Rising Inflation In India & Its Ramifications

Posted in Finance Articles, Total Reads: 3856 , Published on 03 September 2012
Advertisements

Inflation in India – Nature and Magnitude

If it all there is a dream in the minds of India’s policy makers and RBI, it is to conquer the unflinching inflation. Of course in a candid tone we can say that it is a pipe dream at least in the context of current times. Inflation needs no introduction. Inflation occurs due to a steep rise in price levels against the normal purchasing level of consumers. In the recent years, more than any issue Inflation has plagued the Indian economy and undermined its growth prospects. Due to high inflation and deteriorating depreciation of Rupee, India has become a dwindling brick among the BRICS nations and has been downgraded in its credit ratings by S&P, Moody and Fitch.


India’s head line inflation which is based on the Whole sale price index has lowered to 7.25% in June 2012 from 7.55% in May 2012. Though Indian government has registered a success in bringing inflation in non-food items in control, it is still grappling with soaring inflation in food, fuel and power arenas. This article contemplates and comments on the causes of inflation and effects of inflation on financial measures such as balance of payments, depreciation, FDI, FII etc.

How inflation surfaces and why RBI’s measures are backfiring?

Analysis

Inflation generally starts as a demand-pull inflation where a colossal amount of money chases few goods. In order to curb and absorb this colossal money, RBI has been hiking the repo and reverse repo rates. In spite of such a tough stand by RBI, we have not seen a considerable decline in inflation. In fact RBI is held accountable for the dismal growth rate of 6.5% for the year 2011-2012. Most of the corpus money which RBI is targeting at is black money and the black money holders can’t deposit this money in banks (despite attractive interest rates) as they get charged for disproportionate assets case.

This money can neither be invested in the capital markets as Income tax department monitors their PAN transactions. So there is no reason for RBI to keep hiking interest rates when it can’t nip the real culprits. Here we can safely conclude that black money holders are contributing majorly to demand-pull inflation. Other reasons for demand-pull inflation are high disposable income and fake currency notes.

For obvious reasons, seeing the demand-supply imbalance, producers would like increase the supply of production to gain higher profits. The double whammy occurs when these corporate manufacturers can’t access the money in banks due to higher interest rates. Even though corporate are ready to borrow at higher interest rates, government borrows this money which leads to “crowding out of private investment”.

Please note that government spending is an exogenous variable which is insensitive to inflation or depreciation. As the producers can’t get loans from banks they can’t expand their business and even if they get access to limited money this leads to increased cost of production. This is where the “cost-push inflation” sets in. Cost-push inflation is attributed to RBI’s high interest rates, supply chain bottle-necks, increased power tariffs and increased fuel prices. So today what we are seeing is “Cost-push inflation”.

Defying the General and Entrenched Assumption

Is Inflation strengthening the Rupee?

The general perception is that Inflation leads to rupee appreciation. It is premised on the reason that inflation is followed by interest rate hikes by RBI. The attractive interest rates (Reverse repo at 7%) would attract the foreign investors to invest in Indian banks and government securities. As the supply of foreign currency increases Rupee automatically becomes stronger.

Recently RBI has increased the interest rates on NRE, NRO, FCNR (Foreign currency non-resident) accounts to attract foreign investments. This would have worked out to a certain extent in attracting foreign currencies. But the unfavorable factors like policy paralysis, stalemate on reforms, declining growth rate, widening fiscal deficit led to the downgrading of Indian securities by S&P and Moody. Thus the foreign inflows stalled and the rate hikes have not led to rupee appreciation.

Other side of the story – Inflation depreciates Rupee

In fact in realistic terms, the rising inflation in India has led to Rupee depreciation. Higher cost-push inflation has led to poor IIP (Index of industrial production), low GDP (Gross domestic production), and high unemployment. Low IIP due to less production and less profits in turn affects the share prices of the corporate world. So Indian private sector bears a bearish outlook and fails to attract foreign investment in the form of FDI or FII. The foreign countries which are already grappling with sovereign debt crisis and euro zone crisis don’t have money to invest in dismal state of Indian economy. Following this there will be a scarce supply of dollars, Euros, sterling pounds and this makes Indian Rupee depreciated. In the recent times we have seen the lowest levels Rupee depreciated against USD, where $1 = Rs 55and more.

