Inflation

Inflation

I am frequently invited by our HR Department to do interviews. I generally get to do the 'Management Rounds' after the candidates have been filtered thru the 'Technical Rounds'.. The goals of the Management rounds are a bit vague. You get a good opportunity to look into the minds of our young professionals, nevertheless. I generally ask them topical questions and to my dismay, I never got a good answer to questions related to inflation, interest rates , gold prices etc. Mind you, these candidates are not pure techies but most would have done their post-graduation in Management. I am sure they would have at least one paper on macro-economics in their course. Seldom do they go beyond the text book definition of 'Too much money chasing too few goods” and fail to contextualize and reason what is happening in our economy. They can only relate to inflation as it affects them and their budgets and betray their middle-class bias in favour of the Government 'controlling' prices of essential commodities like Petrol/ Diesel , banning exports of food items etc.,etc. When I counter them by saying how they would feel if Government were to fix their salaries at Rs.5000/- and decree that as IT professionals they should work only on Indian projects at subsidised prices for a minimum of 10 years without seeking any on-site ( meaning foreign) assignments, they are nonplussed. Their general refrain is that 'IT' is not an 'essential commodity' as milk, pulses, vegetables and Petrol / Diesel are.

Our current inflation has three sides to it, Monetary, Fiscal and Supply side.

Monetary Policy

In a bid to keep economic growth going, the RBI allows a degree of expansion of money supply. It is a generally agreed principle that mild and moderated growth in money supply and hence the aggregate demand in the economy should lead to expansion of the real economy of goods and services. One major component of Money Supply is incremental bank credit and RBI sees to it that Banks do not give too much loans in a bid to control the aggregate demand in the economy.

RBI has certain tools like CRR, SLR, Repo Rate and Reverse Repo rates and open market operations to control the creation of incremental credit in the economy. Banks frequently run into margin pressures when they need cash in their Balance Sheets. They seek to raise money from RBI by pledging Bonds in their possession. These bonds carry an interest rate on their coupons attached to them. RBI lends them Cash but charges an interest lower than the interest on the bond coupon. This called Repo Rate. Currently it is at 8%. By frequently increasing this rate, RBI seeks to make money costly for Banks. Banks would be discouraged to lend more at current levels of interest rates.

Banks have to perforce raise their lending rates discouraging loan seekers. This somewhat looks like (as the Tamil saying goes) 'catching a crane by placing butter on its head'. But RBI seems to prefer this route than say, for example, hiking the CRR ratio which is seen as draconian by all, especially the Banks as it impacts Banks' profitability badly. Reverse Repo rate is the rate at which RBI borrows cash from Banks. This is currently 7%. A raised Reverse Repo rate raises bench mark rates in the economy. If Banks could make 7% just by parking cash with RBI, why would they lend to you and me unless we pay them much higher, say 14-15%.

But this is only one side of the story. Too much tightening thru monetary policy has its disadvantages. It makes credit costly for the productive sectors of the economy. For e.g. increase in housing loan interest rates have already pulled down the construction activity, a very important force multiplier in the real economy.

The Loan books of the Banks are not seeing abnormal growth. As the industrialists and some economists have warned, any more tightening will hamper real economy. Impeding the production of goods and services will lead to lower growth and hence higher inflation, the opposite of what RBI wants to achieve.

Fiscal Policy

Fiscal policy is in the hands of the Central Government. It means the spending, more importantly, the deficit financing the Central government resorts to. Unlike household budgets, Governments seldom limit their expenses to their incomes. For e.g. our finance minister sought to limit deficit to about 4.6% of our GDP projected for 2010-2011. It is strange Fiscal deficit is not expressed in terms of percentage of revenue of the government, but as a percentage of the projected GDP for the year to come. But that is the way it is. Deficit financing is not scorned at by the economists as you would imagine, ever since Keynes wrote his 'General Theory'. Government spending, even though thru deficits, is supposed to generate a virtuous cycle of employment-incomes-savings-investment. But that is theory.

Last year on the back of sale proceeds of some public sector companies and money from sale of Telecom 3G licenses, our Finance Minister could restrain the deficit to 5.1% of GDP as against the expected 5.5%

But this year, as was commented by most economists, the target of 4.6% looked unrealistic even immediately after the budget presentation. The budget assumed a very moderated international crude price ( I forgot the level assumed in the budget) and a very meagre amount as fuel subsidy. With no commitment to free petroleum prices, political diffidence to increase Diesel prices after the international prices have shot up has already put paid to all pretences of controlling deficit within 5%. It is anybody's guess where the deficit % will reach. Some economists put it at 5.8% to 6% of GDP.

With increased spending on fuel subsidies, salary hikes owing to DA increase for Government staff, hike in military spending, subsidising the existence of Air India like bottom-less pits, unbridled social sector spending like NREGA etc does not create the Keynesian virtuous cycle , but a vicious cycle of price increase and misery for those who do not have bargaining power in the system, the poor.

Diesel subsidy is given to the persons using Diesel either directly or indirectly. Government ends up giving direct subsidy to diesel car owners ( the bigger your car more is the hand-out by the government) and indirectly to those who buy goods and services. The poor who do not own Diesel cars and buy the least of the goods and services pay the Diesel subsidy bill thru inflation. Besides, everybody who is somebody gets cushion against inflation thru increased money earnings, and the person who does not have bargaining power ( an employee in a private sector unit or shop) runs into the wall. Thus thru transfer pricing the better off transmit their costs down the economic pecking order and the and the poor take the hit as there is nobody to transmit to at the bottom!!. Not hiking Diesel /Petrol prices when the international prices go up  is a bigger fraud on the poor people of the country greater than all the scams combined.

Supply Side

This brings us to the third factor of Inflation, aggregate supply.

There are economists who believe Inflation is the sine-qua-non of Growth and it is not possible to achieve growth rates of 8-9% without serious inflation. Some point out at China which is supposed to have achieved 10% + growth on a very meagre inflation. But China cannot be any example. It is a totalitarian regime. Their Government y could kill 50 million people in the name of 'Cultural Revolution' without batting an eyelid.

But nobody disputes that the key to controlling inflation is reforms on the supply side, the other name for economic reforms. Growth is an interplay between Investment and ICOR (Incremental Capital-Output Ratio). The lower the ratio higher is the growth. Our bad roads, power cuts, other infrastructure bottle necks, corruption, inhibiting tax policies and pussy-footing the public sector results in low productivity and hence high ICOR. The virtuous cycle of incomes-expenditure-savings-investment is short-circuited. The resulting high-cost economy naturally excludes the poor and the disadvantaged.

So inflation is not solved by keeping the Diesl prices low and passing on the losses as deficit of the Centre's budget. Removing the supply side constraints is the only solution, else all demand expansion thru Monetary and Fiscal policies act as tax on the poor , the other name for inflation.

This is what is happening to our about 700 million people. When most of the world have seen end of abject poverty, it still stalks our land.

Maturing of our democracy requires pressure created on the political class thru well-informed public opinion. It is a shame that even young managers joining top corporates from Management Institutes mouth the same slogans as our political parties do when posed with questions on inflation.