No cheer in India's low inflation By Kunal Kumar Kundu
BANGALORE - India's efforts to combat inflation, as high as 7.85% a year ago as
measured by the benchmark wholesale price index (WPI), have proved so
successful, in tandem with falling global food and fuel prices, that zero
increases may soon be registered.
The WPI inflation rate rose marginally to 0.31% for the week ended March 21,
compared with 0.27% a week earlier. At the rate the inflation number has been
moving, zero inflation (if not slightly negative index changes) could show up
soon. If in the next two weeks the index increases (rather than falls, as has
been happening of late) by even 0.5, inflation will be recorded as zero.
Even so, deflation does not seem to be a concern - it may be
termed as disinflation, rather than a deflation. This is more of a statistical
phenomenon, as the base effect kicks in big time rather than a situation of a
drastic fall in prices due to a sustained decline in demand.
As can be seen from the chart above, there was a major spurt in the index value
during early to mid-2008, led mainly by rising commodity prices, including oil.
This was a period that saw the Reserve Bank of India going for major monetary
tightening to cool off the inflationary effect.
Subsequently, as the global recession became evident, commodity prices started
cooling off. The lagged effect of monetary tightening also entered into the
equation, resulting in a slowing down of demand. As a result, post-August 2008,
the index value started to fall and subsequently inflation, which is calculated
year-on-year.
Going forward, inflation will remain low or be in the negative zone until the
lower base effect starts kicking in again. After this, inflation will move back
to positive territory. My hunch is that inflation might remain in negative
territory for the next three to four months, after which a reversal might be
visible. Only if real economic data takes a turn for the worse will the specter
of deflation loom. As of now, the indications do not point to such a worsening
scenario.
The other important question that needs to be answered is whether the WPI is
indeed a real indicator of inflation in India? This does not seem to be the
case, as Indian consumers are hardly, if at all, cheering this fall. The fall
in wholesale prices is not percolating down to the retail level. The various
consumer price index indicators currently published are at high
single-digit levels. Clearly, there is a dichotomy here. There is a lagged
transmission (from wholesale to retail) effect and I expect the CPI to start
trending down soon, though it is highly unlikely that it will fall as low as
the WPI has.
Clearly, the fall is not all-pervasive, and it is surely not because of a
sustained fall in demand. A large part of this decline can be explained by the
falling global prices of commodities (as virtually all the large economies are
already well into recession or just about entering the recessionary zone) and
by the various indirect tax reductions announced by the Indian government as
part of its stimulus package to spur domestic demand.
Hence, deflation is not a realistic scenario at this point and it will likely
kick in only if we see a big and sustained contraction in output, maybe 5%
plus. Hence, the real economic data for the next few months will turn out to be
crucial.
On the policy front, this calls for further rate cuts. However, whether these
will translate into lower interest rates in the economy is not clear. Late last
month, the interest rate on 10-year government bonds crossed the 7% mark, which
is already 2% more than what it was in January. As a result, banks prefer to
park their surplus liquidity in safer government securities.
What will also muddy the water is the humungous borrowing needed by the
government to meet the requirements of the various stimulus packages it has
announced. Not only will this lead to downward rigidity of interest rates, it
will eventually crowd out private investment.
Looking ahead, it is quite likely that the focus will be back on inflation some
time next year, although we will not see runaway inflation as we saw last year
since global growth will be extremely benign. Purely domestic factors will
drive prices higher in India.
Inflation will start rising not only because of a lower base effect but also
because of a likely surge in the fiscal deficit. One need not look much beyond
the recently announced interim budget. The deficit numbers announced in this
are ample testimony to the government's failure to rein in wasteful
expenditures, which could have ensured a capping of the deficit.
The so-called movement toward fiscal responsibility (announced with much
fanfare by P Chidambaram when finance minister before his move to the Home
Affairs Ministry late last year) was mostly an eyewash, as the government
resorted to creative accounting practices. This involved reduction of direct
payment of subsidies (which go straight into the calculation of deficit) and
replacing that with various bonds (oil bonds, fertilizer bonds and so on). By
reducing the direct payment of subsidies, the government did manage to show a
lower deficit. In the bargain though, they transferred the deficit burden to
the future generation, which will have to pay the maturing bonds.
Coming back to the recent budget, the officially announced fiscal deficit at
the central government level has shot up to 6%. To this, if we add the state
government deficits and if we bring the below-the-line items (such as the
issuance of various bonds as mentioned earlier) we are staring at a fiscal
deficit of over 10%, and in fact, closer to 12%.
In the current situation, with countries trying to spend their way out of
recession by increasing their fiscal deficit, India has very little headroom to
do so, given its already high level.
After the forthcoming general election that starts this month, things will
deteriorate further if one considers populist measures announced recently by
the various parties aspiring to rule the country. Ranging from rice at two
rupees per kilogram, to free electricity for farmers, to farm-loan wavers, and
on and on, the actual fiscal deficit will end up being much higher and without
any doubt the high level of deficit will be inflationary.
That apart, we have seen investment drying up. Whatever capital investments are
taking place are mostly for those projects on which substantial amounts of
investment have already taken place and it would not make economic sense to
abandon those projects midway.
In addition, many factories have either closed down or are on the verge of
closing. This is more pronounced in the sector of small- and medium-sized
businesses (SMEs). Demand for these has not only dried up, but getting working
capital is a big challenge, given a clear reduction in the willingness of banks
to lend.
What that means is that not only is no new capacity coming up, existing
capacity is closing down. So, once the recovery happens, it is quite possible
that rising demand will not be matched by increased supply, thereby adding to
inflationary pressure.
That leaves one conclusion: while lower inflation numbers do not imply a
deflationary tendency, they are no cause to cheer for India and its consumers.
Given the problems enumerated above, inflation will soon start rearing its
head.
Kunal Kumar Kundu, a former senior economist with a leading bilateral
chamber of commerce in India, now works with the Knowledge Service Division of
Infosys BPO Ltd. He has a Masters in Economics with specialization in
econometrics from the University of Calcutta. The author here is expressing his
personal views.
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