Will the sharp increase in the minimum support prices (MSPs) for various kharif crops lead to higher rural demand? That is the whole point of the exercise, which is aimed at alleviating rural distress, about which the government has been at the receiving end politically. With elections around the corner, ensuring that farmers are taken care of is a key objective.

As Elara Capital says in a note, the average increase in MSPs for FY19 has been 24%, the highest since FY13, when it was 29%. Yet, the Street didn’t seem particularly excited. Barring automobiles, key sector indices such as consumer goods and finance closed with subdued gains on Wednesday. The muted response reflects the market’s reservations.

What are the concerns? Some fear the broad-based MSP hike can accelerate inflation, triggering rate hikes. “The MSP hike is likely to raise inflationary pressures and we have revised up our inflation call for FY19 to 5.3% from 5%. We now expect a 25 bps (basis points) rate hike coming in as soon as August," says Tushar Arora, senior economist at HDFC Bank Ltd.

Gaurav Kapur, chief economist at IndusInd Bank Ltd, wrote: “In terms of impact on headline CPI (Consumer Price Index) inflation, we reckon that the 13% increase in MSP of rice can push CPI inflation higher by about 30-55 bps over the rest of the year."

Anubhuti Sahay, senior economist at Standard Chartered Bank, says that the fiscal cost could go up by 0.1-0.2% of gross domestic product.

In its last monetary policy report, the Reserve Bank of India (RBI) had said, “If the monsoon is deficient and the budget proposals on MSPs lead to higher food prices, headline inflation could rise above the baseline by around 80 bps."

Firms may be better positioned to pass on cost increases from rising food prices, higher wages and other input prices including fuel to consumers if rural demand increases. This has the potential to ignite an inflationary spiral.

But much depends on implementation. Aditya Jhawar, analyst (agriculture inputs and automobiles) at Investec Capital Services (India) Pvt. Ltd, says it has to be seen if the measures improve farm produce realizations, which is dependent on the procurement mechanisms the government has to put in place.

Except paddy, prices of most cash crops such as pulses and cotton are more influenced by their demand-supply equations and by international prices. So the government may set an aspirational target but its influence on prices on the ground remains limited, due to constraints in reach and infrastructure facilities.

A study of key agricultural regions by JM Financial Institutional Securities Ltd corroborates this. “Prices for agri-commodities, particularly ex-cereals are impacted more by global price trends, as barring cereals (paddy and wheat), procurement of most other crop output is not material and is done based on need," JM Financial said in a note last April.

Importantly the JM Financial study cites a National Sample Survey Office report, which says that more than 50% of farmers across different crops sell their produce to local traders rather than the government in mandis, largely at a discount to MSPs set by the government. Small farmers located in the hinterland often do not get the MSP for their produce due to small production quantities, lack of access to storage facilities and inaccessible procurement centres.

In this backdrop, it is surprising the government is yet to come up with the procurement mechanism which will determine how it will ensure that farmers get the MSPs. The experience with regard to pulses has been a cautionary tale. Higher MSPs led to overproduction, which depressed market prices.

RBI’s monetary policy report said, “Arhar and urad prices remain below their minimum support prices at the mandi level in the major producing states viz., Maharashtra, Madhya Pradesh, Gujarat, Uttar Pradesh and Karnataka reflecting the large gap in procurement relative to supply." Of course, if implementation is poor, both inflation and the pressure on the fiscal deficit will be lower to that extent. But won’t poor implementation backfire politically on the government? Will not the opposition be quick to call it another empty promise?

Several other issues remain unanswered. For instance, are MSPs an effective way of supporting rural incomes? States such as Telangana are trying cash transfers.

As far as industry is concerned, it has to be seen if high local prices (due to MSPs) will put industries such as textiles and rice exporters at a disadvantageous position vis-à-vis international peers. Since much will depend on the demand-supply position around October, at the time of the harvest, it’s difficult to predict where prices will be and consequently the impact on costs.

How the government will ensure MSPs in case of bumper harvests is also a big question. Does it have the wherewithal to finance the purchases and store large quantities of all these crops?

Nevertheless, the MSP hikes are broadly seen in line or slightly higher than the government’s earlier announcement of at least 50% above the cost, says an analyst at JM Financial.

The hike in MSPs is expected to have a positive rub-off effect on the incomes of the cereal growing regions, especially the paddy farmers, given the organized channels of procurement in the sector. “We believe paddy (rice) MSP increase will be the most important channel of the impact on the economy," says Sahay of Standard Chartered Bank.

What about agri-input companies? Will they benefit? Once again, it’s too early to be sure. But with rural incomes in recovery mode (post the bad seasons in FY15 and FY16), the higher MSPs should set a positive tone for investment spends unless the monsoon season plays truant, says Jhawar of Investec Capital.

The latest Purchasing Managers’ Index (PMI) shows the Indian economy is powering along at a strong clip. Core inflation has been moving up steadily, as the economy gathers steam. The higher MSPs will add fuel to simmering inflationary fires.

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