: The inefficiency associated with the operations of the state enterprise has a considerable impact on social welfare and the distribution of that social welfare as well as in relation to various metrics associated with food security. Notwithstanding other reforms to the wheat marketing sector in India, addressing the inefficiency associated with the operations of the FCI could bring substantive benefits. Allowing private firms to compete with the FCI will bring substantive benefits to producers and consumers and lead to an improvement in food security. This is true whatever the objectives of the state enterprise are, 21

23 whether they relate to welfare distribution or focuses on profits only (and whether these profits are positive or negative). Building on this scenario, creating an environment where an increasing number of private firms can compete in the marketing chain, even in the presence of the state enterprise, will improve economic welfare but will reduce food security and the more competitive the environment becomes, the greater the potential welfare benefits from reducing the role of the FCI. Comparing the more abstract case of a state enterprise and the private firm alternative depends largely on the objective function of the state enterprise. If the government details the objective function to be welfare maximisation, then there is the potential that it could dominate the private sector outcome. However, any deviation from this, will increase the attraction of the private sector alternative. Thus, in considering the issues of de-regulation, one should consider what the precise responsibilities of the state enterprise are, and how well it meets them. A successful, efficient and welfare maximising state enterprise is likely to be rare. When considering the nature of private sector outcomes, more competitive environments do better across almost all metrics and bring the outcome closer to the welfare maximising ideal outcome. 4. The Food Corporation of India and Alternative Policy Instruments In this section, we build on the analysis above to focus more directly on the responsibilities of the FCI and what policy options exist while maintaining the overall 22

24 objectives of government policy towards both farmers and consumers. The insights above highlight the role that competition in the wheat marketing chain could play in improving welfare for both consumers and producers and the potential implications for food security and under what circumstances they are likely to prevail. But the discussion focussed on market structure issues only and did not address the direct functions of the FCI in terms of maintaining the MSP or procuring wheat for public distribution to vulnerable groups or for the build-up of stocks. This is important. The textbook example of a welfare-maximising state enterprise has some merits but when governments employ state enterprises to influence the functioning of markets with the use of other policy instruments with the aim of ensuring certain policy outcomes, the situation is likely to be altered. We therefore extend the analysis of the wheat marketing chain and focus more directly on the details of the Indian wheat sector by analysing the role of an inefficient FCI co-existing with private firms in the context that the minimum support price is maintained by FCI purchases and that the private firms procure from domestic producers (and, at the margin, via imports) which are sold on the domestic commercial market. The FCI s procurement is directed to stocks and distribution via the TPDS. We highlight the welfare and food security implications of this by comparing the FCI s role in achieving these objectives when the commercial market is relatively competitive and when it is less so. Specifically, the inefficient FCI retains these roles in the procurement and distribution of wheat, but we vary the number of private firms competing in that context. We then proceed to assess alternative policy options with the government meeting these objectives but using different policy instruments (specifically a deficiency payments policy and targeting poor consumers through the use of a food stamp programme) and with the 23

25 role of the FCI limited to procuring wheat from the agricultural sector but only for the purposes of maintaining the buffer stock. (i) The FCI Current Regime and Competition in the Marketing Chain In Figure 7, we report the results from evaluating the FCI s current role but in the context of varying the number of private firms that compete in the wheat marketing chain. In terms of characterising the FCI, we assume that it is relatively inefficient compared with the private sector firms, its procurement aimed at ensuring the MSP and with its procured quantities being held in the buffer stock or distributed via the TPDS. Specifically, in the context of the current policy framework, a more competitive environment (n = 20) increases net social welfare by around 6 per cent compared with n = 4. But as the comparison in Figure 7 shows, the re-distributive aspects of private firm competition are more substantive: with a larger number of private firms, producer surplus is 18 per cent higher and consumer surplus 42 per cent higher compared with the FCI operating in a less competitive environment. Food availability is higher in the more competitive case (despite additional purchases of the FCI to maintain the MSP-see discussion below) by around 19 per cent though, as noted before, there is little difference on the self-sufficiency ratio between the two cases. In the more competitive case, retail (farm-gate) prices are 17 per cent lower (13 per cent higher) compared with the less competitive environment. With higher farmgate prices and lower retail prices, one of the main effects of the more competitive environment is that the retail-farm-gate mark-up is approximately 68 per cent lower in the more competitive case. 24

