Inflation Issue In India

Fridays have become nightmares for the current UPA government. No points for guessing why. The weekly inflation numbers in India are out every Friday. The last thing the government would have wanted was a double digit inflation rate. The number last week was a whopping 11.05%. Though the sudden spike is largely due to the base effect, the fear of outcome of this inflationary trend can't be allayed.

The seemingly obvious reasons for inflation like food shortage, dollar depreciation and the skyrocketing crude oil prices have been discussed in enough detail by various columnists and bloggers. So I don't want to delve upon these reasons. I somehow feel that the cause of the current global inflationary trend is a little more fundamental and profound.

One thing that we have been noticing for the past couple of decades is that emerging nations like China and India are not allowing their currencies to be completely market determined. In fact China as we all know keeps its currency artificially very much low against the dollar. This can be easily noticed by observing the huge difference between GDP at market price and GDP at PPP(Purchase Power Parity)of these nations. The reason is not difficult to guess. This is one good way to boost export led growth and hence increase employment opportunity within your own country. Apart from the currency front, governments take many other measures like creation of Export Promotion Zones (currently known as SEZ in India), resorting to deficit spending etc.

You might artificially create watersheds to store water, but in accordance to the fundamental principle of Physics water seeks its own level. When water is bound by creating water sheds, it develops a potential energy and if the energy is strong enough to break the watershed, then the potential energy is converted into kinetic energy and water seeks its own level, by breaking the barrier. This principle is very much valid in all sciences and economics is no exception.

The same thing is happening in the world economy. The emerging countries like China have artificially created watershed by means of artificially keeping its currency low for quite a long time. What it does in the long run is that it increases the domestic prices (akin to potential energy) leading to what I call as embedded inflation, where inflation gets embedded into the economy. You might ask if inflation is bound to occur, why this is this suddenly showing up now? Well, the looming current financial crisis, food shortage and crude fears are just the triggers. When water blocked by watershed is disturbed by some physical phenomenon like a mild tremor, it is highly likely that water may break the barrier and that’s what is happening now. But we don’t know how intensive the current tremors (read trigger) are.

If you ask me is this artificial depreciation wrong, I would not say so. We create watersheds to preserve water and also save villages. Similarly such monetary measures have definitely boosted the growth of these emerging countries and that's what we have been witnessing for the past decade. But there are no free lunches. The exuberant growth has come at a cost of an embedded inflation which is showing up big time now. The ideal monetary policy is to balance growth and inflation. One might think, forget monetary policy and all the sauce, let market determine every thing; let free market prevail. But we are not living in Utopia where everyone is equally wealthy and capable. About a quarter in India do not enjoy one full meal a day. Inflation less inclusive growth is what governments should aim at. The outcome need not always be optimal (Remember Pareto Sub-optimality!)

So what’s the solution? I would say that in the short term, allow the domestic currency to appreciate to cool the prices. Might be a 25 basis point interest rate hike is on the cards and it is acceptable. The Fed might keep the rate unchanged leading only to an increase in the interest rate spread between the US and India. This might lead to more dollars flowing in and RBI should not resort to buying dollars through MSS. Allow the domestic currency to appreciate. This would automatically cool the inflation (Imports become cheaper and supply within the nation increases)

Let market determine the exchange rate and in the long run once we attain a little more depth and breadth in our financial markets, full Capital Account Convertibility should be the panacea. This is a part of the cycle. The emerging world has come a full circle. Countries like China should not anymore resort to artificial depreciation of the local currencies for the sake of export led growth. I would like to reiterate here that there are no free lunches whatsoever be the context.

PS: It has been 3 years, 3 eventful years since I started blogging. It was on the same day back in 2005 when I had started this blogging journey. Looking back it gives me a feeling of great ecstasy that I have survived. I have learnt a lot in this journey, got a lot of new friends who have appreciated bold and really crazy thoughts of mine. Though I have been not very regular in this journey I have tried to make sure that I don’t present clichéd content in my blog. I sincerely and heartily thank all my readers and wish for greater support in my forthcoming blogging journey.