Only a grain of truth: Outlook Business, 31st May 2008

Export curbs and duty cuts are stop-gap measures to check inflation. The only lasting solution is a big increase in agricultural output

Inflation today has two distinct features. First, it is a global phenomenon, as rising prices have severely affected almost every country across the globe. Considering that the phenomenon has even triggered food riots in some less-developed countries and many other countries have witnessed a higher rate of inflation, India has done creditably so far, with the rate of inflation being pegged at around 7.5% in the country. The second distinct feature of the current crisis is that it has been caused by distortions in fundamentals, which have severely widened the gap between demand and supply. Rarely any other reason except supply shortfall has caused price hikes. Economic theory calls this cost-push inflation.
India was prepared for an inflation rate of 5% for the year. But the applecart has been upset with the figure reaching over 7% in the past weeks. Usually, governments and policymakers grapple with the twin issues of growth and stability. Higher growth and price stability are desirable, but it may not always be possible for a country to enjoy this ideal situation. Policymakers have to work on trade-offs, and growth can be sacrificed here as it is not really visible across the country, as lower wage hikes and layoffs, which characterises these downturns are restricted to urban areas and all specific to industry. But higher inflation affects everyone and, when it is triggered by food, it is serious business.
Cash in reserve
The government has been taking a series of measures to control an increase in prices. On the demand side, the Reserve Bank of India has increased the cash reserve ratio (CRR) to lower the ability of banks to lend. The rationale is that when CRR is up, banks have fewer resources to lend, which, in turn, controls the growth of liquidity in the system and the demand. Interest rates have consequently moved up and are probably coming in the way of growth in demand, which comes from individuals and the industry.
However, this has not really had an impact, as the demand-pull forces had a limited role to play in pushing up prices this year. In fact, the recent hike in CRR is unlikely to be effective because growth in credit is also slack. That banks would be treading cautiously this year in the wake of derivatives losses that some of them suffered would have restricted the growth in credit. So, chasing the demand-pull trail is unlikely to yield positive results.
Reading the flow
On the supply side, the government has followed the twin policy of increasing the flow of goods by liberalising imports to enhance the flow of goods, as well as reducing import costs. This was done earlier in the case of wheat through imports; and reduction in tariffs for cement and pulses last fiscal; and for edible oils and rice more recently. Such measures have been supplemented by export restrictions on rice, edible oils and pulses to ensure that scarce food resources are not exported. Also there have been announcements on stocking essential commodities, since such situations tend to encourage hoarding. Banks have been advised to be cautious in such lending operations.
Reduction in import duties has worked well to reduce the prices of edible oils and thus countered the lower production of mustard (the rabi crop). But the fundamental problem of shortfall in production could not be eschewed.
Building buffers
Increasing imports and curbing exports will work at a country level, not in a global scenario. In a global economy, such measures only add to the supply shortage, as countries are keen to import more while shying away from exports. Countries such as China and Thailand have been imposing export controls, creating imperfections in trade flows. This approach sets up what is called an ‘economic game’, where every country protects their own food stocks and relies more on imports so that they can avoid a crisis.
This eventually affects everyone as global supplies get stifled, leading to higher
Increasing agricultural output is spoken about, but little is done. Unless this balance is corrected, India runs the risk of high inflation every time there is a food shortageinflation. One has been observing this in the crude oil sector, where countries such as the US are saving their own reserves and relying more on imports, leading to a rise in prices.
The other factor that has been working against inflation is the relatively lower base last year at this time. Prices had moved downwards, towards the end of last fiscal year, which pushed up growth rates this year. However, the impact of the base-year phenomenon should not be overstated here.
Getting inflation down can finally work only if we are able to increase agricultural productivity, so as to ensure that supplies keep increasing. This has been spoken of, but little has been done. Hence, we will be running the risk of inflation every time there is a food shortage. This year, production of rice, chana and mustard have been down in the rabi season, which has had its effect on prices as against a good kharif harvest in 2007.
We cannot insulate ourselves from global inflation because there is a progressively greater cohesion between global and domestic prices. These influences come into the system through imports, as has been witnessed in the case of edible oils. Therefore, policies like export restrictions or lowering of import duties can at best be a short-term solution.
Missing links
While the focus of all inflation talk is agriculture and food items, many of those who are into the debate have missed two important points. In the current financial year, prices of manufactured products have increased by over 7%, and this category contributed to about 53% of total inflation. Here, the increase has come from the metals segment on which such policy actions do not work. Further, the increase in administered prices of some fuel products has also fed inflation through higher input costs for farmers as well as for industry.
The government has made clear its priorities in terms of controlling inflation, and has taken several steps to lower the rate. However, such intervention in the markets is likely to have an adverse impact on the fiscal balance, as the thrust has been on trade measures that will affect tax collections. Add to this the higher procurement of wheat this year of over 17 million tonnes (the FCI expects this to touch 20 million tonnes), and the subsidy bill is also likely to increase over time.
Quite clearly, there is a trade-off being traversed by the government, which is understandable under the present conditions. However, one cannot dodge the issue of increasing the presently stagnant yield from agriculture in the country. There appears no other way out. Since this cannot happen immediately, we may have to live with agflation—an increase in the price of food that happens as a result of increased demand—at least for some time, while global factors will influence the price of metals and energy products, over which a country like India may have little control. Monetary policy must keep this in mind to ensure that growth does not suffer with restrictive policies. Therein lies the rub.