Before reading this chapter, it’s important that you read Chapter three – spreading JAM, chapter two – exit problem/ chakravyuha challenge and fundamentals of subsidy.

• Fertilizer accounts for large fiscal subsidies (0.73 lakh crore or 0.5 %of GDP), the second-highest after food.
• Only 17,500 crores or 35 per cent of total fertilizer subsides reaches small farmers

Where does the rest (65%) of subsidy amount go?

Obviously it leaks out to black market, large framers (bounty for the well off) and inefficient producers (exit problem).

We will come to the question of leakages later but before that let us know a few basics about fertilizer sector and it’s regulation in India.

1. There are 3 basic types of fertilizer used—Urea, Diammonium Phosphate (DAP), and Muriate of Potash (MOP) i.e N,P,K fertilizers.
2. Urea dominates the sector. It is the most produced (86%), the most consumed (74%) and the most imported (52%).
3. Urea also faces the most government intervention <50% under movement control compared to 20% for other two fertilizers,>
4. Urea also receives maximum subsidy (70% of total fertilizer subsidy) as well as in per unit terms (75% of cost of urea is subsidized compared to 35% for other two)
5. Urea is also not included in nutrient based subsidy regime

Nutrient based subsidy

Under this method, subsidy is given on the basis of nutrient content in the fertilizer. Suppose govt decided it would give 100 rs subsidy per kg of potash. Now, if cost of a fertilizer which contains 1 kg of potash is 1000 rs, govt will give 100 rs and he would be able to sell it at 900 rs. <govt does not fix retail price, govt gives same amount of per kg subsidy to all manufacturers, if production cost is less, you can sell it lower prices and capture market. It incentivises inefficiency this way.

Contrast this with urea subsidy which is cost plus based . In this regime govt fixes price of urea. Suppose govt fixed urea price at 500 rs per kg. Firm A produced 1 kg urea at 700, govt will give it 200 rs (700-500) so that it could sell it at 500. If more efficient firm B produced 1 kg of Urea at 600 rs, it will get 100 rs subsidy (600-500). Clearly, there’s no incentive to be efficient. More inefficient you are, more subsidy you get.

Other benefits of nutrient based subsidy

• Note that in cost plus method, govt can only subsidize a few fertilizers. But in NBS, govt has to simply state, it will give 100 rs per kg for N, K, P, Boron, Sulfur, Zinc etc. It will thus encourage production of complex fertilizers <many nutrient including micro nutrients in the one fertilizer>
• Complex and micro nutrients will increase the productivity of soil.
• It will encourage greater competition , leading to productivity gains.

Now let’s discuss 5 kind of govt intervention in urea sector

1. Controlled maximum retail price <encourages diversion and black marketing>
2. Firm specific cost plus subsidy <inefficient firms get larger subsidies>
3. Consignment specific subsidy to importers
4. Canalization of imports Only 3 agencies allowed to import <shortages when domestic production falls>
5. Movement control <govt tells how much to import and where to sell>

All these controls result in leakages. As we saw earlier only 35% of subsidy reaches small and marginal farmers.

1. Black marketing– Simply because the principle of one product one price (we discussed it w.r.t. LPG earlier) is violated.

Urea is only subsidized for agricultural uses but it is used for industrial purpose also < one of the ingredients in chemical industry, explosives, automobile systems, laboratories, medical uses, flavour enhancing additive in cigarettes and others>. As we know cost of subsidised urea is 75% lower than cost of non subsidised urea which gives strong incentive to divert it to the black market. Why?

• Simple- Suppose urea for agri use is 250 rs and for industrial use is 1000 rs, there’s strong incentive to sell it to industrial consumers at 750 rs and show it as urea for agri use.
• Similarly, urea is diverted to B’desh, Nepal where urea prices are high.

Result- Shortage of urea in domestic market.

Who suffers – small and marginal farmers. Rich farmers are well connected and get subsidies urea while small farmers have to buy urea from black market at much higher price <51% of farmers buy urea at above M.R.P.>

In the three eastern states bordering Bangladesh, 100 per cent of farmers had to buy urea at above MRP in the black market <diversion to B’desh>

Black market effects are aggravated by a further regulation—canalisation. As we saw , only three firms are allowed to import urea into India, and they are also instructed when to import, what quantities to import, and in which districts to sell their goods. And we all know how good govt is in forecasting needs.

Result- Shortages and shooting up of urea prices when demand is at it’s peak and invariably small farmers suffer disproportionately.

Reform by govt.-neem-coating urea

• Neem-coating makes it more difficult for black marketers to divert urea to industrial consumers.
• Neem-coating also benefits farmers by reducing nitrogen losses from the soil by providing greater nutrient to the crop <less urea required>
• Work as pesticide
• Less water pollution

2. Benefits large farmers– A regressive subsidy. As we saw small farmers suffer due to black marketing while large well connected farmers take advantage of subsidies.

