Till January this year all the commentators on the economy never got tired singing praises of the Indian economy. It was as if the momentum would never stop. Nobody felt otherwise. And suddenly the tide has turned and how. Newspapers have all started bleeding now. All of a sudden gloom us looming large. Where ever you see you only read about the carnage / the mayhem. Commentators are searching for new adjectives to express this meltdown. How come such renowned commentators, the intellects sway so easily with the tide?Where is the thought leadership that we would like to see? How come the tides turned 180 degrees. The latest blockbuster on the block is called - INFLATION. In the world of finance the headline invariably misleads. I have put together a note on inflation and I hope readers will get a better grip of the subject after reading the same.
Why is Inflation different this time? The global perspective
To understand the present bout of inflation, let us at the outset understand the functioning of the global economy, which is in a state of extreme imbalance. This is simply because developed western economies, particularly the United States, are consuming on a massive scale leading to enormous trade deficits.
Crucially, their extreme levels of consumption and imports are matched by the tendency of the developing countries in having an export-driven economic model. Thus while a set of developing countries produces, exports and also saves the proceeds by investing their forex reserves back in these countries, developed countries are consuming both the production and investment originating from the developing countries.
(Explain this in a simple manner using illustrations)
In effect, developing countries are building their foreign exchange reserves while the developed countries are accumulating the corresponding debt.
What is the reason for this imbalance in the global economy? After the Asian currency crisis, many countries found it better to be with the Dollar. They saw the US as a safe haven and started investing in US treasuries. This was done despite getting lower yields as compared to other growing economies and maybe even their own.
The developing countries are stacked with dollars in forex reserves. Hence, any devaluation in the Dollar is hurting these economies as much as the US. But with the sub-prime problem the faith in the resilience of the US economy has started to wane.
This is driving investments away from the dollar and into other assets like commodities causing its price to rise. To add fuel to the fire investments are being also driven out of equities into commodities due to the huge bout of volatilities being experience across equity markets.
This overflow of money into commodities is one of the reasons for the inflation that we are experiencing. Supply-Demand mismatch too is fuelling inflationary forces.
The Economist’s commodity index shows a rise, over the last 12 months, of 32.2% for all commodities and 54.3% for food. Crude is up 66.4%. It is widely believed that this rise in these prices has come about on account of a huge spurt in demand in commodities and energy, arising out of newfound prosperity in emerging economies, particularly India and China. Thus supply is genuinely strained.
World supply has further got adversely affected on account of
1. Drought in the southern hemisphere causing a lower harvest worldwide (specifically in Australia and Brazil). The combined effect of increasing demand from emerging economies and low stock positions world over have resulted pricing pressures on global wheat supply. Wheat demand is expected to rise, while world production is expected to decline further in the coming months. As a result, global food stocks, already at historically low levels, may fall further by 20 per cent. In such a situation despite the lowering of import tariffs on wheat to zero the situation does not seem to improve as the basis international price is already higher than domestic prices.
2. Diversion of corn to bio-fuel to meet the huge energy demand by emerging markets.
All this is sending prices of substitute grains and poultry soaring.
While the drought situation might correct itself sooner rather than later, the shortage on account of diversion of agricultural produce for fuel rather than food is structural in nature for world economy. This rise in demand for everything can be only handled by stepping up production of both commodities as well as fuel.
While monetary policy changes might strengthen the dollar and help reverse or flow of money from commodities back to dollars thereby reducing price pressures on commodities, the genuine shortfall in supply cannot be met by any policy measures. Long-term structural changes have to be made to reduce price pressures on commodities. Some structural measures will have to be taken to bring the situation under control.
Possible measures to control Inflation
- Increase agriculture output: There is a strong case to increase agricultural output. The challenge is to meet a secular rise in the demand for every agri commodity — not to switch crops from those with less demand to those facing higher demand. This means a combination of bringing fresh land under cultivation and hiking productivity of existing tilled land. Bringing fresh land under cultivation is scarcely an option for countries like India and China. But Brazil, Argentina, Australia, etc, can do this relatively easily. Bulk trading entities in the public sector as well as organized retail players should undertake contract farming and bring in economies of scale.
- Better transport, logistic and storage facility: There is plenty of room for India to raise farm productivity. The biggest challenge here is to build rural roads, so that additional output in interior villages can be transported outside to integrate into the national market. Without such integration, a lot of potential output is forgone: any increase in output in a closed community only serves to lower prices, depriving the farmer of any incentive to increase output. Better storage facility like deep freezers and warehouses should be built to increase the life of agriculture output. Necessary steps should be taken to facilitate global coordination, for rational distribution of the existing supply of scarce commodities.