26 Figure 7: The Current FCI Regime and the Degree of Competition in the Marketing Chain % Change % Change in Social Welfare % Change in Producer Surplus % Change in Consumer Surplus Change in Total Availability (%) Change in Consumer Prices (%) Change in Farm Gate Prices (%) -20 One of the main differences that arise when we compare the competitive environment is the public expenditure costs of the policies. Clearly, with the TPDS, the government exchequer has to cover the cost of subsiding low-cost food to the most vulnerable through the TPDS. Also, with the FCI charged with maintaining the MSP, if farm-level prices were to fall below the MSP, FCI procurement would have to increase to support the stated Minimum Support Price. When the number of private firms that co-exists with the FCI is low, retail prices are relatively high and, because of the oligopsony power the few firms have with respect to procurement, the farmgate price is low. This results in a relatively high subsidy outlay by the FCI in the distribution of low-cost food and relatively high outlays to support farm-gate prices. In terms of gauging the public expenditure impact, we measure the costs of these activities relative to the social costs of the current FCI regime (assuming a small 25

27 number of firms) as a whole. It is clear that the costs of supporting the MSP and the TPDS are expensive if competition among private firms is limited, the cost of these activities amounting to around 37 per cent of the net social welfare effect. However, with a more competitive environment, farm-gate prices are bid up (because competition in the procurement market raises prices), such that the role of FCI in maintaining the MSP becomes unnecessary. In this case, the cost to the public exchequer lies only with the TPDS but the costs of this policy remain at around 37 per cent of the net social welfare effects because the higher procurement cost almost offsets the savings from not having to purchase to maintain the MSP. (ii) The FCI, Competition and Alternative Policy Instruments In the final step in our analysis of the Indian wheat marketing system, we amend the policy instruments the government uses to meet its objectives of supporting farm-gate prices and providing access to low-cost food to the most vulnerable. However, rather than use the MSP, we assume that the government uses a deficiency payments policy to ensure that farmers receive a guaranteed price for their output. Thus, whatever the level of competition in the procurement market, if the procurement price is below the guaranteed price, the government makes up the difference through direct payments rather than the FCI procuring directly in the agricultural market to raise prices to the stated minimum support level. With respect to targeting the poorest and ensuring access to low cost food, we assume that the government instead uses a food stamp programme. 5 Note that, in this analysis, we are abstracting from considering issues associated with the practical implementation of these alternative policy instruments 5 In assessing the pilot food stamp programme in Maharashtra, Ramaswami and Murugkar (2005) report that the government of that State provided food stamps which were worth one-quarter of the cost of food-grains. We use this same proportion in calculating the budgetary cost of the food stamp programme. 26

28 and consider only the impact they will have on the distribution of welfare and food security metrics. 6 In the results presented below, we compare the deficiency payments/food stamp scenario with the case with the current MSP/TPDS regime. In both cases, we assume that competition from private firms is limited, the reason being that with a small number of private firms, the greater the likelihood that the guarantee price would have to be binding. The results presented show improvement with this new policy across all metrics, with the exception of the producer price and producer surplus, which is maintained at the same level across both scenarios, i.e., the guaranteed price/deficiency payments policy gives the same outcome to producers as the MSP when the number of private firms is low but with policy being met by public expenditure changes rather than by purchases by the FCI to maintain the MSP. The results from this comparison are reported in Figure 8. Specifically, maintaining the objectives of policy in terms of providing current safety nets but reducing the FCI s function to procuring for the buffer stock only, may increase social welfare by as much as 82 per cent. The percentage increase depends on the procurement price set by the private firms, a price that is indeterminate. However, if the profits of these firms are held constant at the value that would pertain were the guaranteed price not present, then there is a unique procurement price. As noted, producer surplus remains unchanged but total consumer surplus increases by 159 per cent; this is reflected in lower consumer prices (by 25 per cent) and the total availability of wheat increases by 18 per cent. This clearly shows that the FCI crowds 6 Ramaswami and Murugkar (2005) provide practical details of how the pilot food stamp programme in Maharashtra was designed. 27

