The Ogre of Inflation: Causes, Solutions and Side Effects - Suresh Srinivasan

Background

Inflation levels scaled new heights crossing the 6% mark reaching a fourteen-month high during the week ended March 15. This caused serious concerns for consumers. The situation further worsened when inflation, based on a Whole Sale Price Index (WPI), crossed the 7% mark during early April and reached a forty-month high.

An average Indian is reported to spend approximately more than 50% of his total income on food consumption, and to that extent, the current bout of price increases in food items is expected to sharply hurt the domestic budget of Indian families. An all round price increase was visibly evident over the last month or so with prices of most essential commodities such as food items, milk, edible vegetable oils and vegetables rising sharply along with those of manufactured goods, fuel, steel and cement. Given the sensitivity of the common man to the issue of price-rise and his vulnerability, inflation also has significant political ramifications in an election year. The price rises have been of great concern to the ruling UPA coalition, and a series of emergency meetings were held by the Cabinet Committee on Prices to review the same.

What is different with the type of inflation this time around?

One can argue that inflation has always remained an issue in the Indian context. Since India is undergoing large-scale and expansive growth, one of the biggest challenges facing the country, and for that matter any economy growing at a pace of 8% plus, is that of tackling inflation. Usually during such a phase of growth, regulatory policies are created to facilitate all round economic growth. When there is a surge in bank credit directed towards consumers (for example, more credit cards sanctioned and more loans provided to consumers), such actions invariably increase the disposable cash in the hands of the consumers and their ability to spend increases significantly. Similarly, when more credit is directed towards construction, commercial and residential real estate sectors, it is common to find surplus liquidity created in the economy, pushing up demand from consumers. However, the goods and assets in the economy are more or less static at this point which eventually results in more money chasing fewer goods. This leads to an increase in the prices of goods and assets. This type of an inflationary pressure is generally described as ‘demand pull’ inflation. In such situations, the Central Bank resorts to fiscal measures such as increases in interest rates or increase in Credit Reserve Ratio (CRR). These reduce liquidity in the economy and thereby bring down the excessive demand. We have seen this phenomenon frequently happening in India during the past when inflation levels surged past the 5% mark and fiscal measures were taken to bring it under control. However, the type of inflation that the country is currently facing is different from the ‘demand pull’ inflation described above and the traditional fiscal measures might not be appropriate to tackle such a situation.

The Reserve Bank of India (RBI) has indicated that the reasons for the current bout of inflation are more supply driven – commodities are in short supply and inadequate to meet even normal levels of demand, which is causing prices to rise. The average stockholdings of commodities in the country are mentioned to be significantly lower than the acceptable levels. It is also a fact that shortage of food items is not a problem unique or restricted to our country; the global stocks of food items have dropped to dangerously low levels with inflation hitting the roof in many developed and developing countries. There is a serious shortage of food supply in Australia and export of rice has been regulated in many countries including Thailand and Vietnam. Also, the use of cereals for bio-fuel production is diverting a significant level of food commodities to other purposes and is partially responsible for creating the shortage.

Analysts argue that this is not the first time that global supply of food items has dwindled, this also happened during the early 1970s when food commodity prices increased by more than 70%. That was primarily driven by the fuel price increases around that time and the inflationary impact then was, to a large extent, permanent. However, the Green Revolution and the high agricultural growth that followed in India during the late seventies and early eighties mitigated the supply side problem significantly. In the current situation, however, the global food supply crisis is likely to persist for a longer time frame as developing economies have turned out to be large scale consumers, whereas agricultural production has not been keeping pace. Thus substantial growth in agricultural sector will be critical in tackling the present problems.

The political angle; who is to blame?

The Left parties, predictably enough, have blamed the ruling government for this debacle. It is widely perceived that the government lacked adequate commercial intelligence and research capabilities to assess the demand and supply positions of critical commodities on an ongoing basis, and thereby failed to put in place an intelligence mechanism to forecast price levels.

The Left parties have further called for banning derivative products and futures trading in many of the commodities, citing that such speculatory motives in these transactions will lead to hoarding of commodities by the wholesalers. They claim that one of the main causes for price increases has been the artificial supply shortage created by many wholesalers. So who is responsible for this situation? The government? Perhaps not in entirety, but it is a fact that given the global scale of the commodity problem, the Indian government and policy makers should definitely have anticipated this problem and managed the situation in a more proactive manner.

Possible solutions

Rightly, the government has started to selectively cut excise and customs duties on many critical commodities like edible oils, steel, cement so that they are available in larger quantities and at lower prices, which will definitely provide relief to some extent. Parallelly, exports of edible oil have also been banned. Customs duty on various other commodities like butter and ghee has also been cut. Import duty on many items including maize has been scrapped. Apart from tariff measures, the Government has also taken a series of administrative steps to clear hoarding and improve supply in the domestic market. The government has also held a series of meetings with the steel manufacturers’ association that includes large manufacturers including Tata Steel, SAIL and Essar for deliberations to reduce steel prices; this is expected to lead to a reduction in prices by at least 20% in the short run. With the present inflationary trends being mostly supply related, interest rates and CRR adjustments might not be enough to address the issue in its entirety. Given the intensity of measures taken by the government, the wholesale prices of edible oils have started dropping significantly, but it seems that it may be a longer period before we see long term reduction in inflation rates. One has to appreciate that there are short term measures and quick-fixes only and will not suffice in the long run.

Side effects of the inflation containing mechanism

Analyze the effects of the inflation controlling measures adopted by the government on the country’s import-export equation, and many interesting facts emerge. The current bout of polices targeted towards lowering inflation in the country has seriously impacted the import-export balance of the country. There are many factors that have impacted this sensitive balance. For the eleven months ended Feb’ 08, India’s exports amounted to around $140 billion, while imports amounted to $210 billion, throwing up a trade deficit of around $70 billion.

India had originally targeted an export of $160 billion for the current year, which now does not seem to be achievable given the various curbs on the exports of essential cereals, metals and other essential commodities. Moreover, traditional export-oriented industries like textiles, handicrafts and leather have all been experiencing negative growth in exports for quite some time due to the strengthening rupee. The case with the (IT) and IT enabled services (ITES) businesses has been slightly different, as their exports of services in volume terms have not decreased but the net export realization in Indian rupee terms has been impacted due to the strengthening rupee. Further, slowdown in the US and other Western economies has also had a negative impact. To add to it, import liberalization and duty cuts on many commodities have aggravated the situation. These have significantly boosted imports, widening the trade deficit. To top it all, crude oil prices have reached historic highs and have added to surging import costs, as India is one of the largest consumers of crude oil.

To achieve a balanced long-term solution for this critical problem, therefore, the government needs to address the following issues:

 Speed up measures for boosting agricultural growth. The sector is currently growing at less than 2%; there needs to be 4% growth in the agricultural sector.

 The public distribution system (PDS) needs to be strengthened. This will require co-operation between the State and the Central Authorities. It will allow the produce from farms to be procured at a good price, and enable delivery of the same at reasonable prices to the consumers.

 Speculative transactions of futures on commodities need to be cautiously managed. If not, these could result in hoarding and further artificial shortage.

 The problems arising from the cascading global commodity shortages need to be cautiously watched, and proactive measures taken in a timely manner. This will ensure that the balance of trade position is not unduly impacted due to unavoidable knee-jerk and reactive measures of the government.

In conclusion, it is going to be a tightrope walk for the government as well as regulatory authorities that needs to be sincerely executed in order to ensure that the common man does not suffer more.

The writer is an MBA, Chartered Accountant and Cost Accountant with 18 years of industry experience. At present he is a PhD scholar at IIT Madras.

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