Federation of Karnataka Chamber of Commerce and Industry: April 2008 Issue
INFLATION’S LOOMING THREAT GOING FORWARD,
by Adhvith Dhuddu, Regular Columnist

The first four years of our Finance Minister’s term unfolded with buoyancy and resilient growth in most sectors. GDP grew handsomely, rising household incomes pleased the masses, corporate profits scaled new highs, the stock markets ventured into uncharted territory and prices across the board were relatively stable.

But the recent and sudden spike in prices exacerbated the looming inflationary threat and is creating jitters in the Finance Ministry, Commerce Ministry, RBI and more so at 7, Race Course Road, the PM’s Residence. Speculation about early elections is alive and well but even the regularly scheduled May 2009 elections could be marred with high inflation and outrageous price rises. This recent price rise is merely a preview of the agony faced by the electorate if appropriate measures are not taken to prevent further price rises and curtail inflation.

Recent measures taken during the damage-control mode seemed to have assuaged some pressures but pivotal factors which determine inflation (discussed below) are still at bay. Our FM, PM and RBI governor have vocally pledged that price stability

In a great nation like India, it is quite a pity when a starving family and has to make a choice between food and medicine when somewhere in the country food reserves in godowns are rotting.

is a high priority objective and are even willing to sacrifice growth to suppress inflation; a positive sign. But let’s examine what the FM has said before about inflation, price stability and monetary policy to measure him against his own benchmarks and analyze some root causes of inflation to tackle unfavorable price rises in the future.

Economist John Maynard Keynes said, “Inflation is a form of taxation which the public find hardest to evade and even the weakest government can enforce when it can enforce nothing else.” This invisible tax eats into the savings and incomes of the rich and poor alike, but impacts the lower rung more. In a developing economy like ours, the absence of a social security safety net and absence of income and employment insurance in the unorganized sector (which employs a significant portion of our population) severely aggravates the inflationary consequences for lower and lower-middle class families. The published inflation rate clouds the all important rate of increase in the price of basic food which affects the majority of our population. For example primary articles (which comprises 22 percent of the WPI and contains food articles) registered a growth of close to 9 percent at March end.

Many attribute the current spike in inflation to global externalities like widespread commodity price rise, supply shortages, demand increases, etc. This is true only to a certain extent as these trends have been in place for sometime (1-2 years). There are some reasons unique to India which is driving up inflation and needs to be tackled. Here are some of the fundamental macro issues causing inflation (and will continue to do so if they are not confronted).

1. Outrageous Money Supply: Going back the basics of inflation you learn that it is primarily caused by money supply issues. A continuous increase in money supply creates a situation where more and more money is chasing the same number of goods and services and this automatically drives up prices (irrespective of the supply-demand equation of the product). The importance of this characteristic cannot be stressed more because it has been the primary cause of high-inflation periods in recent economic history. USA (1973-1982), Germany

A continuous increase in money supply creates a situation where more and more money is chasing the same number of goods and services and this automatically drives up prices.

(during the 1970s) and Japan (1971-1980) experienced high inflation during the periods mentioned. All these were caused due to an increase in money supply and the central banks of all these economies had to drastically reduce money supply and increase interest rates to squeeze inflation out of the system.

Looking at the numbers from the recently released Annual Policy Statement 2008-09 from the RBI (abbreviated as RBI-APS-0809 for future references) proves the above point. According to the report, money supply (M3) increased by 20.7 percent in 2007-08, and 21.5 percent in 2006-07. Supply of money in the form of bank credit to the commercial sector increased 20.3 percent and 25.8 percent in the preceding two years respectively. All these increases are above the long term average rate of money supply growth in India. In fact later in the report RBI even acknowledges that, “money supply has risen above indicative projections,” and hence has decided to slow the printing presses. They plan to moderate monetary expansion (i.e. money supply) this time around only at 16.5-17 percent. The RBI deserves restrained applause because this is a step in the right direction and the problem is being tackled at its root. This is just the start and there should be a continued effort to control the supply of money, or we could see multi-year inflationary periods like the ones experienced by USA and Germany in the 1970s.