3. Subsidy to inefficient firms– result of cost plus regime which does not encourage efficiency gains.

Result – even though urea consumption has increased steadily over the last 15 years, no new domestic production capacity has been added, leading to a large dependence on imports. Efficient firms are forced to shut their shops.

Externalities of urea prices

What is externality?

an externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit <for instance, vehicle owners pollute the environment, we all suffer the consequences an example of negative externality. Can you give us an example of positive externality in comments plz>

• It’s clear urea is under priced compared to other fertilizers resulting in excessive usages.
• Ideal N:P:K ratio for Indian soil is 4:2:1 but actual ratio is 8.2:3.2:1 i.e excessive usage of urea

Result-

• Deterioration of soil quality
• Fertilizer leaching to water bodies resulting in pollution of water
• Algal bloom

Reforms- aim of reform is to eliminate leakages while benefiting small farmers

1. decanalising urea imports—which would increase the number of importers and allow greater freedom in import decision–would allow fertiliser supply to respond flexibly and quickly to changes in demand
2. bringing urea under the Nutrient Based Subsidy program

Turning fertiliser into JAM

Fertilizer subsidy is an ideal case for JAMming (Chapter three) as leakages are high and central govt controls fund flows.

Also, urea manufacturing is not labour intensive so no harm to workers.

Ideally fertiliser subsidies would be targeted only at small and marginal farmers. But there are problems with targeting

1. Assessing poverty—based on landholdings or some other measure—will be difficult
2. How to target tenant farmers and sharecroppers <10% of all farmers are such farmers and they should not be excluded in any case>
3. Relatively low levels of last-mile financial inclusion in much of rural India <last mile challenge, chapter three>

What can be done if not JAM?

Set a cap on the number of subsidised bags each household can purchase <just like 12 subsidized LPG cylinders> and require biometric authentication at the point of sale (POS) <BAPU (chapter three)>

• Requiring biometric authentication would make it harder to conduct large-scale diversion
• Imposing a cap on the total number of subsidised bags each farmer can purchase would improve targeting <Small farmers would still be able to get all their urea at subsidised prices but large farmers may have to pay market prices for some of the urea they buy>

As urea is more sensitive, it could be initiated first for other fetilizers

Other reforms-

• Rationalise subsidies to domestic firms <shifting to NBS regime> which would release fiscal funds to spend more effectively on schemes that help poor farmers, such as drip irrigation and connectivity through the Pradhan Mantri Gram Sadak Yojana
• Secure long term fertiliser supplies from locations where energy prices are cheap
• Encourage Indian firms to locate plants in countries such as Iran following the example of the Fertiliser Ministry’s joint venture in Oman, which allowed India to import fertiliser at prices almost 50 per cent cheaper.

Suggested reading- Fertilizers and challenges of reform

Self study- New Urea Policy 2015

Preferential Trade Agreements (PTAs) have been proliferating, especially since the establishment of WTO and about 619 PTAs have been signed so far of which 413 are already in force <there are only 185 sovereign states according to UN>.

But not all PTAs are same. Go no further before reading this blog to understand hierarchy of FTAS (cover pic) in detail – What is economic integration and what are the different types of trade agreements?

India and FTAs

• India has long-standing commitment to multilateralism under WTO agreements but in line with global trends, India has made use of FTAs as a key component of its trade and foreign policy. If WTO is going nowhere, we can’t just sit and expect WTO negotiation to conclude, we also have to sign FTA or we will be left behind
• So far, India has mainly focused on partnering with other Asian countries, and in goods more so than in services <with SL, Afghanistan, Thailand, Singapore, Bhutan, Nepal, Korea, Malaysia and Japan and regional trade agreements SAFTA and ASEAN>
• Outside Asia, We have signed FTAs with Chile and MERCOSUR <What is MERCOSUR, answer in comments>

But not all FTAs are same and depth of integration offered by different FTAs in different sectors are different. For instance, the India-Korea CEPA contains chapters on Origin Procedures, Telecommunication and Audio-Visual Co-production, but these are not included in the India-Japan CEPA. There are provisions in India-Japan CEPA not included in Indo-Korea CEPA <this all creates complications as number of FTAs increase and they all have different rules, regulations and procedures> <What are rules of origin? answer in the comments below>

Concept of spaghetti-bowl effect / Noodle bowl effect

Concept was propounded by world’s foremost trade economist Prof Jagdish Bhagwati is analogy between the tangling of spaghetti or noodle in a bowl with the tangling of different FTAs, He argues that so many FTAs with their differential tariff rates, rules, procedures muddy water so much that leads to discriminatory trade policy and results in often contradictory outcomes amongst bilateral and multilateral trade partners.

