Government Intervention And Black Markets

India recently doubled its import customs duty on gold from 2% to 4%. At the current price of INR 31,000 per 10 grams of gold, the import duty works out to INR 1,240 per 10 grams.

Until 1992 gold imports into India were restricted by the Gold Control Act 1962. In 1992 the act was abolished and free import of gold into the country was allowed with payment of customs duty at INR 250 per 10 grams. Gold imports went up from nothing to 100 tonnes. As the price of gold started increasing, the duty remained fixed and was futher brought down to INR 100 per 10 grams in 2003.

Growing up in India, I watched a lot of bollywood movies. The bad guys throught the 1970s and 1980s in India were food adulterators and gold smugglers. By 2003 the gold smuggling market in India virtually disappeared and official gold imports had touched 800 tonnes per year.

The government of India increased import duties on gold in March this year and by May gold imports into India had fallen 32%. Only the naive would believe that Indians have changed their preference for gold because of an increase in customs duty. The sad part is that the entire government bureaucracy is aware of this fact. The motivation behind changing the import duty on gold seems ulterior. The government will gradually destroy the above board and compliant gold and jewellery industry and the entire industry will now move back into the black market.

A reverse example is visible in the fertilizer industry. The government of India has historically regulated the price at which fertilizers can be sold to farmers in the country. The difference between the actual cost of the fertilizer and the price at which it is sold is paid by the government as a subsidy to farmers that is channeled through fertilizer companies. The two most popular varieties of fertilizer used in India are urea (nitrogen based) and DAP (diammonium phosphate).

DAP sold in the world market for a price between USD 170 and USD 250 a metric tonne between 2000 and 2006. In 2007 the price of DAP doubled from USD 250 to USD 500 a metric tonne. In 2008 it again doubled to USD 1000 a metric tonne. It declined during the financial crisis and currently sells for about USD 600 a metric tonne.

As the price of DAP increased rapidly, the government was not able to increase the selling price to farmers and the government's subsidy burden exploded upward. In 2008 a metric tonne of DAP was sold to farmers for INR 9,350 compared to the imported cost of INR 55,000 per metric tonne. Unsurprisingly Indian DAP demand started growing rapidly.

While India's natural consumption of DAP was increasing, smuggling was a big contributor to consumption growth as well. Truckloads of fertilizer started leaving the country's porous border into Bangladesh and from there were exported to the rest of South Asia.

In 2010 India introduced the Nutrient Based Subsidy (NBS) regime that fixed the quantum of subsidy and allowed fertilizer companies to set the retail price of DAP. Urea was not dregulated. The price of DAP increased first to INR 15,000 a metric tonne, then to INR 19,000 and currently is at INR 24,000. The subsidy on a metric tonned of DAP currently is at INR 15,000.

However, as prices of DAP increased, the consumption of DAP in the country started declining. DAP consumption has fallen 29% over last year. Commentators talk about substitution of urea for DAP as farmers are unable afford DAP at increased prices. But this is not borne out by facts as urea consumption has not increased correspondingly. It is also not possible that actual demand for fertilizers in aggregate has declined because farm output and yields continue to rise. Clearly, the increase in retail prices has made smuggling a less profitable business.

In my opinion, elimination of subsidy completely or targeted subsidy through direct transfers will see a further decline in fertilizer consumption. Urea might see a precipitous decline in consumption if prices are increased and subsidies reduced.

What is likely to be the impact on companies? Those companies that have strong distribution networks and sell to actual farmers will not see any significant degrowth. However, those that import a lot of fertilizer or rely on bulk sales (most likely source of diversion) are likely to get disproportionately impacted. On the macro front, India's subsidy burden will come down and India's fertilizer imports might decline significantly.

One more example where government subsidy creates a black market is in the kerosene market. The government has fixed the retail price of kerosene at an unrealistically low price and heavily subsidizes the fuel. The argument for subsidizing kerosene is that it is a cooking fuel used by the poorest of the poor in India.

However, the biggest use of kerosene is to adulterate petrol/gasoline. A litre of kerosene is sold for INR 15 (at a loss of INR 35 per litre) compared to a selling price of INR 70 for a litre of petrol. Adulterating petrol with kerosene is therefore a phenomenally profitable business. One can however see that if the subsidy is eliminated, the business is not likely to remain very profitable.
Kerosene adulteration of petrol is an organized crime in India and is run by criminal/political syndicates with payoffs reaching the highest offices of the country. It is unlikely that this differential will be eliminated any time soon.

Unintended consequences an impacts of government interventions need to be watched very carefully. It is important not to take numbers and statistics at face value.