A common argument that is cited to support the increasing money supply numbers is the increase in net capital inflows. I will discuss this in detail later.

2. Inefficient Food Distribution Channels and Farming Techniques: Anyone blaming the supply-demand mismatch for recent price spurt in food articles needs to think twice before making that claim. The Ministry of Agriculture recently released numbers stating that, “total food grain production is expected to increase to an all-time high of 227.3 million tonnes in 2007-08 from 217.3 million tonnes in 2006-07.”

So, if the increasing disposable income of families is being reflected in the increased demand and supply of food is at record levels, why is it that food prices are going through the roof? It’s a simply because of horrendous and outright awful supply chain management and distribution techniques (or lack of them) that is driving up prices. The various middlemen coupled with rotting grains in the warehouse automatically decrease supply and increase the prices. No rain God, clearing of debts, increasing of fertilizers, giving free electricity or water, increasing/decreasing all sorts of taxes and duties, banning and placing limits, etc will solve this. It’s been tried repeatedly and has failed miserably. It’s pretty abysmal when our farmers are toiling hard in the fields only to see significant portions of their crop rot in godowns because of inefficient food and crop management.

In a great nation like India, it is quite a pity when a starving family and has to make a choice between food and medicine when somewhere in the country food reserves in godowns are rotting. We boast of churning out quality engineers, being home to IT behemoths and rich industrialists, but these are insignificant if we cannot feed our own people well. India’s food economy has to be strengthened and some basic steps like improving distribution channels, optimizing supply chains improving storage facilities must be undertaken. Knowing the unreliable nature of our government especially in the agricultural sector, the best way of doing this is to introduce competition. This should be a long term commitment and will eventually be undertaken when there is a crisis, like how the

Artificially keep the Indian Rupee (INR) undervalued vis-à-vis the USD by pumping in billions of dollars is analogous to pouring money into a bottomless pit for short term happiness. This flawed approach to undervalue the currency to improve growth is wrong and unsustainable in the long run.

foundations of our economy were reformed during a crisis. When a patient’s veins or arteries are clogged hampering the blood circulation, the doctor does not pump in oxygen, replace a leg or a hand, or improve the condition of the blood, he tries to open up the arteries first to improve blood flow and then tackle other issues. This is what needs to be done in the agricultural sector in India.

3. Misguided Currency Management: The misconception that a weak currency vis-à-vis the US dollar (USD) is good for Indian businesses because it serves as a backbone for export oriented businesses is widespread in India. The cheer leading from export oriented industries and export lobbies to artificially keep the Indian Rupee (INR) undervalued vis-à-vis the USD by pumping in billions of dollars is analogous to pouring money into a bottomless pit for short term happiness. This flawed approach to undervalue the currency to improve growth is wrong and unsustainable in the long run.

I agree that advocating an absolutely hands-off approach could be detrimental and make our currency extremely volatile creating ripples in the economy. Instead there should be a slow process of decontrolling currency valuation to allow the market forces to operate with relative freedom and enable price discovery. Another option is to allow the value of the INR vis-à-vis the USD to rise faster.

Besides helping the fight against inflation a strong local currency is beneficial in other ways. A stronger INR will automatically reduce food exports, keeping more food at home, hence increasing supply. Our strong currency will also increase imports

There should be a slow process of decontrolling currency valuation to allow the market forces to operate with relative freedom and enable price discovery.

of food because the same currency can now buy more hence increasing supply again. The government can then refrain from the ancient and unsuccessful policies of raising and lowering duties, banning and limiting stocks, etc. The increased purchasing power of the INR will be able to buy more products for the same amount of money. All this will automatically reduce inflation because of an immediate increase in supply and stronger currency being able to purchase more. There are some caveats associated with this technique but if executed with precision, it can work well.

Coming back to the argument that money supply should grow to support net capital inflows, we can see how a stronger currency can solve this too. According to RBI-APS-0809, “net capital inflows surged by 172 per cent to $81.9 billion during April-December 2007,” requiring the RBI to increase the supply of Indian Rupees. In lay man’s terms, over the last few years the demand for our currency has gone up but that strength is not reflected completely at the current price of our currency. Its common sense that demand for a certain product increases in the financial markets when the market perceives it to be undervalued and slowly reduces when the market thinks the price is fair.

