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Sunday, May 27, 2012

Why inflation is rising in India? (In simple words)



There are a myriad of reasons for the rising inflation.Let us first understand –what inflation actually is.

Simply put, inflation is the increase in the prices of goods and services from their previous level. Inflation erodes the purchasing power of the currency - this means Rs. 100 shall now fetch you fewer goods and services than what it could buy earlier.


What is the basic theoretical cause of the inflation?

Demand and Supply Rule’ explains the basic reason for the inflation. When demand for goods and services increases and if this elevated demand is not counterbalanced by the increased supply then the prices of goods or services are liable to rise.
There are a score of reasons for the elevated demand but we shall restrict ourselves to the vital-few.


·         The excess money in the economy: When this excess money chases available goods and services in the system, inflation rises.
When money supply in the system increases RBI hikes the policy rates to suck the money (liquidity) from the economy. But policy rates can’t be hiked beyond a limit as it unfavorably hinders the growth of the economy.
·         Growing population of India: Burgeoning population of India keeps the demand high. Australia has around double geographical area than India but strange thing is that India’s population increases every year by about Australia’s total population.

Pragmatic reasons responsible for rising inflation in India

(1)    US Money Printing: To prop up the fledgling USA economy US Federal Reserve opted for the Quantitative Easing or the money printing. As interest rates in USA were hovering near zero level and significant portion of this money was routed to India for better returns as Interest rates in India were much higher than US rates and equity markets in India too were more promising.
This money entered India at such a high speed which resulted in the meteoric rise of the capital markets. Everybody was talking about 10 % GDP growth rate.
But 2008-crisis changed the situation and growth rate of Indian GDP slid miserably.
Foreign money which entered India too started departing back.
But inflation once increased did not retrace and momentum of inflation continued.
US quantitative easing spooked big investors and they became skeptical about Fiat Money and raised their allocation in gold and this resulted in gold soaring new heights day by day.
Soaring gold prices resulted in higher Indian gold import and subsequent higher Current Account Deficit.
If in future too, if US goes for QE3 and part-proceeds comes to India, inflation shall keep on rising.

(2)    Chinese growth: Chinese export-oriented economy which is driven by low-cost manufacturing fuelled the global commodity prices. Barring Aluminium almost all commodities tripled or quadrupled in price. Even though presently Chinese economy is slowing but commodities never landed to their previous price level. Again if Chinese economy picks up, demand for the commodities shall shoot up further pushing the inflation higher.
Cheap Chinese manufacturing badly affected the exports of Indian capital goods companies and their export took a hit. Lesser exports meant lesser flow of foreign currency (mainly dollar) and weaker rupee.
General inflation rises in a nation with the weaker local currency.

(3)    Weaker Rupee: After 2008- crisis crude prices bottomed around 35 US dollars per barrel and presently crude prices are hovering around 91 dollars per barrel.

This means crude prices have risen by around 160 %- but wait are we missing something?
Yes.
Crude is bought in dollars and therefore rupee-dollar exchange rates come into play.

Let’s understand this-

Date
Crude prices
Dollar-rupee exchange rate
Feb 09
35 $/barrel
44 Rs.
May 12
91 $/barrel
56 Rs.

Simply put, in Feb 09, crude was 1540 Rs. per barrel while presently we need 5096 Rs. for a barrel, this means in rupee terms crude oil has become dearer by whopping 230 %.
In India petro-product prices are regulated by the government. On papers only, petrol prices are not regulated by the government but in reality oil marketing companies can’t hike petrol prices on their own.

Some of you may argue that if petrol prices are governed by the government than how crude prices could increase the inflation?

 Though prices are regulated by the Indian government but government keeps on hiking the petro prices though not proportionately with the rising international crude prices.
As dollar is the world’s reserve currency and a majority of global financial transactions take place in dollar. Any currency depreciating against the dollar makes the import costlier and trade deficit of that nation widens. Recently dollar has appreciated against all major currencies including Euro and Rupee.

Rupee depreciation has made imports costlier for India. 70% of India’s oil need is catered through imports and in aforesaid point we have already seen how depreciating rupee increments the trade deficit.

Europe’s debt crisis resulted in Euro depreciating against the dollar and subsequent rise in the dollar index. This happened as investors withdrew money from India to park their assets in dollar denominated safe assets and to meet the financial obligations arising in the Euro region.

Weaker rupee not only affects crude only but imported fertilizers, steel and coal too become costlier.  As coal is used in cement and steel manufacturing we see cascading inflation. Expensive fertilizer prices, ultimately translates into dearer food items.
Higher crude price results in higher transportation costs and that makes each and every commodity (that requires transportation) dearer.