29 out the private sector such that there are potentially substantive potential benefits from reform even if current safety nets are retained but met by other means. Moreover, since the combination of food stamps and deficiency payments is more direct, the costs of this policy to the public exchequer also falls, by around 13 per cent. Figure 8: The Current FCI Regime and the Potential Effects of Deficiency Payments Policy and a Food Stamp Programme % Change % Change in Social Welfare % Change in Consumer Surplus Change in Total Availability (%) Change in Consumer Prices (%) (iii) Summary and Principal Observations There are several important implications that arise from this analysis of the current role of the FCI and the policy options that are available while maintaining the overall objectives of government policy in the provision of safety nets. These are summarised below: Retaining the structure of the current regime and retaining the responsibilities of the Food Corporation of India, but improving the efficiency of its 28

30 operations could bring significant benefits to consumers and producers and improve food security. Retaining the current regime and providing an enabling environment in which private firms can enter and compete more effectively in the procurement and marketing of wheat would likely bring significant benefits. Maintaining the policy objectives of the government but achieving them through the use of other instruments, while minimising the role of the Food Corporation, could bring significant benefits in welfare, principally consumers, without adverse effects on producers. 5. Conclusions The continued growth of the food subsidy, low productivity growth and inadequate investment in Indian agriculture and the inefficiency in the functioning of the Food Corporation of India are the factors that create the pressure for reform. Central to these reforms is changing the role of the Food Corporation. Given its dominant status in the procurement and distribution of wheat, the future role of the Food Corporation of India will be central to the reforms that should take place. Clearly, as one considers its future role, the question arises of what net benefits more competition in the wheat marketing sector can bring. But, at the same time, the Government of India faces the very real constraints of its stated objectives of maintaining farm incomes and ensuring that low-cost food is available to the most vulnerable. It is this issue of the reform of the Food Corporation, subject to the constraints of the provision of these safety nets, together with the potential role of the private sector that has been addressed in this paper. 29

31 To assess these issues, we have drawn on a theoretical framework calibrated with data that characterises the Indian wheat market. We have analysed the issue of reform from two directions. First, we considered the role of a welfare maximising, potentially inefficient state enterprise against the potential alternative of private firms alone characterising the wheat marketing sector. In this context, we abstracted from the availability and use of other policy instruments other than the manipulation of the market via the state enterprise. The analysis suggests that there are potential gains from improving the efficiency of the FCI and that the relative merits of the private sector depend on fully understanding the objectives of the state enterprise. Anything other than a highly efficient, welfare maximising state enterprise will likely lead to inferior outcomes compared with those that would materialise with private sector competition. If the FCI did not characterise the market, the more competition there is, the greater the potential benefits for both farmers and consumers and across various metrics that relate to food security. Building on this framework, we then explored the options for the FCI as it currently operates and its mandate in managing the TPDS and the MSP. Again, in this context, we allowed the FCI to be less efficient than private sector firms. We then compared the likely impact of more competition even under the current regime and subsequently analysed whether the role of the FCI could be limited to procurement for the buffer stock only while the other two objectives of government policy could be met by other means such as a guaranteed price and deficiency payment, and a food stamp programme. As we show, there are substantive potential benefits available both in welfare terms and across various food security metrics. 30