MacroScan - Exorcising Inflation

The ghost called inflation is back to haunt the government. Inflation was the country's Problem No. 1 for much of India's post-Independence history. But since the mid-1990s the problem seemed to have gone away. Not only did the annual rate of inflation measured on a point-to-point basis decline quite sharply to below five percent, but food grain and foreign exchange stocks accumulating with the government made the task of managing any inflationary threat seem like child's play.

Recently, however, inflation seems to have once again become an issue. It all began with reports from the ground that retail prices of many essentials like pulses and vegetables were rising, though the official wholesale price indices (WPI) were not reflecting the trend. Then came the news that the tendency had begun to affect staples like wheat. These ''straws in the wind'' became a cause for concern when it emerged that government stocks of cereals were depleting, the harvest was not as good as expected and procurement was way below target. Finally, the official WPI began signalling a potential crisis.

The last of these facts needs explication. Even the most recent wholesale price indices relating to the week-ending June 10 (released on June 23) do not point to a disconcertingly high overall rate of inflation. According to those figures, aggregate inflation on an annual point-to-point basis, stood at just 5.24 per cent, which is well below the 8-10 per cent rate that signalled a problem in the past.

There are two reasons for this. First, the ''system'', long-accustomed to low inflation, now seems less inflation-tolerant. Taking a cue from international policy trends, the financial media is already predicting a rise in interest rates-an expectation that has been endorsed by the Reserve Bank of India's words and deeds in recent months. Inflation, it is argued, is a sign that the system is ''oveheating'' with-in layman's parlance-''too much money chasing too few goods''. This is seen to require a hike in interest rates to curb debt-financed investment and consumption spending. And, as expected, the yield on government bonds, which leads the trend in overall interest rates, has been rising. The yield on benchmark 10-year Central Government bonds has risen to a four-year high of 8.13 per cent.

The problem here is that higher interest rates are what the ''system'' fears most. As has often been noted in this column, India's 7-8 per cent rate of growth, which the government wants to raise to 9-10 per cent, is based on the availability of plenty of cheap money. That spurs debt-financed consumption spending and housing investment. It also allows corporations to restructure their debt, reducing interest costs, raising profits and spurring investment in sunrise sectors. A rise in interest rates could put the brake on the debt-financed growth spiral.

Low interest rates also support the stock market boom, which has been misrepresented to be a sign of a healthy economy. As the recent downturn in global and Indian stock markets shows, higher interest rates, or even the expectations of a rise, can badly damage the confidence of financial investors, drive stock prices down and wipe out large volumes of illusive paper wealth. The reason is simple-a lot of speculative investment that inflates the stock bubble is financed with debt. If interest rates rise to make it less profitable to borrow and bet, these speculators pull out, depressing stock prices and eroding the value of indices misused as symbols of economic health. Thus expected or actual increases in interest rates are a threat to the ostensibly successful trajectory of growth based on debt-financed spending and symbolised by stock market buoyancy that the UPA government celebrates.

The second reason why an aggregate inflation rate of 5 per cent plus is providing cause for concern is that the aggregate conceals significant variations in the rate of price inflation across commodities, with some essentials registering particularly high price increases. According to reports, in the middle of week-ending June 23, spot prices of pulses like chickpea (chana) and black gram (urad) in Delhi's markets have risen by 40 and 70 per cent respectively, when compared with a year back. Prices of vegetables like tomato are soaring in retail and whole sale markets. And, more recently, wheat prices have also been on the rise, with spot prices having risen by close to 14 per cent when compared with the corresponding date of the previous year.

These differentials are visible in the recently released WPI figures as well, with the point-to-point rate of inflation between 11 June 2005 and 10 June 2006 varying from as low as 2.9 per cent in the case of manufactured products to between 9 and 10 per cent in the case of wheat, fuel and sugar and finally to as much as 35 per cent in the case of pulses. Since the commodities subject to excessive price increases, though few in number, are largely essential consumption goods, inflation has re-emerged as a problem even when the average rate of inflation stands at just 5.2 per cent.
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With the WPI beginning to reflect these trends, the government has decided to act, by exploiting the cushion offered by the large foreign exchange reserves available with the central bank. On the day before the public release of the latest WPI figures, it decided to permit freer import of specific commodities at lower rates of customs duties, on the grounds that increased domestic supply based on imports would help dampen domestic price increases. While an extension of the decision taken in February to import wheat to shore up depleting government stocks, the more recent announcement goes much further. It permits private actual users of wheat like flour millers, biscuit manufacturers and bread makers to import wheat duty free till the next rabi harvest. It has allowed customs duty-free import of sugar till the beginning of the next crushing season which starts in October. And it has put a ban on exports of pulses. All these are expected to augment domestic supply and dampen inflationary price expectations.

This knee-jerk reaction to use imports or reduced exports as a weapon against inflation is of course based on the premise that international prices rule below domestic prices and that inflation is the result of inadequate domestic supply. Neither of this is necessarily true. Thus, sugar mill owners have claimed that duty-free imports of the commodity would have no effect either on domestic supply or prices, because the landed cost of imported sugar is at Rs.23-24 a kg well above the domestic price of Rs.18 a kg. And exports of pulses in 2004-05 stood at just 2.4 lakh tonnes, whereas imports touched 12.96 lakh tonnes.

The more important issue is whether the government's move addresses the real causes of recent inflationary trends. There are a number of such causes. The first of these is the poor agricultural production performance. While inadequate purchasing power may have prevented this from being translated into a situation of supply shortage relative to demand, this is a problem that needs addressing. But the focus of the government's agricultural policy has been that of enhancing credit to agriculture. However, credit has often proved more a problem than a solution, since returns to farmers are inadequate to meet repayment commitments, as reflected by the spate of suicides by debt-encumbered farmers. Moreover, small and medium farmers are often unable to access credit even when it is available in principle. What is needed is to increase public investment in agriculture-a policy alternative precluded by the government's refusal to garner more taxes and its commitment to sharply reduce its budgetary deficit.

Second, removal of controls on the movements of agricultural commodities, liberalisation of rules relating to the operation of private traders and agribusiness firms and the failure to procure adequate amounts at the minimum support price has resulted in a situation where stocks with the private trade are rising while those with the government are increasingly eroded. This has encouraged speculative hoarding at the first sign of an indifferent harvest, resulting in price increases. Speculation, rather than an actual supply-demand imbalance seems to be the problem.

Finally, complacence over inflation has prevented the government from exploiting options available for absorbing the effect of the rise in international oil prices, resulting in an engineered increase in prices resulting from increases in the prices of universal intermediates like petrol and diesel.

In sum, the problem is not one of excess demand in all cases but of manipulated shortages and cost-driven inflation. By trying to deal with these problems with easier imports the government is only increasing its dependence on foreign finance to manage domestic inflation, since it is the availability of such finance that makes enhanced imports an option at a time when the country's trade deficit is widening. It is not clear whether such a policy would be successful. And even if it is, it would imply that the returns to domestic farming would be eroded further, aggravating the long-term deceleration in the rate of growth of agricultural production. Dependence on foreign finance and a worsening of the agrarian crisis seem to be the costs of using imports to exorcise the ghost called inflation.