Let’s understand this with an example- Suppose rule of origin rule in TPP implies that Vietnam can only export textile which is made from Vietnami Yarn. Now Vietnam has an FTA with say B’desh or India and Yarn is covered under it. Indian yarn is cheaper yet Vietnam will not buy it because textile manufactured from it will not be covered under TPP. Multiply it across more than 400 FTAs and you can understand how complex it can get and more complex it gets, advantage developed and bigger countries.

Small countries don’t have resources to investigate whether US is actually following rules of origin for it’s exports. At much bigger level, it would look like this

It’s safe to say that developing countries like India should invest their energy in successful negotiation of WTO rounds as they can negotiate them better collectively, outcomes are not very complex thus beneficial to less resourceful. But as we can not wait for that to happen indefinitely we should also sign FTAs which would be beneficial to us.

Mega-Regionalism

Until recently FTAs were signed mainly bilaterally and regionally <india-Bhutan, ASEAN ka SAFTA, North America ka NAFTA, Europe ka EU> but of late PTAs have begun to morph into mega-regional agreements, which would encompass a large share of world GDP and trade. Consider for instance:

1. TPP- 40% of Global GDP and 33% of trade (already sgined)
2. TTIP- 50% of GDP and 30% of merchandise trade, 40% trade in services (negotiations continuing) <TTIP is trans atlantic trade and investment partnership b.w EU and USA>

India is not a member of either of these two grouping but is negotiating it’s own mega regional- RCEP (regional comprehensive economic partnership) which is not as ambitious in scope as the other two agreements.

With the signing of TPP and TPIP, India will have access to these markets at higher costs <member countries will get preferential treatment; resulting in some negative impact on Indian exports and thus our GDP growth. Different studies suggest negative impact on India’s GDP from -0.1% to -.2%.

TPP/ RECP is very, very important topic for prelims/ mains/ interview. For prelims, name of countries in TPP, in RCEP, in ASEAN, in all 3 grouping, in only 2 groupings etc is very important. Look at the figure below, it will help you remember the names well

Other way to remember the names is continent wise

• 4 ASEAN members- Malaysia, Singapore, Brunei ,Vietnam
• 7 RCEP members-  4 ASEAN above + Australia, New Zealand, Japan
• 5 American countries Canada, Mexico, United States, Chile, Peru (3 from North and central America + 2 from South America)
• Please note that China and Korea are not part of TPP

For detailed analysis on TPP for mains/ interview purpose, please read our blogs here- TPP decodified and RSTV summary, importance of TPP

To PTA or Not to PTA?

Over the years, India has signed many FTAs, have they benefited us? As number of FTAs and mega regional pacts are proliferating, should we sign more FTAs?

Any FTA will lead to increase in trade as tariff and non tariff barriers come down but if it leads to much higher imports than exports and thus negative trade balance, impact can be considered as negative.

Concept of trade creation v/s trade diversion

Another aspect of FTAS which like Spaghetti bowl effect is a criticism of FTAS wrt WTO- whether actually trade is being created or is it merely shifting to inefficient firms?

Trade creation -In WTO, a country reduces tariff for every other country in this world and because of this tariff decrease, outside firms can compete with domestic producers and trade increases leading to trade creation.

Trade diversion– occurs when tariff preferences offered under an FTA causes a shift of imports from firms in non FTA member countries to less efficient firms within the trade bloc, which now become competitive due to tariff reliefs.

Let’s understand this with an example-

Suppose country B is imports mangoes from country C and D, Until now, it imposed 20% tariff on both, thus major market share is captured by country D which is more efficient but  now, B and C sign an FTA and now mangoes from C are imported at zero tariff. Consider this

Now C has become more competitive and trade will get diverted from D to C, that’s another side effect of FTAs.

Impact of FTAs on India’s trade

• The overall effect on trade of FTA is positive and statistically significant
• With ASEAN, trade has resulted in more imports than exports, this widening our trade deficit
• Impact of FTAs on different industry segments fall differently <it’s only to be expected>

Conclusion

• FTAs have increased trade with FTA countries more than would have happened otherwise.
• Increased trade has been more on the import than export side, most likely because India maintains relatively high tariffs and hence had larger tariff reductions than its FTA partners
• The trade increases have been much greater with the ASEAN than other FTA.

What should be India’s stance towards FTAs and mega regional trade agreements?

• Multilateral trade liberalisation remains the best way forward
• But the WTO process seems to have been overtaken by preferential trade agreements
• Against this background, India has a strategic choice to make: to play the same PTA game as everyone else or be excluded from this process

In the current context of slowing demand and excess capacity with threats of circumvention of trade rules, progress on FTAs, if pursued, must be combined with strengthening India’s ability to respond with WTO-consistent measures such as anti-dumping and conventional duties and safeguard measures.

• For understanding economy concepts, read through our collections on Economics Concepts Simplified