Inflation in India now has been stubbornly hovering close to 10%, and RBI's attempts to tame it have been nothing but counterproductive for the Indian economy. Despite 12 hikes (350 basis points) since March 2010, inflation still remains high. The RBI's "hawkish stance" on monetary tightening has won Governor Dr. Subbarao very few admirers. Corporate leaders voiced their disappointment and the Financial Markets did not hide their dismay either.
It is a well-known notion that every Central Bank's biggest challenge is to balance the trade-off between Economic Growth and Price Stability (Inflation). Also, economic theory tells us that conventionally, the level of economic activity in a country can be adjusted by adjusting Interest Rates, which determine Aggregate Demand.
Increase in Interest Rates = Decrease in Aggregate Demand
Decrease in Interest Rate = Increase in Aggregate Demand
For example, increase in interest rates will cause the interest on loans, credit card debt, EMIs, etc. to rise. Other things equal, this would make people use their credit cards less, and cut discretionary spending to meet the rising interest payments. Overall there will be a slowdown in economic activity. Conversely, when the level of economic activity is low to begin with, and the central bank needs policy action to stimulate it, it would lower interest rates. By doing so, it would encourage people to borrow more (take more business loans, shop more) and hence increase economic activity.
This brings us to the question of how does Interest Rates affect Inflation? The answer to this is pretty straightforward on the surface of things. Low interest rates give more borrowing power to consumers & businesses, which gives them more spending power. With the increased spending, the economy gets stimulated and Inflation is a natural by-product of this growth. Hence, at lower levels, inflation is actually encouraged as it’s a sign of economic growth.
Now that our basic understanding of economic theory has been refreshed, lets get back to the situation on hand. Over the last decade, the developed economies have led themselves in hot soup. Loose policies (low interest rates & low poor supervising) encouraged the use of debt, but the scale became enormously reckless. In 2008, we saw corporations grappled with high debt being unable to repay and had to be rescued by their Governments. The situation this time around is somewhat similar, but the culprits are not corporations, but rather sovereign nations. So obviously, now the severity of the situation is much higher.
While the scope of this issue is exceptionally broad, I will try to stick with events in India in this blog. Now then, having laid the backdrop, lets address the key issue: The RBI, the interest rate hikes, and the impact on GDP growth & the common man (who does not understand economics).
With access to dozens of economics PhDs in his advisory group, one would expect that he would have got the point by now. I’m not sure if Dr. Subbarao cannot see, or doesn’t want to admit, that his monetary tightening has not been working, and has only been hurting growth. It’s time he has to think outside the box. I admit that the situation is tricky, and political agendas only make decision making harder. However, sometimes one needs to stop over-analyzing things to tackle core issues.
India’s GDP growth rate is 2nd only to China, and this comes despite the global slowdown, political & bureaucratic hindrances, and infrastructure bottlenecks. With such economic growth, some inflation is inevitable. Especially considering that India imports its oil, most cars on the streets are imported brand names, as are our electronics, thereby making India a deficit nation too (More on fiscal deficits later).
To simplify our focus on inflation, lets take a closer look at its components. In doing so, one can see that the biggest components of Indian Inflation are rising Food & Energy prices. While energy prices are more a global factor and there is little we can do to drastically change its impact on the common man, the blame for food inflation can be put on inept Government Policies entirely. Over the years, enough has been talked about the country’s infrastructure bottleneck. Broken roads, rusted railways, poor warehousing facilities and outdated logistics, coupled with shortage of trained semiskilled labor, widespread corruption, a log jam of pending legal cases; the list is endless. The 2010 Commonwealth Games held in New Delhi was a showcase of all of the above-mentioned problems to the world. Oh the shame!
Such issues do not enjoy the press coverage as Bollywood parties do, for obvious reasons. But some research and dirt-digging led me to find out that roughly 40% of our agricultural harvests end up rotting due to bottlenecks in supply-chain. Oh the waste! If you think about it, the solution to most of India’s problem seems simple. Stimulate investment in infrastructure and we minimize the wastage too! Right?
This is the point where I highlight what is in my opinion, the key difference between Indian and Chinese way of reforms. Indian infrastructure investments are usually too little too late. We make our roads long after the point where we absolutely cannot function without them anymore. Then too, the quality is so poor that less than 1 year into it, and heavy maintenance and repair work is required. On the other hand, China builds roads in advance, anticipation future needs. Infrastructure investments in India, much like any other investments, require ROI to be delivered as quickly as possible. In contrast, Chinese infrastructure investments assume this same ROI delivery period to be closer to 15-20 years, and hence the infrastructure is made to last, with minimal maintenance and repair.
So wrapping it all up, all I'd like to say is this:
- Despite all the above mention issues, India IS growing.
- So some inflation is inevitable.
- But 10% is a bit too high and is hurting the common man.
- To lower it in a sustainable fashion, traditional monetary policies (of raising interest rates) will not help.
- What will help is removal of wastage from the system.
- This can be achieved by investing in 2 key spaces:
- The Supply Chain Infrastructure
- Bureaucratic hindrances