But, in the case of the Indian Rupee, because the value of the currency has been artificially suppressed, the demand for it doesn’t seem to go away. The government ends up fighting a battle on two fronts: it has to continue to keep the Indian Rupee undervalued (to help exporters) by pumping money, but also try to decrease the demand for

Increasing the currency’s strength will mean less money needs to be printed to support net capital inflows, less money needs to be printed to support artificial currency valuation and less money needs to be printed as the purchasing power of our currency increases, eventually also helping tame inflation.

the currency so that market forces don’t overwhelm governmental force suppressing the price of the Indian Rupee. Finally the government has to continue printing more money to support the required payments to keep the INR undervalued. As capital inflows increase, as demand for local investment increases, and in general as the demand for INR increases it should be reflected in the currency, but it is not. So allowing the currency to strengthen will automatically relive the pressure to continue increasing money supply at high rates. Increasing the currency’s strength will mean less money needs to be printed to support net capital inflows, less money needs to be printed to support artificial currency valuation and less money needs to be printed as the purchasing power of our currency increases, eventually also helping tame inflation.

Consider this practical case: A year ago the central bank was making a valiant effort to keep the Rupee at 44-45 levels (vis-à-vis the USD), but eventually gave in when they were overwhelmed by market forces (and also the rising cost of suppressing the INR) and stepped back to allow a 10-15 percent appreciation of the Rupee to 39-40 levels. What about the approximately $120 billion pumped in to keep the Rupee at 44-45 level? It’s gone, wasted and will never come back (i.e. being held in USD denominated assets); in fact its value has now decreased because the US dollar has depreciated vis-à-vis the Rupee (imagine if this money could be used in more productive ways). History has shown repeatedly that as an economy strengthens, over the long run the value of its currency will rise. It is basically pointless to continue pumping money continuously to keep the currency at an artificial level. Think of the same situation two years from now when our government will again struggle to keep the Rupee at the 39-40 level by pumping in money and again give up to let it rise to the 35-36 level. With the democratization of finance and integration of financial markets over the globe it will become increasingly difficult and expensive to control currency values.

4. Flawed analysis that banning exports, tweaking import/export duties, fixing stocks levels, etc will solve the inflation problem: For some reason, our politicians and bureaucrats don’t seem to understand that these temporary tweaks will not solve inflationary issues in the long run. Generally, a complete scrap of import or export duties is good, but banning any kind of exports or imports, mandating stock levels, etc is unacceptable in a capitalistic and forward looking economy like India and is synonymous to going one step forward and two steps back.

On monetary policy, the FM said a few years ago that, “Unless we bring the fiscal deficit down to 3 per cent or below, we cannot gain mastery over inflation.” The finance ministry along with the RBI has worked diligently to achieve this number and have to be given credit for their efforts. On last count, the Gross Fiscal Deficit (GFD) for 2007-08 constituted 3.1 percent of GDP (from RBI’s Annual Policy Statement 2008-09). A significant assist from increased tax revenue cannot be denied and definitely contributed to this achievement.

There is another crucial reason that inflation needs to be brought under control. High inflation rates usually results in an ultra-low or negative net savings

But our Finance Minister certainly deserves credit for his ability to be able to balance the demands from the left and the right, the aam admi and the corporations, the public and the private sectors.

rate. According to our own Finance Minister, “High inflation and a negative return for depositors/savers make for an explosive combination, when key elections are round the corner.” (November 2^nd, 2003). Let’s see how our captain navigates this ship going forward.

It’s a relatively stress free job to analyze numbers, rely on theories and suggest remedies for the problems facing the economy right now. But our Finance Minister certainly deserves credit for his ability to be able to balance the demands from the left and the right, the aam admi and the corporations, the public and the private sectors and still manage to keep India’s growth intact and its flag fluttering proudly in the sky.