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Is India Heading Towards Stagflation?

Posted in Finance Articles, Total Reads: 3801 , Published on October 17, 2012

Concerned over the fact that India’s growth prospects have been on the downward slide since quite some time now and the inflation is also not showing any chances of easing anytime soon, there is a lot of noise in the policy and economic circles all around that India might be headed towards stagflation. Now most of us who rely only on inflation and deflation figure to build our perceptions as to where the prices of the things that we buy on a daily basis are headed are quite baffled when they hear this new term. And when we come to know that it is going to strike us closer home, in India, it worries us even more.

So what is stagflation? Economists define stagflation as a situation in which the inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high. So practically stagflation occurs when the economy isn't growing but prices are, and people are also losing jobs; which is not a good situation for a country to be in. In the past there have been instances in the 1970s when countries like US faced the same because of sudden rise in oil prices which led to an increased inflation in the countries. There were massive job losses and the GDP of the US contracted during those years. The period marked the recession of 1973-1975.

The question now comes: are we facing a similar situation today or at least approaching the same? A lot of us might say yes considering the negative sentiment that has been around for a while now. We constantly hear of policy paralysis on the part of government, slowing industrial growth, declining foreign inflows, frequent fuel price hikes, below average monsoons, corruption and so on. These reasons are in fact good enough to convince anyone that sooner or later we are doomed and there is no stopping the inevitable.

Historically, economists have never been able to ascertain the exact cause of stagflation. Some economists believe that it is the excessive government regulation that leads to stagflation; while there is another line of thought which advocates that it only the market forces of demand and supply which lead to high inflation levels, which finally leads to stagflation. Now, when we cannot really diagnose the real cause of problem, finding a solution becomes all the more difficult. Some economists suggest raising the interest rates by central banks as an option to control stagflation, but then it solves only half the puzzle because the increase in interest rates can stifle growth which is already under the pressure of stagflation. The second option is to decrease the key rates to stimulate growth, but then this leads to increase in inflation. So we see that there is no straightforward solution to the problem. And therefore it is considered one of the darkest phases in the history of economy of any country – slow growth, high unemployment and high inflation.

Now let us come back to our problem. Is India heading towards stagflation? In all probability I would like to contend that we do not really have stagflation staring us in the face. While we may have many reasons to believe otherwise, but let us first consider some points before we reach a final conclusion. Technically stagflation refers to a situation when we have high inflation coupled with stagnation. While we all agree that the inflation has been on the higher side for quite a long time now(refer to Fig1 showing the trends in WPI in the last 12 months in India.), our economy is nowhere near stagnating. We might think of a plus 9% growth as our target for becoming a developed nation by 2020 or whatever, but that does not mean that a near 6% growth is equivalent to stagnation by any means.

We are not contracting;it’s only that we are growing at a slower pace than we were a few years ago. And given the global scenario – the Eurozone crisis, the rising oil prices, political instabilities in different parts of the world it is a feat accomplished in itself. The second important factor is inflation. Inflation in India is high primarily due to supply side bottlenecks, hoarding, high cost of transportation and inherent inefficiencies in our system. Lastly, the third important factor that contributes to stagflation is the rising unemployment. We in India are not witnessing any situation where factories are shutting shops or the industries or the services sector is laying off people. So we are pretty much safe on the unemployment front. We have had the worst part behind us in the years of 2008-09 and have learnt our lessons, nevertheless the hard way.

Fig1: WPI in India from June 2011 to May 2012

(Image Source: http://www.inflation.eu)

Let us analyze, why is India in a situation where many think that we are facing stagflation. Policy inaction, corruption, red-tapeism etc. seem very clichéd to me now. What I believe is that too much dependence on the government support and spending rather than investment has led us down and brought us to the brink where rating agencies like Moody’s can say we are on the verge of stagflation. We, as a country have failed in the recent past to project ourselves a favorable destination of investment. We have also failed to utilize our large base of young and educated population all the while. China at the same time has pipped us to the post on the same front and emerged as a preferred destination of FDI, as depicted in Fig 2 below. Though they might not be better off us in many other fields, but let us refrain from getting into all that now; we still can learn a lot of good things from the Chinese.

Fig2: Comparison of FDI in India and China between 1982 and 2010

Finally, I may have convinced you to some extent that stagflation is not staring us in the face as of now, but lets not be complacent about it. We need better policies, better environment for businesses to flourish, better working conditions for our people. Cases like FDI in retail, formulation and implementation of GAAR, 2G auctions, coal field allocations etc can be very good starting points for us to demonstrate that we are really concerned about current state of affairs and are ready to take proactive steps which will go a long way in restoring the lost confidence.We are definitely not running the risk of stagflation in the short term but to safeguard our future we need to start taking concrete steps sooner than later.

This article has been authored by Anmol Sikka from IIM Ranchi.

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