Effects of Inflation on GDP and ensuing “Conundrum”

As aforesaid, cost-push inflation is attributed predominantly to RBI’s high interest rates (due to high inflation), supply chain bottle-necks and increased power tariffs. It gradually leads to steep hike in prices as the factors of production become costly. This will lead to lesser demand and lesser consumption by final consumers. Lesser consumption will result in losses to the firms and eventually leads to cutting down on employment. Unemployment and limited production of goods & services results in lower GDP. To buttress this finding we have a concrete proof unveiling in front of us where the GDP of India has grown only by 6.5% for FY2011-12.

What is the “Conundrum”?

There has been a lot of hue and cry from several policy makers, economists, politicians, corporate honchos of India to welcome foreign capital inflows in order to improve India’s GDP. One pitiable fact is that India’s outflow of FDI is $16bn in 2011-12, which is more than the incoming FDI. We need more FDI inflows in sectors like airlines, insurance and retail. But the foreign investors can make money in their enterprises in India only if Rupee appreciates. Let’s see how they do. The most favorable factor for foreign investors in India is that the domestic consumption (79%) in India scores high over the exports (21%). Let us see the favorable/unfavorable factors to FDI in India vis-à-vis China in the following table.

Country

If Rupee appreciates/Yuan Appreciates

If Rupee depreciates/Yuan depreciates

India

Good to foreign investors as India is predominantly a domestic-consumption led economy rather than an export economy. The profits earned in rupees out of domestic consumption will be exchanged for more dollars if Rupee is strong.

Not so good for foreign investors. As rupee depreciates, foreign investors can earn profits from exports but export share is less in Indian market.

China

If Yuan appreciates, foreign investors in China will be at loss. It is because China exports nearly 57% of its goods and services and if Yuan is strong other countries wouldn’t like to import from china.

Yuan depreciation is very much conducive to China as it is an export-led economy.

So we can interpret from the above table that India can attract more FDI for improving its GDP only if Rupee emerges stronger. But currently Rupee is too weak to attract foreign inflows of capital. Besides weaker rupee, the gloomy global economic prospects may not allow foreign capital to India. Thus India is facing the conundrum that foreign capital requires stronger rupee where as stronger rupee comes only from increased foreign capital inflows.

Interaction among Government Fiscal Deficit, Inflation and CAD (Current Account Deficit)

Government spending has increased by 4 times from the year 2007. As most of its spending goes to imports, it is facing fiscal deficit and is encroaching on (S-I) excess savings over investment. To increase S-I component, Investment spending I should be reduced by keeping interest rates high. Now this leads to high cost-push inflation.

G (govt. spending) = (S, savings – I, Investment) + Net Taxes (T) + (M, Imports – X, exports).

Though there is more liquidity in the system government is not stopping giving subsidies on crude oil and electricity (so T component is less). It is leading to more usage of them and leading to more current account deficit year after year. Please see the below table.

India’s current account deficit (CAD) increased to $78.2 billion (4.2 per cent of India’s GDP) for the year ended March 2012, from $46 billion (2.7 per cent of GDP) last FY2010-2012. This CAD is highest ever in the history of Indian economy according to the RBI.

Year

Crude oil imports($bn)

Gold Imports($bn)

FDI($bn)

NRI remittances($bn)

FY 2001-02

12.6

4.2

6.1

15.4

FY 2011-12

155.6

61.5

46.6

70.0

Conclusion:

1) RBI has not shown a great success in controlling inflation as it is a cost-push inflation. This cost-push inflation can be controlled by government intervention by removing supply chain bottlenecks, increasing taxes and reducing subsidies.

2) Bring down the interest rates as they are inhibiting GDP, employment, IIP and exports and instead introduce structural reforms.

This article has been authored by Krishna Chaitanya S & Manu AR from SJMSOM, IIT Bombay

Image: FreeDigitalPhotos.net


Advertisements


If you are interested in writing articles for us, Submit Here