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Inflation: Profit for the rich, patience for aam aadmi

There are three kinds of lies: lies, damned lies, and statistics': Originally attributed to Benjamin Disraeli and popularized by Mark Twain.

To paraphrase the above in the Indian context one can safely add the fourth type of lie -- statistics provided by the government of India.

Witness a press release from the government of India released on May 16, 2008. This media release relates to the inflation rate prevailing in India for the week ended May 3, 2008.

Accordingly, the annual rate of inflation, stood at 7.83 per cent for the said week, compared to 7.61 per cent for the week prior to that one. But it has to be noted that these are provisional figures, that is, these are subject to revision in future. And usually it takes approximately two months to get the actual figures.

In other words, by mid-July we could get the final data for the week ending May 3, 2008.

Similarly, the final data for week ending March 3 in contained in the May 16 press release. While the provisional data for the relevant period originally showed a lower rate of 5.92 per cent, the final data now reveals a rather alarming figure of 7.78 per cent.

In effect, in March 2008, the inflation had crept close to 8 per cent, while the government had under the guise of giving provisional figures smothered it to less than 6 per cent.

Naturally, now as the provisional figures for the week ending May 3, 2008 inch close to 8 per cent, one is worried whether the final figures could be close to 10 per cent.

It is quite obvious that the government is using the systemic deficiency in the computation of these figures to postpone the 'shock of high inflation.'

Further, all these figures relate to wholesale prices only. Obviously, inflation calculated at retail levels would be much higher. And remember these are government data.

So what is going wrong?
To understand the cause and consequences of the present bout of inflation in India, I would seek the indulgence of the reader to the following illustration. When this government was voted to office, the international rate of a barrel of crude oil was about $30 and the exchange rate of an American dollar to the Indian rupee was approximately 45. This meant that a barrel of crude would cost approximately Rs 1,300 in India.

Today, the international price of crude has gone up to abut $130 to a barrel. Strangely, the rupee has not commensurately appreciated against the dollar. Consequently, as the exchange rate of rupee to a dollar is at 42 at present, a barrel of oil in India would cost approximately Rs 5,500 -- an inflation of about 320!

And one way of tackling this 'inflation' would be to allow the rupee to appreciate to Rs 10 per dollar. In that scenario, the cost per barrel of crude oil would be Rs 1,300 -- which would mean that it would correspond to the price prevailing four years ago. And should the rupee appreciate to that level, naturally, there would be no inflation.

The rupee appreciation in the above illustration to Rs 10 per dollar is surely an extreme example. Nevertheless it effectively demonstrates the potency of an appreciating rupee in tacking inflation, especially in the context of a global commodity market that is constantly appreciating.

Obviously, rupee appreciation is no longer an option to the policy-framers. Rather, in a scenario when crude, gold and virtually every commodity (including rice and wheat) have appreciated in dollar terms, it is perhaps the only logical option available to the government.

It may be recalled that early last year India was confronted with an inflation rate in excess of 7 per cent. And the government promptly allowed the rupee to appreciate to more than 40 to a dollar. And by the middle of the year, it substantially brought inflation under control. Despite the lessons learnt last year, the government -- for some strange reason -- is loath to allow the rupee to appreciate this time around.

In an intriguing twist to the entire tale, the government has allowed the rupee to depreciate vis-a-vis the dollar during the past few weeks. Strange are the ways of the government! Obviously, the government is entirely clueless in its diagnosis and is vacuous in its prescription. Or is it something more sinister?

Impact of forex reserves, the silent killer
Another dimension to the entire issue is the issue of our burgeoning foreign exchange reserves. You may recall that India faced a huge forex crisis in the early 1990s, when it fell to less than one billion dollars. Since then, India has seen an unprecedented accumulation of foreign exchange. Forex reserves now stand in excess of $300 billion today.

This accumulation of forex reserves has its own impact on the inflation in India. And this requires some explanation. To understand what has been stated above, one needs to look into the composition of these reserves and distinguish between capital and revenue flows.

