The sub­sidy trap

Financial Mirror (Cyprus) - - FRONT PAGE -

Few poli­cies place good eco­nom­ics so di­rectly at odds with good pol­i­tics as sub­si­dies for food and en­ergy. The is­sue of un­af­ford­able sub­si­dies is now front and cen­tre for three of the world’s most im­por­tant new lead­ers: Egyp­tian Pres­i­dent Ab­del Fat­tah el-Sisi, In­done­sian Pres­i­dent-elect Joko “Jokowi” Wi­dodo, and In­dian Prime Min­is­ter Naren­dra Modi.

Sisi is con­fronting the need to cut sub­si­dies bet­ter than might have been ex­pected. Modi, by con­trast, is do­ing worse than ex­pected – even tor­pe­do­ing a long-an­tic­i­pated Word Trade Or­gan­i­sa­tion agree­ment. With Jokowi, it is too soon to tell.

In July, Sisi ac­com­plished what few lead­ers in North Africa or the Mid­dle East have: he sharply cut long­stand­ing fuel sub­si­dies and al­lowed prices to rise by 41-78%. Sur­pris­ingly, few protests ma­te­ri­alised.

Egypt’s food sub­sidy pro­gramme, which costs more than $5 bln a year, is in ur­gent need of re­form as well. The price of bread has been kept so low that it is of­ten fed to an­i­mals. Past at­tempts to re­duce such sub­si­dies in North African coun­tries have brought un­rest and even top­pled gov­ern­ments. But the Sisi gov­ern­ment ap­pears to be mak­ing progress here as well. Bread sub­si­dies have al­ready been cut by 13%.

Sisi had lit­tle choice. Even with sub­sidy cuts, the cur­rent gov­ern­ment is tar­get­ing a bud­get deficit of 10% of GDP in the com­ing fis­cal year (com­pared to 14% oth­er­wise). Still, few ex­pected Sisi, who took of­fice in a frag­ile po­lit­i­cal en­vi­ron­ment, to move faster than Modi, who was elected with a whop­ping demo­cratic ma­jor­ity amid hopes for sweep­ing economic re­form.

In In­done­sia, when Jokowi takes of­fice in Oc­to­ber, he will in­herit a long his­tory of fuel sub­si­dies that, at $21 bln a year (up to 20% of gov­ern­ment spend­ing), the coun­try can no longer af­ford. Out­go­ing Pres­i­dent Susilo Bam­bang Yud­hoy­ono took a first courageous step by rais­ing fuel prices a year ago. Jokowi’s ad­vis­ers favour cut­ting the re­main­ing sub­si­dies, and he has al­ready forthrightly said that he grad­u­ally, over a four-year pe­riod.

Economists feel con­fi­dent in op­pos­ing com­mod­ity sub­si­dies be­cause agri­cul­tural and en­ergy mar­kets tend to ap­proach the ideal of per­fect com­pe­ti­tion, with a large num­ber of con­sumers on the de­mand side and pro­duc­ers on the sup­ply side. Where com­pe­ti­tion is im­per­fect, gov­ern­ment, not large pri­vate mo­nop­o­lies, is usu­ally the rea­son.

Crit­ics of the in­vis­i­ble hand point out that, left to them­selves, pri­vate mar­kets can fail in a num­ber of ways. For ex­am­ple, in­come in­equal­ity and en­vi­ron­men­tal ex­ter­nal­i­ties are two of the most prom­i­nent jus­ti­fi­ca­tions for gov­ern­ment in­ter­ven­tion.

What is strik­ing about food and fos­sil-fuel sub­si­dies is that they are of­ten pro­moted in the name of the en­vi­ron­ment or eq­uity, but usu­ally do lit­tle to achieve th­ese goals, and of­ten have the op­po­site ef­fect. Less than 20% of Egyp­tian food sub­si­dies ben­e­fit poor peo­ple. Gaso­line sub­si­dies in most coun­tries ben­e­fit the mid­dle class, while the poor walk or take public trans­porta­tion. In In­dia, less than 0.1% of ru­ral sub­si­dies for Liq­ue­fied Pe­tro­leum Gas go to the poor­est quin­tile, while 52.6% go to the wealth­i­est. World­wide, far less than 20% of fos­sil-fuel sub­si­dies ben­e­fit the poor­est 20% of the pop­u­la­tion.

Food and en­ergy sub­si­dies can also dis­tort public pol­icy, as Modi’s gov­ern­ment, seek­ing to pro­tect In­dia’s agri­cul­tural sub­si­dies, has shown. In­deed, its veto of a WTO com­pro­mise has de­railed the most im­por­tant progress in mul­ti­lat­eral trade ne­go­ti­a­tions of the last ten years.

Agri­cul­tural sub­si­dies some­times seek to ben­e­fit con­sumers at the ex­pense of pro­duc­ers, es­pe­cially in poor coun­tries, and some­times seek to ben­e­fit pro­duc­ers at the ex­pense of con­sumers, es­pe­cially in rich coun­tries. In­dia’s poli­cies try to do both. As a re­sult, In­dia has ac­com­plished the ex­tra­or­di­nary feat of ra­tioning grain to con­sumers at ar­ti­fi­cially low prices, while si­mul­ta­ne­ously suf­fer­ing ex­cess sup­ply, be­cause farm­ers are paid high prices. (Farm­ers are also sub­sidised via agri­cul­tural in­puts – elec­tric­ity, wa­ter, and fer­tiliser – to the detri­ment of the en­vi­ron­ment.) The gov­ern­ment has pur­chased huge stock­piles of rot­ting rice and wheat, while the limited amount avail­able to con­sumers is al­lo­cated in ways that are




so cor­rupt and in­con­sis­tent with the stated goal of help­ing the poor.

The gov­ern­ment would like to keep its sub­si­dies and stock­piles. But it knows that this would vi­o­late WTO rules. Un­able to ob­tain a per­ma­nent change in th­ese rules, Modi ve­toed the WTO’s ea­gerly an­tic­i­pated Trade Fa­cil­i­ta­tion Agree­ment.

Once sub­si­dies are in place, they are ex­traor­di­nar­ily dif­fi­cult to re­move. When world com­mod­ity prices rise, as they of­ten have over the last decade, cit­i­zens who are ac­cus­tomed to the do­mes­tic price be­ing set in the mar­ket are more likely to ac­cept the re­al­ity that of­fi­cials can­not in­su­late them from the shock. But peo­ple who are ac­cus­tomed to ad­min­is­tra­tively es­tab­lished food and en­ergy prices hold the gov­ern­ment re­spon­si­ble.

That is a strong rea­son not to adopt such sub­si­dies in the first place. But it does not nec­es­sar­ily mean that, once sub­si­dies are in place, keep­ing them is a savvy politi­cian’s best op­tion. If the al­ter­na­tive to rais­ing the price is short­ages or ra­tioning, an­gry pro­test­ers may mo­bilise any­way. Sim­i­larly, the pro­cras­ti­nat­ing leader is un­likely to ben­e­fit if ever-widen­ing gaps force an even big­ger re­tail-price rise when the day of reck­on­ing comes.

The savvy politi­cian should prob­a­bly an­nounce the un­pleas­ant ad­just­ment as soon as he takes of­fice. Jokowi and Sisi seem to have adopted this ap­proach. Modi, de­spite his huge elec­toral man­date and hype about mar­ket re­forms, has fallen short.

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