Inflation

Over the last decade India has seen a downward spiral in the inflation rate thereby leading to price stability. This price stability has been the cornerstone of our economic policy regime for a long period. The Finance minister in his budget reiterated the stated policy using the words of the prime minister: "I think no Government in our country can be oblivious to the objective of ensuring reasonable price stability without hurting the growth process." But these good times may be coming to an end.

The recent changes in the global macro-environment have led to possible downside risks to the world markets. Global prices of crude oil, commodities and food grains have risen sharply in the last year. Important commodities like iron ore, copper, lead, tin, urea etc are seeing sharp price increases. Food grains like wheat and rice have increased in the world market by 88 % and 15 %, respectively. While noting all these inflationary trends, the finance minister acknowledges the criticality of management of the supply side of food articles. Added to these pressures have been copious capital inflows, thereby creating greater demand due to excess liquidity. While capital inflows per se are not negative, inability to direct these capital flows to stimulate economic activity would lead to more money chasing limited goods and services. This would lead to steep increases in prices and a possible general economic slowdown.

Has the budget 2008 done enough to stimulate economic activity in the country? The answer seems to be more NO than YES. The government has by providing loan waivers to farmers and increasing funds to social sector ensured that demand from rural India remains robust. Moreover, the personal tax cut which ranges from 4000 to 50000, depending on which tax bracket one falls in, also implies that the urban middle class has an enhanced buying capacity. While these measures are likely to lead to increased demand, it is unclear whether industry will be able to supply goods and services with enhanced productivity and lower costs.

Industry has also been positively impacted by reduction in excise (by 2 percentage points) and reduction in central sales tax (by 1 percentage point) thereby reducing costs. But herein ends the good news. Corporates continue to face a high cost of capital. The RBI’s monetary policy and the huge government borrowing imply that industry has limited access to capital and capital shortage also leads to higher interest rates. Policy attempts to slow down foreign capital inflows through controls implies that Indian corporates have a cost of capital close to 10% while most companies in US and Europe have access to funds at interest rates less than 5%.

In addition, the lack of any special stimulus to physical infrastructure – rail, roads, port – only means that our supply chain is significantly constrained. Most studies indicate that inadequate physical infrastructure has led to significant delays and cost increases, thereby reducing the productivity and cost competitiveness of our industry.

Given the heightened sense of uncertainty in world financial markets, it would be extremely difficult to predict the trajectory of inflation. As of now there are two possible emerging scenarios. Scenario 1 is that of a domestic consumption (owing to personal tax cut and loan relief to rural India) induced growth in the Indian economy as the world corrects itself for excesses in the credit market. Scenario 2 presents the possibility of cost increases in commodities, poor augmentation of physical infrastructure leading to supply side bottlenecks, which in turn would fuel enhanced costs and reduced productivity. Greater money chasing such products and services would only stoke up inflation.

As of now both the scenarios seem possible. But what is more likely to happen is that in the short run Scenario 1 might unfold, but if we are unable to control commodity prices, direct FOREX inflows to productive sectors, and improve the overall physical infrastructure within a reasonable timeframe, in the longer run we shall not be able to avoid the nightmare of Scenario 2.

By Srinivas Rao