The Hindu Business Line : Slaying the inflation monster

Inflation is a political hot potato. If the prices do not fall in time, then governments fall. With key Assembly elections coming up, especially in Uttar Pradesh, and the Congress party's poor showing in the Delhi Municipal elections, the inflation problem is no doubt giving the Finance Minister and many of his Cabinet colleagues sleepless nights. That apart, the Congress Government came to power on the promise of looking after the Aam Aadmi (the common man), and as one politician put it, the aam (public) is most badly hurt by daam (price rise). The lower the income, the greater the marginal utility of money, and so even a small rise in prices hurts the poorest the most. In this situation, apart from the political exigency, it is critical to control inflation from the humanitarian point of view also.

The Signs

Inflation, as indicated by the Wholesale Price Index, touched a two-year high of 6.73 per cent for the week ended February 3, 2007 from 3.69 per cent a year ago. It has since held above 6 per cent. The Consumer Price Index has risen nearly 7 per cent in urban areas over the past year and nearly 9 per cent in the rural areas.

The Reasons

There are three main reasons behind this spurt in inflation: The economy has been seeing unprecedented growth in the last four years. In the last year, it saw 9.2 per cent growth in GDP. This growth has been mainly consumption led. With more spending, comes greater demand for credit. With low interest rates, India saw a record growth in credit offtake, with bank credit growing at close to 30per cent in late 2005 and early 2006. This fuelled inflation.

The second reason is a genuine supply side shortage. In the last year, agriculture grew by a mere 2.2 per cent. Whether because of climate change or lack of irrigation and other facilities, agriculture is simply is not keeping pace with the rest of the economy. So as demand rises, with greater income in other sectors, prices also rise. Numbers never lie: On a year-on-year basis, the price index of primary articles increased by 12.03 per cent; that of energy inputs by 1.01 per cent and of manufactured products by 6.57 per cent.

The third reason is the Reserve Bank of India's valiant efforts to support the rupee. Whereas growing IT exports, foreign investments and India's increasing competitiveness in other industries have brought in more dollars, leading to an impressive war chest of $200 billion plus in foreign exchange reserves, the RBI's policy of buying dollars has injected a lot of unintended liquidity into the economy.

Beating the Wrong Dog

The RBI has raised the repo rate six times in a row since January 2006, and it now stands at 7.75 per cent from 6.5 per cent a year ago. The Cash Reserve Ratio (CRR), the amount of demand and time liabilities that banks have to keep locked up with the RBI, was increased from 5 per cent to 5.5 per cent in December 2006, and then to 6 per cent in the last cycle. Now it is to be increased to 6.5 per cent in two steps. This will suck out an estimated Rs 15,000 crore out of the banking system. This would make credit more expensive (as has already happened), and that would dampen inflation to some extent.

However, this can also hurt in two ways: First, interest rates would increase further, and this would dampen growth, in general, not just credit growth. Second, money market participants would have a field day borrowing in dollars and investing in rupees to make money from the interest rate differential. The conversions would be mopped up by a frenzied RBI, trying to maintain the rupee's value in the market. While this is necessary to some extent to prop up the sunrise export sectors (such as information technology) and to protect the value of the RBI's own investments in dollars it is having to overdo it because of the peculiar government policies in this regard, and is injecting huge amounts of liquidity into the system in the process.

No wonder, that in spite of all the monetary tightening, broad money supply (M3) growth touched 22 per cent in March 2007 higher than the 16.9 per cent growth recorded in the year before. The rupee should be made freely convertible so that people can hold all their dollars and convert them into rupees whenever and wherever they would like to (say, Singapore or London), and the RBI does not need to buy them and increase the supply of rupees in India.

Farmers shortchanged

Meanwhile, the Government itself has got into a tizzy and is intervening in the market to control prices, without addressing the real reasons behind the price changes. In February, the Government banned forward trading in wheat. Media reports suggest that the Government has also asked private players to desist from buying in the wheat market till the Food Corporation of India (FCI) has had its fill, clearly a unconstitutional and illegal action that shortchanges wheat farmer, and keeps prices artificially low. The answer lies not in controlling demand, but in increasing supply.

The Government has been importing wheat in the past year. It should import more, and this is the surest way to depress prices. It tried to control cement prices in a rather clumsy manner by calling a meeting with cement manufacturers and asking them to forego `illegitimate' profits. It failed to do this; now it has seen the light and decided to reduce import duties. This will make imports of cement more attractive. More imports mean more supply, and lower prices.

These problems have arisen fundamentally because we have failed to deliver good governance to the agricultural sector, leading to low productivity there. So the stress of the recent Budget on irrigation and rural infrastructure is right. Corporate entities that interface with agricultural producers can also help them adopt best practices such as co-operative farming, water harvesting and multi-cropping.

However, these will yield results only with a lag. So for the moment, the only way out is to import commodities that are showing maximum rise in prices. Price controls don't necessarily reduce prices, they create black-markets where distribution gets even more skewed. The Government should play by market forces and ease out the supply side. It should also reduce the RBI's role in the foreign exchange market.

(The author is a Senior Consultant with the Domain Competency Group of Infosys Technologies Ltd. The views are personal. Feedback can be sent to Raghuvir_mukherji@infosys.com.)