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Inflation: Look out!

Jun 7, 2004

Americans are getting stronger. Twenty years ago it took two people to carry 10 dollars' worth of groceries. Today, a 5 year old can do it. - Henny YoungmanWell, no other quote on inflation can be more practical than the one mentioned above. If kept unchecked, inflation has the ability to impact price levels in the country, which could potentially slowdown economic growth. Besides, an inflationary environment erodes returns to investors. For instance, if the return on your portfolio was 12% when inflation was at 4%, the real rate of return was 8%. However, if rate of return remains the same and inflation edges up to 6%, then the real rate of return from the investment declines to 6% (Click here to know your 'real returns' from your investments).

Source: World Economic Output (2004), IMF

As the global crude oil prices rise, though with little vigor, the specter of high inflation again stares the world in its eye for once more. A look at the graph above indicates one important fact. In the recently released World Economic Outlook for 2004, the International Monetary Fund (IMF) has projected inflation in 2004 to be higher than that witnessed in the previous few years. For instance, inflation in the US is likely to touch a level of 2.1%, larger than 1.6% of 2003 and the past 3-year average of 1.7%. Similarly, inflation is likely to touch a level of 4.3% (3.8% in 2003), greater than the last 3-year average of 4.1%. For China, the expected level of inflation is likely to be around 3.5%, almost three times of the last-3 years' average.

But what are the key factors that have resulted in inflationary impact in India?

  1. Apart from rising crude prices, the exorbitant rise that has been witnessed in commodity prices (like steel, cement and aluminium) also has had an impact. And the Indian economy has not been spared of the effect of this rise in commodity prices.

  2. Another reason can be attributed to the low base i.e. low inflation levels during a major part of FY03 (for instance, inflation stood at 3.2% in January 2003 versus 5.6% in January 2004). To that extent, the rate of increase in inflation is magnified. The RBI had mentioned about low base in its mid-term policy last year.

...and will high inflation affect India's economic growth?

Rising inflation indeed has the seeds of stalling the economic growth. But even this depends on various factors like the level of capacity utilisation of the industrial sector in the country, employment levels and competition. If manufacturers are operating in an economy where supply exceeds demand, the ability to increase prices of goods when input costs are rising is limited. Take the case of the Indian auto industry. Even though steel prices have rocketed in the last two years, the prices of cars have not followed suit (this is a global phenomenon as well).

This example is true for other industries like consumer durables, FMCG and so on. Since the country has had a very good food grain output, there has not been an upward pressure from higher food prices as well (controlled prices of petroleum products also cannot be ignored). Secondly, if there is surplus manpower available for employment, corporates may not increase salaries at the same rate of inflation because there are alternative. Since the Indian economy is believed to have 'excesses' across segments even now, the rate of rise in inflation is expected to be on the lower side. In India's case, the Reserve Bank (RBI) expects inflation at 4.5%-5% for the current fiscal, which is almost the same as last fiscal year.

But the concern is somewhere else. Since the government has not increased prices of petroleum products in line with global crude prices, PSUs and the government are absorbing the impact of the same. But how long can this continue when one considers the fact that deficit could increase? As Ajit Dayal says, "I don't think there is a moment in history, when oil prices have gone up and inflation across the world and in India has not followed".

Secondly, interest rates in India have remained low due to excess supply of money. If money flow into the country slows down, this support could vanish. Since central bankers are worried about inflation, interest rates could increase in India.

What has inflation to do with investing?

Inflation affects everyone in his or her daily life. And investors are not of a different breed anyway! A high level of inflation reduces the real gains of equity investors, and this is a direct effect. The indirect effect of inflation on equity investors comes from the fact that rising prices reduce profitability of companies (if they are unable to increase product prices).

Overall, investors have to keep the possibility of interest rates going up in this fiscal in mind before making investment decision (be it debt or in equities). As Subir Gokarn of Crisil puts it "If the investment revival comes this year, I think looking ahead two years or so, you will start to see a clear tightening of interest rate".

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