Friday, October 04, 2013

Why India's rampant inflation remains a puzzle?
[Editor: At last Economic Times seems to have spoken my hearts out. I have been saying this, since the days of Dr.Y V Reddy. I feel there has been a gross misuse of the monetary instruments
like Repo and CRR by the successive RBI governors and the Finance Ministers of India. I even heard a CMIE director once saying, "It therefore shows that inflation cannot come down only by keeping high interest rate". I have argued many times here in this blog, citing how cost-push inflation is a menace and why food inflation cannot come down in the long run only due to monetary measures. I had also in the past questioned the rationale behind keeping the high interest rate inspite of falling M3 [M3 for March 1, 2013 is Rs.83820.2 billion while till September, 20, 2013, it is Rs.87949.2 Billion. Variations over Financial Year So Far: 6.1% in FY13 while it is 4.9% in FY14. Year-on-year: 13.6% in 2012 while it is 12.5% in 2013. Source:]. I had also, requested the government many times (though this blog and Facebook positing) to stop inflation forecasting, for the reasons best known to all. Moreover, in India, the de facto way to measure the rupee's value is to compare it to the US dollar. But look at China's currency (the yuan) which is essentially "pegged" to the US dollar, so its exchange rate against the US dollar fluctuates very little because the Chinese government controls and fixes the exchange rate. So, the question is why is RBI showing so much brinkmanship shown in case of India? Now if we take the statistics from January 1st - September 26th, we will find that Indian Rupee has depreciated 4.26 per cent against the Brazilian real, 7.5 per cent against the Russian ruble, and actually appreciated 0.1 per cent against the Japanese yen! What a world of a difference it makes when one simply changes the currency he/she is valuing the rupee against. Hence, according to a number of experts, Indian Rupee should not be valued against only one currency (the US dollar); instead, it should be valued against a basket of currencies to get a better understanding of its true, intrinsic value.
Now, it appears that all these "wrong" policy measures had a devastating effect not only on the Indian Stock Market but also on Indian GDP; apart from creating a high Fiscal Deficit. It is time the government of India takes the help of eminent economists like Dr.Kaushik Basu, Dr.Surjit Bhalla, Dr.Omkar Goswami, etc for solving the inflation puzzle, leaving aside group-ism and regionalism. Till now all the three governors, Dr.Y V Reddy, Dr.Subbarao and Dr.Raghuram Rajan along with two Finance Ministers, viz. Mr.P Chidambaram and Dr. Pranab Mukherjee, have failed to find the correct medicine to cure this chronic disease]
India's rampant inflation remains a puzzle. Without a better understanding of inflation, policymakers are shooting in the dark and could end up making costly policy mistakes with huge unwanted consequences. India's inflation has been persistently high and has risen in the last five years to the highest among all emerging economies, matched only by Vietnam. Global inflation and inflation in all other emerging economies have, in fact, fallen in the last years.

In its latest monetary policy announcement, the RBI has surprised markets by increasing the repo rate on concerns over inflation. Many experts and business groups have criticised the RBI as they assert that inflation is related to supply-side factors - especially in the food sector - and, therefore, tighter monetary policy will have little effect on it. Tighter monetary policy will only hurt growth without helping control inflation.

A complicating factor peculiar to India is the multiplicity of inflation rates. Should one target wholesale (WPI) or retail (CPI) inflation, or core inflation, which is defined as non-fuel, non-food inflation? In the past, WPI and CPI inflation moved closely together, so ambiguity on which rate to focus on was not such an issue. But over the last five years, they have diverged largely due to food inflation that has a bigger weight in the composition of the CPI.

So why is food inflation so high and why does it persist?

One explanation is that the procurement price for cereals has been rising very rapidly, above the rise in the cost of production. Over the last five years, the procurement price of cereals has increased over cost of production by almost 15-60% for a cumulative differential of around 150% over a five-year period. So, the food subsidy has doubled from around 40,000 crore in 2008-09 to over 80,000 crore in 2012-13, and is likely to rise further in 2013-14 as the new food Bill is implemented and the issue price at which grain is sold is reduced.

Release Grain, Now

The rapid increase in purchase prices has two effects: it increases the offtake of grain from the market and increases grain prices in the open market, and it increases the food subsidy Bill that adds to the fiscal deficit and, thereby, fuels inflation.

The government has not released grain above the buffer stock norms and we have seen the most perverse outcome of rising food stocks and rising food inflation. Instead of releasing grain in the open market to reduce prices, India arranged the largest export of grain ever in its history in 2012-13, exporting 10.1 million tonnes of rice, 6.5 million tonnes of wheat and 4.8 million tonnes of corn as domestic prices were below international prices.

One option now, as another bumper crop is expected in 2013-14, is to switch from an open-ended grain purchase policy to a policy of only procuring what the government needs for its PDS and buffer stock. This will mean more grain will be left in the market and government stocks will decline over a period of one year. Selective imports of pulses and oilseeds may also help contain inflation.

Another factor is rising farm wages ascribed to tightening labour market due to the NREGA programme. Rural wages have risen; this explains declining poverty despite rising food prices - but they also contribute to higher costs of production - especially for vegetables, onions and horticultural crops. The solution here is to find less-labour-intensive methods of production that are consistent with higher rural wages.

The Deficit Matters

But supply-side factors do not explain the persistence of inflation. High fiscal deficits have immediate inflationary consequences. In the past, India ran high fiscal deficits without high inflation, by financing the deficit by forcing the banking system to hold government paper cheaply. But as the capital account was opened up, foreign inflows came into the country and as these inflows were not adequately sterilised, they helped fuel inflation. The prices of non-tradables, such as real estate, skilled sector wages and services went up sharply.

A large fiscal deficit in 2008-09 could be justified as a necessary stimulus to manage the global crisis, but persistent high fiscal deficits have hurt growth and fuelled inflation.

Poll Vault

Fertiliser and fuel subsidies must be brought down but they will have short-term effects. For example, diesel price increases will have pass-through effects: a 1% increase in diesel prices increases inflation by almost 0.1% in the short term.

But as it reduces the fiscal deficit, the longer-term impact is lower inflation. But how to manage this trade-off before an election?

So, the inflation story is not simply a supply-side issue as some believe. India's inflation is a combination of demand and supply-side factors and must be tackled comprehensively. Having the RBI raise repo rates further to tackle inflation will be the worst choice. Fiscal policy must play a key role as well.

The writer is director general, Independent Office of Evaluation, Government of India. Views are personal

Courtesy: The Economic Times