Saturday, April 5, 2008

Inflation concerns rise

The inflation story is assuming alarming proportions. Figures for the week ended March 22, reveals that inflation has risen to a three year high of 7%.

Earlier this week, the Government of India announced measures to ease supply side constraints by abolishing import duty on crude form of edible oils, cutting rates on refined edible oils and banning non-basmati rice exports. The Government scrapped import duties on all crude edible oil forms, while cutting duties on refined palm, sunflower, soyabean, coconut oils and hydrogenated vegetable fats to 7.5 per cent. This follows previous measures like ban on futures trading in wheat, rice and pulses, and ban on exports of pulses. These were follwed with the withdrawal of incentives for export of basmati rice.

On a year-on-year basis, the wholesale prices have risen by 27% for iron and steel category, 21% for edible oils, 6% for cereals, 11% for vegetables, 10% for milk, 9% for dairy products, 5% for cement, and 9% for both mineral oil and coal. As can be seen, the major cause for concern comes from iron and steel and edible oils.

The problem faced by the Government is that the recent price rises are not an isolated Indian phenomenon, and cannot be solved by even addressing all our supply side concerns. Global commodity prices - energy, minerals and raw materials, and foodgrains - have been an upward rise for over two years now, and shows no signs of abating. IMFs commodity price index shows that since 2005, food prices are up 65%, metal prices 70%, and petroleum products are up 175.7%. The reasons for the price rises have been well documented here, here, here and here.

Inflation in all our neighbours is much higher than here. Apparently, we are only 79th among high inflation countries. Chinese inflation for February touched 8.7%, an eleven year high. Developed countries too are facing unprecedented inflationary pressures. In an interdependent and integrated global economy, India cannot continue to remain isolated from this global trend.

As has already been written about in previous posts, the Indian growth story is not likely to be affected much by the inflation. The strong demand side pressures will ensure that investments in infrastructure, real estate, inputs to infrastructure sector etc will remain robust. India Inc's order books are already overflowing. The corporate sector has reported a 35 per cent growth in orders in FY07 at Rs 74,568 crore. Order books during the second and fourth quarter of FY08 grew by more than 100 per cent, while the biggest order inflows, in absolute terms, were recorded in the second quarter ended September 30, 2007 at Rs 59,253 crore. The order inflow in the fourth quarter totalled Rs 40,729 crore compared with Rs 19,280 crore in the fourth quarter of FY07, belying slowdown concerns.

The rise in prices has also had little impact on the sales of consumer durables and non-durables. This can be partly explained by the fact that in a nascent and fast growing consumer market like ours, the demand for such products are likely to exhibit inelastic characteristics. The consumer base, especially in the villages and small towns, is expanding very fast, even faster than the supply, and more than off-sets any fall in demand in the older markets due to higher prices. Experts say that consumers have become more value-conscious and less price-sensitive in the mid-priced segment and above, and this segment is also expanding very fast.

The government intervention till date have been focussed on easing supply constraints on food grains. But the major contributor to the 7% inflation has been from non-food primary articles, which have risen 14.6% and basic metals and alloys which have risen 22.9%. In contrast, the food basket has become dearer by only 8.2%. There is precious little the government can do to ease the supply pressures on the non food and metal categories. The high global market prices for these commodities and our dependence on imports means that we have little choice but to live with these higher prices. Further, the relatively small quantities of our imports in relation to the total demand for those commodities, means that the influence of these policies are likely to be only minimal.

Given the cost push, rather than demand pull, nature of the present inflationary pressures, any monetary tinkering is likley to have little impact. Credit growth was at a very reasonable 22% for the last fortnight of February. In fact, they are likely to rebound with adverse consequences on the economic growth. This has been explained in previous posts.

The only hope is for the recession in US to weaken demand for raw materials and other inputs in exporting nations, thereby causing a fall in prices of commodities. The global economy has been growing at a scorching pace over the past decade, stretching the supply side to its seams and resulting in capacity over-utilization. It was only to be expected that such growth cannot be sustained for longer periods, and the supply side bottlenecks develop and inflationary pressures start to emerge. The trend in global commodities prices for the coming quarter will be critical to the propsects of the Indian economy.

The increasingly integrated global economy has severely limited the ability of individual nations to successfully implement domestic policies to contain inflation. In this context, it is a moot point as to whether it is possible to contain inflationary pressures in India, even if the domestic supply side contraints are removed. In an integrated global economy, even with domestic surplus, global demand-supply conditions will determine prices. For example, India has surplus production in iron ore, yet prices have more than doubled in the past year, from $60-70 per tonne in 2007 to $140 per tonne now. This has been a major contributing factor to the rising steel prices too. Domestic policy measures like lowering import duties, are most likely to be offset by the producers in exporting countries raising their prices, thereby capturing the benefits of the lower duties. Regulatory controls and easing supply side restrictions can at best ease inflationary pressures slightly, but cannot contain it when global prices are rising.

The uncertainty and volatility calls to focus the need to maintain social security mechanisms like Public Distribution System and various welfare schemes. Such systems provide a comfort cushion to insulate the poor from the adverse effects of globalization and emergence of this integrated global economy.

There is a case to be made against this weekly WPI-based inflation scare mongering that has gripped the financial media in India now. In the first place, no major economy publishes weekly inflation figures. Second, a distinction needs to be made between core inflation, which strips out the large fluctuations in specific commodities, and nominal inflation. The former conveys a more accurate reflection of the reality.

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