- Fiscal measures: Some fiscal measures will surely help in alleviating the immediate problems on hand. These being: -
o Allowing the rupee to appreciate, at least temporarily would lead to cheaper import prices on commodities
o Other measures like hike in CRR to squeeze excess liquidity and practicing LAF (liquidity adjustment facility) like MSS, issuances of special bonds and government securities, which would suck out excess liquidity and help control inflation.
Why is Inflation different this time? The global perspective
To understand the present bout of inflation, let us at the outset understand the functioning of the global economy, which is in a state of extreme imbalance. This is simply because developed western economies, particularly the United States, are consuming on a massive scale leading to enormous trade deficits.
Crucially, their extreme levels of consumption and imports are matched by the tendency of the developing countries in having an export-driven economic model. Thus while a set of developing countries produces, exports and also saves the proceeds by investing their forex reserves back in these countries, developed countries are consuming both the production and investment originating from the developing countries.
(Explain this in a simple manner using illustrations)
In effect, developing countries are building their foreign exchange reserves while the developed countries are accumulating the corresponding debt.
What is the reason for this imbalance in the global economy? After the Asian currency crisis, many countries found it better to be with the Dollar. They saw the US as a safe haven and started investing in US treasuries. This was done despite getting lower yields as compared to other growing economies and maybe even their own.
The developing countries are stacked with dollars in forex reserves. Hence, any devaluation in the Dollar is hurting these economies as much as the US. But with the sub-prime problem the faith in the resilience of the US economy has started to wane.
This is driving investments away from the dollar and into other assets like commodities causing its price to rise. To add fuel to the fire investments are being also driven out of equities into commodities due to the huge bout of volatilities being experience across equity markets.
This overflow of money into commodities is one of the reasons for the inflation that we are experiencing. Supply-Demand mismatch too is fuelling inflationary forces.
The Economist’s commodity index shows a rise, over the last 12 months, of 32.2% for all commodities and 54.3% for food. Crude is up 66.4%. It is widely believed that this rise in these prices has come about on account of a huge spurt in demand in commodities and energy, arising out of newfound prosperity in emerging economies, particularly India and China. Thus supply is genuinely strained.
World supply has further got adversely affected on account of
1. Drought in the southern hemisphere causing a lower harvest worldwide (specifically in Australia and Brazil). The combined effect of increasing demand from emerging economies and low stock positions world over have resulted pricing pressures on global wheat supply. Wheat demand is expected to rise, while world production is expected to decline further in the coming months. As a result, global food stocks, already at historically low levels, may fall further by 20 per cent. In such a situation despite the lowering of import tariffs on wheat to zero the situation does not seem to improve as the basis international price is already higher than domestic prices.
2. Diversion of corn to bio-fuel to meet the huge energy demand by emerging markets.
All this is sending prices of substitute grains and poultry soaring.
While the drought situation might correct itself sooner rather than later, the shortage on account of diversion of agricultural produce for fuel rather than food is structural in nature for world economy. This rise in demand for everything can be only handled by stepping up production of both commodities as well as fuel.
While monetary policy changes might strengthen the dollar and help reverse or flow of money from commodities back to dollars thereby reducing price pressures on commodities, the genuine shortfall in supply cannot be met by any policy measures. Long-term structural changes have to be made to reduce price pressures on commodities. Some structural measures will have to be taken to bring the situation under control.
Possible measures to control Inflation
- Increase agriculture output: There is a strong case to increase agricultural output. The challenge is to meet a secular rise in the demand for every agri commodity — not to switch crops from those with less demand to those facing higher demand. This means a combination of bringing fresh land under cultivation and hiking productivity of existing tilled land. Bringing fresh land under cultivation is scarcely an option for countries like India and China. But Brazil, Argentina, Australia, etc, can do this relatively easily. Bulk trading entities in the public sector as well as organized retail players should undertake contract farming and bring in economies of scale.
- Better transport, logistic and storage facility: There is plenty of room for India to raise farm productivity. The biggest challenge here is to build rural roads, so that additional output in interior villages can be transported outside to integrate into the national market. Without such integration, a lot of potential output is forgone: any increase in output in a closed community only serves to lower prices, depriving the farmer of any incentive to increase output. Better storage facility like deep freezers and warehouses should be built to increase the life of agriculture output. Necessary steps should be taken to facilitate global coordination, for rational distribution of the existing supply of scarce commodities.
- Fiscal measures: Some fiscal measures will surely help in alleviating the immediate problems on hand. These being: -
o Allowing the rupee to appreciate, at least temporarily would lead to cheaper import prices on commodities
o Other measures like hike in CRR to squeeze excess liquidity and practicing LAF (liquidity adjustment facility) like MSS, issuances of special bonds and government securities, which would suck out excess liquidity and help control inflation.
