Home > Uncategorized > ANALYSIS: Fighting inflation the wrong way

ANALYSIS: Fighting inflation the wrong way


Headline inflation peaked at 9.4 percent in December 2010. India has spent almost the whole of 2011 fighting inflation with interest rate hikes and has wrestled down headline inflation from 9.4 percent at the end of 2010 to 7.5 percent in December 2012 — a reduction of 1.9 percent. This has been achieved by bringing down overall GDP growth rate from 9 percent to 6.9 percent — a reduction of 2.1 percent. Has the battle against headline inflation succeeded? Inflation is far from licked. In fact, a more detailed look behind the aggregate numbers shows a shocking failure to diagnose the problem correctly. Moreover, the policy tools in use, mainly interest rate hikes, are unlikely to bring down inflation much further. Is India then looking at another wasted year in 2012?

First consider inflation. The biggest component of headline inflation has been inflation in food prices. This has consistently topped headline inflation, but for the seasonal fall in food prices in winter that lowers the prices of vegetables, etc. In fact, inflation in food prices has turned negative for the last two months indicating a fall in prices of agricultural produce. Manufacturing inflation continues to be high at around 6 percent and has not abated. The government itself is not sanguine that headline inflation will be any lower than 7-8 percent by March end this year. As India heads into summer in April, food inflation in all probability will pick up. Fighting inflation is going to be a Sisyphean enterprise for the Reserve Bank of India (RBI) alone.
The RBI has not been candid about the cause of Indian inflation beyond talking vaguely of the need for fiscal consolidation. Nor has the RBI chosen to focus on core inflation, which is inflation after food and energy prices are stripped out of headline inflation. This number roughly represents the growth in wages to all labour in the economy over and above the actual increase in its productivity. The government has been rapidly increasing the nature and scope of its poverty alleviation programmes such as the National Rural Employment Guarantee Scheme that has resulted in some Rs 600 billion flowing into wages to labour while getting little by way of output, growth, or productivity enhancement in the economy from such doles. In fact, through various other such doles, such outlays may actually double in the coming years.

What these doles collectively do is to increase wages to ‘labour’, putting more purchasing power in their hands without any corresponding increase in output in GDP. This purchasing power translates into demand for wage goods like food. With little or no growth in agriculture, which has at best grown at 2 percent per annum against a population growth of 1.5 percent, food inflation is inevitable. Furthermore, wages under schemes like the National Rural Employment Guarantee Act (NREGA) are indexed to inflation and will automatically increase as food prices increase. This higher wages chasing a stagnating output sets off an inflationary spiral that simply cannot be addressed by increasing interest rates on such things as housing loans to the middle class or loans used for investment in infrastructure. To the extent hikes in interest rates actually cut off investment in infrastructure, the RBI is limiting both GDP growth and productivity gains, the only two things that can actually help sustain the increase in doles to the poor. Clearly, interest rate hikes do not address the wage goods inflationary spiral.

Political paralysis on the other hand has meant that the government cannot do any of those things that can result in enhanced growth and productivity in agriculture. The entire agricultural supply chain from harvest to retail shops is riddled with small oligopolies, waste, and graft due to government intervention, under-investment and inefficiency. Measures such as easy means to lease land by corporate farms to catalyse investment in food production, permitting foreign and corporate investment in agricultural distribution and marketing, cold storages and warehousing are the crying need of the day. However, unimaginative politics and vested interests have stymied necessary reforms. We need reforms that can unleash a second wave of productivity growth at the heart of the economy that will enable us to sustain the poverty alleviation programmes. Without them, enabling doles that help people graduate from poverty into participation in the market economy are unhelpful. An effort to sell reforms is conspicuous by its absence.

RBI’s other preferred measure to fight inflation is fiscal consolidation by the government. It is something a government obsessed with doles to buy votes has paid scant heed to. There is great danger in applying IMF orthodoxy to our problems without deep consideration. Just as fighting a supply side, wage inflation fuelled by doles is not the right response, fiscal restraint should not cut off (a) needed investment in things like infrastructure that accentuates supply bottle necks and (b) reduce the stimulus needed by the economy to offset a high level of private savings by households that include ruinously deflationary imports of physical gold.

Instead, fiscal consolidation must focus on two areas that hold  the largest potential for success. By policy creep, more than design, oil subsidies that go largely to the middle class have ballooned by the failure to fully pass through the increase in crude prices. There is simply no sense in subsidising a scarce imported commodity’s consumption by the middle class. The government must bite the bullet and raise domestic prices of POL products consistent with international prices and enable automatic pass through. This measure alone can offset the outlay on NREGA. It has the added attraction of productivity gains as the economy learns to make more efficient use of a mispriced resource. Productivity gains through more rational pricing have been huge in other economies abroad.

Policy creep and playing to the gallery have reversed the growth in tax to GDP ratio for the economy as a whole from 14 percent to something like 11 percent. This crucial ratio is now back to the level when the economy was bogged down in the Hindu rate of growth at 3 percent. The fall in the ratio needs to be reversed. India has far less government than its size requires, which is why we are seeing the state cede space to anarchy, be it in terms of police services or general governance. On any measure of government to population ratios, our government is too small to be effective. That does not mean we hire more deadwood. But it does mean that the state step in where markets fail to provide the required level of investment in things like education, healthcare, infrastructure, water, sanitation and the like. For that to happen, the government needs to raise more taxes, not by upping tax rates but by widening the tax base. Direct tax exemptions need to be whittled down and GST implemented on a war footing.

Last but not the least, India needs a dream that lends coherence to reforms. That dream should be rapid but planned urbanisation in place of the chaos that prevails today. There is no point in pretending that we live in villages. We do not. We have outgrown our villages by our sheer numbers and are spawning ghettoes where another ‘village’ begins before the other ends. Reforms in land acquisition and use, urban planning techniques, expansion of housing and related infrastructure can put the economy into an entirely different growth orbit where double digit growth will seem just plain ordinary. We have just about everything in place to adopt such a strategy for growth — everything except the government with the imagination to grab the opportunity and gumption to make it happen.

The writer is a trader. She can be reached at sonali.ranade@hotmail.com or @SonaliRanade on Twitter

Categories: Uncategorized
  1. September 15, 2012 at 11:59 am

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