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Economy: A round up - Views on News from Equitymaster
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Economy: A round up
Jul 6, 2007

The news that brings the greatest cheer is the successive reduction in the inflation rate across the various indices. As was expected the bountiful Rabi or winter crop helped ease prices of cereals and pulses while the Reserve Bankís raising interest rates dampened the enthusiasm to hoard these food grains. The inflation rate has started to climb down almost as fast as it climbed up. Provided the monsoons do not flood entire tracts of the country, and that sanity prevails where international crude oil prices are concerned, we expect headline inflation rate as measured by the Wholesale Price Index (WPI) to further reduce from these levels over the next six months.

Fig.1: Consumer and Wholesale Prices Reduce

Complacency now will be fatal

This seeming dramatic reversal in inflation rate numbers however, hides a deeper structural trend. The demand for goods is seeing a gradual increase in the prices of manufactured consumer goods. But what is more disquieting is the persistent 8% to 10% rise in prices of cement, metals, machinery and machine tools. This is bound to raise the general price level in the country and form the base for future inflationary conditions.

Last few weeks have also seen the Reserve Bank of India supporting the dollar yet again. Whether it did so under duress from the exporters lobbying with the Minister for Commerce and Trade is a matter of conjecture. But Indiaís central bank might just be fulfilling its obligations to the 20% of GDP earners - the exporters - with inflation having retreated to some extent.

Of the various components of Reserve Money (the sum total of new Rupees released by the RBI) Foreign Exchange Assets of the RBI have continued to grow at the cost of lending to the commercial as well as to the government sector. What it means is all that foreign capital that flowed into India has not gone into production, but into RBIís coffers. If not deployed in building up actual factories and roads, this money holds a great inflationary potential as in normal course of time such easy money stokes up real estate and stock markets creating asset-price bubbles and of course inflation as production does not kept pace with increased incomes.

Fig. 2: The impact of propping the US Dollar

While this is happening, the more productive and income generating private and to some extent the public sector have had to take recourse to money from the markets at higher costs. The government has stopped taking recourse to printing money (monetising its deficits by borrowing from the RBI) due to its inflationary impact. This is reflected in the lowering of governmentís share in the reserve money creation (See Fig.2). Thus what India is currently doing is following a restrictive fiscal policy but an expansionary monetary policy. This creates more money while production levels do not increase commensurately and the resultant normally would be endemic inflation.

Whether this price rise comes in thanks to freak shortages of agricultural goods and/or a general increase in the trend growth of inflation, remains to be seen. Thanks to this however, Indian exporters currently upset with the exchange rate parity will have more cause to worry as over the next two years if this party continues, their goods will be costing much more than their international competitors.

In the long run a Rupee deliberately kept from getting stronger will add to Indiaís woes rather than gain anybody. A good solution to this would be to reduce all barriers to imports and let the general price level in the country reduce as cheaper imports substitute the higher priced goods in our economy. And at the same time reduce the need for the RBI to intervene in the Foreign Exchange markets. As this would be akin to political hara-kiri, we see not many ways out but to let the Rupee appreciate some more over the next few years.

Given the reluctance of the RBI to rein in money supply we foresee another spurt in the inflation rate as 2007 draws to a close. For the Indian Inc, 2008 should bring in higher raw material expenses, higher capital costs (and thus more depreciation) as well as higher interest charges.

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