End of fertilizer price decontrol?

It was with great fanfare that the Government of India launched the Nutrient Based Subsidy (NBS) regime for fertilizers in April 1, 2010. It effectively dismantled the administrative control over fertilizer prices. The subsidy was to be fixed, based on the nutrient content of each fertilizer, and then transferred as a back-end subsidy to the manufacturing companies. It gave companies full freedom to fix Maximum Retail Prices (MRPs), though there was an informal understanding to keep price hikes within 'acceptable' limits.

It went off relatively well in its first year, raising hopes of further reforms in the subsidy regime. However, following the steep increases in global petroleum prices in recent months, the wheels seem to be coming off the NBS regime. The manufacturers have been left with no option but to increase the MRP to cover for the increased import prices. As I have blogged earlier, in response the government has been forced into revising the subsidy for 2011-12 three times already.

Faced with continuing rise in fuel prices, the Government has issued directions to the fertilizer companies to restrict the MRP increases to a band. The Businessline points to a recent circular issued by the Department of Fertilisers asking firms to limit the increase in the MRP of di-ammonium phosphate (DAP) to Rs 600 a tonne for the kharif season ahead. It writes,

"Since the MRP, prior to April 1, averaged Rs 10,750 a tonne, a Rs 600 rise works out to Rs 11,350 a tonne. To this, if the 1.03 per cent excise-cum-education cess imposed in the 2011-12 Union Budget is added — this is recoverable from farmers — the new admissible MRP would be roughly Rs 11,470. Against this, companies like Coromandel International, Indian Farmers Fertiliser Cooperative and Zuari Industries have already declared MRPs of Rs 11,700 to Rs 12,000 a tonne, exclusive of State-level and local levies. It remains to be seen if they will now have to roll back their MRPs to the May 5 circular-prescribed levels."

The NBS regime for fertilizers is a test case for cash transfers with PDS. It highlights the challenges in subsidy administration posed by price volatility. However, unlike the fragmented food grains markets, fertilizer market is more integrated. Therefore it is possible to develop an index, also linked to global crude prices, that is a reasonable reflection of fertilizer prices. The subsidy payable to manufacturers or distributors could be calibrated with respect to this index, so as to avoid the repeated ad-hoc revisions. This does create a slight fiscal uncertainty, though the variation is not likely to be so much as to imbalance government finances.

Fertilizer subsidy rates go up (again)!

It has come faster than expected. I had blogged just yesterday about the inevitability of the revision in fertilizer subsidies for 2011-12 in view of the rising import prices. The Businessline reports,

"An inter-Ministerial panel under the Secretary, Department of Fertilisers, is learnt to have approved higher import parity prices of $612 a tonne for DAP and $420 a tonne for MOP, as against the existing levels of $580 and $390. These upward revisions would translate into increased NBS rates for phosphorus (P) and potash (K). Currently, the NBS rate on P, linked to a $580-a-tonne reference price for imported DAP, is Rs 29.407 a kg. On the proposed $612-benchmark price, it will go up to around Rs 31 a kg. Likewise, the NBS rate on K will rise from Rs 24.628 to Rs 26.5 a kg with the assumed landed price being raised to $420 a tonne."

Interestingly, even if the NBS rate on P is increased to Rs 31, the resulting higher subsidy of Rs 19,220 or so on DAP would take the gross realisation to Rs 29,970 a tonne, leaving the farmer to still pay the gap of Rs 600-700 a tonne. The report also says that the MOP prices are currently quoting at $520 a tonne, far higher than the proposed revised import parity price of $420 a tonne, leaving the farmer to again absorb the losses. Further, there will be no buffer available to cushion against future price increases, which is inevitable given the global petroleum price trends.

Two important market expectations are getting anchored here. The domestic wholesalers and retailers realize that there is nothing sacrosanct about the once a year subsidy fixation announcement. They have the incentive to raise the MRP to cover the full subsidy instead of raising the MRP based on the import prices. As I had blogged earlier, given its size, India's procurement decisions and import parity price signals will quickly get embedded into the global market prices. So what is the way out?

