The RBI governor, Raghuram Rajan, has a difficult task this week. He has to decide whether to keep interest rates constant or raise them — bearing in mind the possible taper of the U.S. Fed's bond buying programme, a decline in industrial production and a rise in inflation. The sharp increase in consumer price-based inflation, to more than 11 per cent, has significantly added to the RBI's headache. The increase in inflation is mainly due to the nearly 15 per cent increase in food prices. This has been led by a 61 per cent increase in the price of vegetables. There are structural problems in agricultural markets, which continue to be regulated by old laws and require licences. Entry into these markets is not free and they remain uncompetitive. The rising demand for food has been met not by an increased supply but by a rise in prices instead.

The demand for vegetables, meat, milk, fish and other food items has been rising with rapid GDP growth and a rise in incomes. Rural demand has increased since 2008 as a result of the MGNREGA and rising rural wages. As income levels increase, the first change in people's consumption basket is in food items. Indian households start consuming more high protein products and fresh vegetables. This phenomenon is discernible in household consumption data. The share of cereals in total food consumption has declined as incomes have increased.

At the same time, after the global financial crisis, world commodity price inflation has decreased. Inflation in tradables, mainly manufactured goods, has been low. Consequently, households have to spend a smaller share of their income on non-food items. Relatively cheaper non-food items means that the share of disposable income available for the purchase of food has gone up. This has further increased the demand for food.

As we know, Indian agriculture is entirely private. If there was free entry into markets and they were competitive, we could expect a better supply response to the increase in demand. In cereals, some of the food inflation is due to higher minimum support prices. MSPs have risen faster than before because the export of cereals is now allowed and, since 2011, world prices are taken into account in their determination. But this does not explain the rise in the prices of vegetables, meat, etc, which are outside the purview of MSPs.

A second explanation is that the MSP system for cereals creates a pro-cereal bias in policy and production. The price system as well as the subsidies for inputs focus on cereals. This reduces the relative risk of growing them. Even though the price for non-cereals — cash crops, vegetables, etc — may be higher, their risk-adjusted returns are lower.

A third explanation often heard for the high food inflation is hoarding. It is argued that traders hoard food to push up prices. But this only explains the rise in the prices of non-perishables. Products like meat and fish, whose prices have also been rising, cannot be stored without cold storage facilities. They are more likely to go bad than see an increase in prices if they are hoarded. Also, hoarding may cause some price volatility but it cannot explain the persistently high inflation for five to seven years in a row.

The lack of a supply response can also be explained by the absence of free and competitive markets, and by laws that do not allow a customer to buy directly from the farmer without a licenced mandi trader as the go-between. On one hand, the Essential Commodities Act does not allow private persons to hold inventories of agricultural goods that are on the list of essential commodities because it assumes traders are speculators, black-marketeers and hoarders. On the other, the agricultural produce marketing committee acts do not allow people to transact without them.

The APMC acts were created in the Sixties and Seventies by various states to promote agricultural marketing. But these and the Essential Commodities Act created several barriers to the development of free and competitive agricultural markets. A licence for trade in agricultural products requires owning a shop/ godown. This has led to the monopoly of licenced traders. It is a major entry barrier for new entrepreneurs who, attracted by the high returns, may want to enter the market. But the licensing system prevents entry and thus competition. Some market yards were established many years ago and these do not have the space for the construction of new shops and godowns. No new licences are available in such a situation. Traders, commission agents and other functionaries organise themselves into associations, which generally do not easily allow the entry of new players. The law hinders both food processing and direct organised retail tie-ups with farmers.

Though the question of agricultural marketing reform has been under discussion for nearly a decade, no action has been taken. In 2003, the Central government, after holding consultations with state governments, and trade and industry representatives, formulated a model APMC act. This was circulated among the states. But until January 2013, only 16 states had amended their acts, and only six had notified the amended rules.

The lack of cold storage capacities and strong supply chains are a serious cause for concern. To be rectified, investment is required. But the inadequacy of public infrastructure such as roads, power supply, etc constrain profitable investment. The thousands of crores that are spent on food storage in India actually go towards storing cereals and building warehouses for the Food Corporation of India or for the public distribution system. Even according to the most lenient estimates, the leakages here are more than 50 per cent.

Central legislation dealing with essential commodities has been liberalised to remove the controls on the movement, storage and marketing of agricultural goods and abolish the licensing system. The number of commodities covered under the act has been reduced from 54 to seven. However, in order to contain the inflationary pressure on the prices of essential commodities, the government has been imposing stock limits on paddy, rice, pulses, sugar, edible oils, edible oil seeds as and when required. At times, as we saw recently, when Mamata Banerjee announced restrictions on the trade of potatoes, even state governments have been imposing restrictions. The ad-hoc approach to the imposition of controls on stock limits and the movement of produce goes against the spirit of reforms, and hinders investment and free trade in the country.

This article was originally published in the Indian Express