Unlike China, which has largely built its forex reserves by its gargantuan exports, India has predominantly built its forex reserves through capital flows.

The following table captures the composition of India's forex reserves since 1991, when we virtually had zero reserves:

  • Total capital flows since 1991 = $360 billion
  • Total revenue flows since 1991 = $60 billion
  • Net forex reserves = $300 billion

It may be noted that India's imports have exceeded its exports in the aggregate by $60 billion during this period. Indian policy-framers have to frame appropriate policies to attract capital flows to compensate for the current account deficit. And unlike China, which attracts FDI flows, India attracts FII flows, i.e. huge flows into the stock markets and remittances /deposits from Non-Resident Indians.

According to reports, India had accumulated forex reserves of about $100 billion during 2007-08. This means a sustained inflow of approximately Rs 400,000 crore into the Indian economy during this period. Naturally, this led to the classical case of too much money chasing too few goods -- the classical definition of inflation.

It may be recalled that the aggregate increase in the money supply (M3) in India was a mere 12 per cent in 2003 when this government took over. Now, thanks to the incessant capital flows, the aggregate money supply within the economy now stands at 23 per cent -- far too high for comfort.

The boom in the stock market caused by such increased money supply naturally translated into a real estate boom, commodities boom and other asset boom, including art. Obviously, the increased liquidity within the economy was the cause of the boom, not the economic policies of the government. And when this 'boom' extends itself to commodities like wheat and rice, we classify it as inflation.

When this government took office, rice was approximately Rs 18 a kg in the retail market and the Bombay Stock Exchange's Sensex was at around 5,000 levels. Today, while we applaud the rise in the BSE index to 16,000 levels, we do not see a concomitant increase in the price of rice to say Rs 72 per kg. Yet we moan of inflation, forgetting there at a macro level every market is interlined.

It may be recalled that our persistent deficits in the current account, caused by a variety of factors not the least being the burgeoning oil import bill, is a cause of worry for our policy-framers. And in order to compensate for the current account deficits, successive governments have liberalised capital flows. Perhaps, in the process, they have over-compensated.

While all these have ensured a build-up of forex reserves, it has nevertheless created another set of problems -- one of excessive liquidity within the economy. While the government took credit for the spectacular rise in the stock market, it failed to look into the downsides of pursuing such a policy.

In the extant Indian context, a stock market boom, a real estate boom and benign inflation are an impossible trinity.

But this too has huge risks
However, the solution of allowing the rupee to appreciate is also fraught with huge risks. It may lead to cheaper imports, constrict our exports and thereby increase the existing current account deficits further. And should capital flow not match revenue deficits we could be well and truly in trouble on the forex front too, especially as the Indian industry has not yet attained the necessary global competitiveness.

Instead of improving our competitiveness by building appropriate infrastructure, liberalising local laws and reducing transaction costs, the government took the easy way out to protect and subsidise the Indian industry through a weak rupee. This is akin to building muscles by administering steroids -- an easy but unsustainable route.

What cannot be forgotten in the melee is that it has been suspected by the Reserve Bank of India that the ill-gotten wealth of our politicians, bureaucrats and businessmen are routed back to the stock market through the Participatory Notes (PNs) route -- estimated to be approximately $60 billion, using the foreign institutional investor route.

Further, PNs offer a completely tax-free and absolutely secretive way to park one's ill-gotten wealth into India. Crucially, any policy rollback, vis-a-vis capital inflows or PNs, could well trim the spectacular gains made by the stock markets in recent years. A government that benchmarked itself on the performance of the stock markets can ill afford such a policy intervention.

No wonder it is left with the only option of risking inflation and presumes that it can fudge figures and get away with it in the onrushing elections.

Isn't that a risk worth taking given the stakes our elite have in the stock markets through PNs? Profits for elite, patience for the aam admi!

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Last modified on Sunday, 07 July 2013 07:36