The price volatility problem with cash transfers

I have blogged earlier that price volatility, especially with food grains, is the most difficult challenge with cash transfers. One of the strategies to overcome this is to provide a large enough subsidy, inclusive of a volatility buffer, so that even if price increases, the buffer will cover for the increase. The nutrient-based subsidy (NBS) for non-urea fertilizers under implementation since April 2010 uses this strategy to cover for price volatility.

It is therefore instructive to examine the experience with NBS in fertilizers. Under this model, fertilizers are sold to farmers at its decontrolled MRP (minus the subsidy) and the subsidy amount paid separately to the fertilizer companies. The nutrient-wise fertilizer subsidy is fixed once a year, based on its market and import prices, and with a reasonable buffer to cushion the producers against price fluctuations over the year.

What has been the progress report with this subsidy regime in operation for more than a year now? A recent report in Businessline highlights the sharp volatility in the prices of fertilizers, as reflected in the manner in which the subsidy fixed for 2011-12 (operational from April 1, 2011) was sharply revised between November 2010 (when it was originally fixed) and March 2011 (when the subsidy amount was frozen). It now appears that even this may have to be revised.

Recent imports of DAP have been for $612 per tonne (or Rs 27,540 per tonne), which with duties, freight and other charges will retail at about Rs 30,735 per tonne. Against this, the MRP of DAP is currently at Rs 10,750 a tonne and the NBS payable from April 1, 2011 is Rs 18,474 (fixed assuming a landed import price of $580 a tonne), thereby grossing the company Rs 29,224 for every tonne of DAP. This deficit of more than Rs 1500 a tonne or Rs 75 a bag will either have to be covered through an increase in subsidy or passed on to the farmer.

Given important state elections coming up, it is almost inevitable that despite the original decision to fix the subsidy once a year, the subsidy rates will be revised again. Similarly, even on MoP, where global suppliers are apparently pushing for a landed price of $420 a tonne (which is more than the current reference rate of $390 a tonne), a subsidy revision looks certain.

Further, there is also the problem of market expectations that get formed by the subsidy price announcements. Since India is one of the largest fertilizer importers, its procurement decisions and prices signals get embedded into the global market prices. Though the subsidy rates announced includes a volatility buffer, the market prices naturally get anchored at the upper end. As the Businessline report says,

"For 2010-11, the Centre had fixed the NBS rates on nitrogen (N), phosphorus (P), potash (K) and sulphur (S) with reference to corresponding import prices of $310 a tonne on urea, $ 500 on DAP, $370 on muriate of potash (MoP) and 190 a tonne on sulphur. For 2011-12, the Centre – in a bid to talk down world prices – initially, on November 19, pegged these reference prices lower at $280, $450, $350 and $125 a tonne. But with global prices showing no signs of easing, the Centre, on March 9, announced new NBS rates for 2011-12 based on higher landed prices of $350 for urea, $580 for DAP, $390 for MoP and $180 for sulphur."

The Businessline report also quotes industry sources who claim that the government's decision to tinker with the DAP reference price has contributed to the steep increase in its import price in recent months. Also, the NBS regime has had no effect on lowering the subsidy burden. In fact, subsidy burden is also projected to go up by Rs 30,000 Cr to Rs 82, 245 Cr, up from the budgeted provision of Rs 52,837 Cr for 2010-11.

The experience of fertilizer highlights the difficulty of managing price volatility and also ensuring access to fertilizers (or food grains) at affordable prices. The much greater price volatility and political sensitivity associated with food grains means that any buffer will have to be much larger. Far from lowering it, the food subsidy outgo will therefore increase.

Admittedly, with fertilizers, given the reasonably integrated national market, it may be possible to calibrate subsidy to a price index. However, this approach cannot work with food grains whose prices vary so widely across the country at any point in time, that it is impossible to capture it in one index with any reasonable degree of reliability. So what is the way forward? More food for thought!