Financial Daily from THE HINDU group of publications
Monday, Oct 14, 2002

Port Info

Group Sites

Mentor - Economy

Can inflation fuel growth?

Vidya Pitre

Vidya Pitre examines the critical level of inflation which has a bearing on asset depreciation and, in turn, on economic growth.

PROVIDING for depreciation is an important constituent of gross investment and is a key variable determining the growth process.

The depreciation provision has always remained a major source for generation of funds against fiscal incentives.

Data for large public limited companies show a sharp increase in depreciation provision from Rs 319 crore in 1975-76 to Rs 1,189 crore in 1987-88 and to Rs 9,945 crore in 1999-00. Its share in internal funds amounted to Rs 71.1 per cent in 1999-00. For the economy, as a whole, consumption of fixed capital accounted for about 10 per cent of GDP in 1999-00.

The conduct of discretionary monetary policy, especially since 1970, revolves around the choice of a rate of inflation for the national economy consistent with the choice of a rate of growth. In developing countries, the dilemma becomes worse, especially with the conviction that there are segments in the growth-inflation curve in which some inflation is beneficial for growth.

The remark in Report on Currency and Finance-2001 that " the optimal level, there is also a recognition that the growth-inflation curve has non-linear segments — that is, inflation at the same low level has positive effects for growth `by greasing the wheels' of the economy...", therefore, needs thorough discussion.

The starting point for the analysis of such a process would be the identification of a threshold/optimal level of inflation. This is the level beyond which it has negative effect on the growth. The report contains a review of the literature that proliferated in this area since 1970. Studies conducted vis--vis the Indian situation provide a 4-7 per cent range that may be regarded as an output-neutral inflation rate. The positive effect of inflation peters out after 7 per cent.

In the following, the impact of inflation on the growth rate is discussed from a slightly different angle.

An increasing number of companies have been adopting the practice of revaluation of assets, which enables the companies to offer the same fixed assets as security at a higher value for obtaining larger loans. The depreciation provision computed on the basis of such revaluations is one of the factors underlying its growth.

The Rangarajan study group on `Financing of the Private Corporate Sector in the Sixth Plan' observed: "As for the argument that taxation of profits computed on the basis of historical costs leads to over-taxation and saps the capacity of companies to replace assets, it is, no doubt, true that where depreciation is based on historical costs, depreciation funds may fall short of the requirement for replacement of assets when the asset prices are raising rapidly, depending on the relative rates of inflation and the rates at which assets are written off."

In other words, with an inflation rate of 10 per cent per annum, the replacement cost of an asset of, say, Rs 100 works out to Rs 259 at the end of 10 years. If interest on depreciation funds is taken into account, the accumulated amount would go up to Rs 158, with interest at the rate of 10 per cent.

The Rangarajan group further computed the value of that asset with original cost at Rs 100, interest at the rate of 10 per cent and capital allowances at the then prevailing rates. The figure was about Rs 237 (in this case, new plant and machinery deduction up to 50 per cent is available in the first year).

This also does not meet the replacement at current cost. According to the group, depreciation based on historical cost will not be adequate for replacement of assets under inflation, if the rate of price increase exceeds critical levels. It does not reject the adoption of inflation-accounting, conceptually. It puts forth technical or practical problems for actual implementation.

Identifying critical level of inflation rate: The study just mentions `critical level of inflation' but does not discuss how to identify this level. It is rather vague when it states: "With a moderate rate of inflation, inflation accounting is not necessary". We had attempted earlier an exercise with a view to identify the critical level. In the following it is presented again. For this identification of critical level, an example was taken for illustration:

`a' is the initial value of machine (Rs 100)

`n' is the number of year of life (10)

`r' is the money rate of interest (10)

`R' is the rate of inflation (10)

`A' machine worth Rs 100 at the annual inflation rate of 10 per cent will cost Rs 233 at the end of 10th year. The depreciation provision (straight-line method) with the rate of interest 10 per cent will add up to Rs 158.4. This amount is less than replacement cost. We, therefore, proceed to examine allowable inflation rate for a given interest with different life periods. An asset costs Rs 100 in the initial year. We observe that at a given interest rate, with the increase in the life of machine, the allowable inflation rate increase. At the level, the depreciation provision made over the period would meet the cost of replacement at current prices. It is this level that is defined as the critical or allowable level of inflation in the present exercise.

At 10 per cent interest rate, with ten years life, the allowable inflation rate is observed to be 4.8 per cent. With the interest rate at 15 per cent, a 7.6 per cent inflation rate is seen to be taken care of. For an assumed life of 20 years, it would be 8.6 per cent, for 25 years 9 per cent, and for 40 years 10 per cent, and so on.

In the present example, graphically, the relationship appears to be linear because of the limited range, though mathematically it is not. When differentiated, we get R as an increasing function at increasing rate with incremental change in `r'.

Thus, for the given life of an asset, there is a positive relationship between the rate of inflation and the replacement cost. Further, with increase in life of the asset, the gap between normal interest and inflation rate narrows, tending towards convergence.

This inflation has an impact on replacement cost of the present stock. In other words, it is valid for a stationary economy. In a growing economy the replacement required will be still higher. So the impact will be much higher than in a stationary economy. The extent of its impact is brought out by Sir Roy Harrod in an article published in Journal of Economic Literature in 1970.

In an interesting exercise, he set an equation that is hailed in growth literature as a fundamental theorem of dynamic economics. He put forth a framework where the role of amortisation/replacement in financing net investment emerges as the key parameter.

According to Harrod, this factor was not generally appreciated in growth literature. This is of greater importance in developing countries, where savings tend to be in short supply. Thus, it is of higher priority to avoid inflation, which erodes the value of amortisation funds. The beauty of the formulation is that it is valid for all growth rates and all production periods and for all elements in time.

Harrod worked out the contribution of amortisation funds to net investment in stable price conditions. With ten years of replacement and 5 per cent growth rate, the funds would finance about half of net investment. Further, this contribution is calculated for taking different rates of growth and life periods. For 6 per cent growth and 30 years of life, these funds yield contribution at 36.10 per cent, while for 20 years, the contribution will be 40.5 per cent.

The very useful contribution of these funds to net investment will be largely or wholly lost if price inflation is proceeding. Harrod calculates for 4 per cent per annum growth and a 15-year life, a price inflation of 2 per cent per annum, considered moderate, and which reduces the contribution of amortisation funds from 44.9 per cent to 17.4 per cent. A 5 per cent per annum inflation would wipe out the contribution altogether and make the current available funds fall short by 5 per cent of what is required for mere replacement.

The monetary authorities in India, therefore, would find very relevant at the present time the concluding remark by Sir Harrod: "The most important moral seems to be that, it is specially incumbent on the poorer countries where current savings may be inadequate for useful investment projects, to avoid price inflation."

Send this article to Friends by E-Mail
Comment on this article to

Stories in this Section
Does one size fit all?

Can inflation fuel growth?
A job is a job
Bother of brother's pay cheque
Many a little makes a mickle

The Hindu Group: Home | About Us | Copyright | Archives | Contacts | Subscription
Group Sites: The Hindu | Business Line | The Sportstar | Frontline | Home |

Copyright 2002, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line