(4)    Food inflation: This is one of the vital policy-led reasons responsible for the inflation. Recently food inflation has played a pivotal role in boosting the overall inflation. A few of Government’s faulty policies are responsible for the food item induced inflation-

·         MSP hike for political benefits:  MSP or Minimum Support Price is the minimum price at which government buys grains, cereals and other agricultural produce from the farmers.
In India around 70 % of the total wheat produced that comes to mandi  (trading arena) is bought by the government, so bread, biscuit and flour makers can buy remaining 30 % of the wheat that too at higher prices. This is why bread price has been doubled in the last 5 years.
Not only central government but state-governments also buy the produce that too at even higher prices.
If market price of wheat is Rs. 10-12 per KG than government buys it at Rs. 14-16 thus incurring a loss of Rs. 4 per kg.

Now the million dollar question, what government will do with this wheat?

It distributes little portion of it through rationalized shops at much subsidized rate and rest is simply handed over to FCI (Food Corporation of India). As storing 6.3 crore tonne wheat is not a simple job, this wheat rots/spoils as government can’t afford to bear the storage cost.
Government should stop buying agro-products directly from all the farmers to garner votes and instead let this produce come in the market for the fair price discovery .Government should buy from poor farmers only.

·         Decreasing acreage in the name of development

Visit any district magistrate’s office and you shall find ‘Applications for the Land Diversion’ piled up. Diversion is the process of granting the permission to start commercial operation on an agricultural land.
With real estate prices skyrocketing, many farmers preferred to sell their land to commercial builders.
Recently in Singur (WB), 1000 acres of fertile land was seized from farmers for erecting the Tata’s Nano plant. Though WB government was changed in the polls on this issue and TATA Motors retreated but many farmers are still not in the possession of their land.
India’s population is increasing by leaps and bounds while arable land is depleting. This is why food item prices have an upwards bias.

·         Indian government’s populist policies  

In India MNREGA (Mahatma Gandhi Rural Employment Guarantee Scheme) was implemented with a holy purpose of helping rural people with employment in their vicinity but this scheme was implemented in damn hurry with political agenda in mind.
Under this scheme cash was distributed as wage without ensuring the productivity. State governments too were not prepared to effectively implement the MNREGA schemes.

How MNREGA helped food inflation to soar

1.       Under MNREGA wages offered were much higher than what farmers paid to farm-labors so labors never turned up at farms. This resulted in hiring of labors at higher wages which increased the cost of grain production and ultimately which was passed on to the consumers. MNREGA rates became the industry benchmark and with every rise in MNREGA rates, prices of food items are bound to increase.
2.       States like Punjab, which is called ‘Granary of India’, is already grappling with the scarcity of farm-labors and implementation of MNREGA aggravated the situation. As a result farm wages were increased discriminately and this increased cost of production was ultimately passed on to the consumers, resulting in higher inflation.
3.       Milk, poultry and other protein rich food products which are predominantly supplied from rural areas. Higher wages in the hands of rural workers resulted in higher local consumption and thus upward pushing the prices of protein rich products.

(5)    Commodity Market Manipulation: Theory says commodity markets ensure the fair price discovery of the commodity items and helps farmers to come out of the clutches of unscrupulous middlemen.
But as far as India is concerned, this theory is partially true.
Whenever price of a commodity surpasses comfort levels and enters into much higher territories, government bans the trading of that commodity on commodity exchanges.
We have seen, though not immediately but slowly prices start falling to their justified levels. Market is abuzz with the flurry of news about artificial price propping by few players- Guar gum price appreciation is the recent example.

(6)    Shortage of the coins/change in the economy:  This is not a silly reason but the most overlooked reason and no major economic book or paper talks about this.
  Coins up to 25 paisa denomination are discontinued and in market there is increasing scarcity of Rs. 1 and Rs. 2 coins. Shopkeepers and traders are upward-revising prices in the name of rounding the price. Price tag of a commodity/item worth Rs. 5 directly gets revised to Rs. 10 with some increment in quantity which is more in favor of traders/shopkeepers.
Shortage of coins make non-branded items (which have no printed price on it) dearer and causes overselling of low-priced branded FMCG products.

(7)    Increase in disposable income

Two decades of the liberalization resulted in higher deposable incomes in the hands executives and businesses in the urban area. Government’s welfare policies like MNREGA (Mahatma Gandhi Rural Employment Guarantee Scheme) resulted in increased money in the rural area and consequent higher spending. Elevated demand without compensating higher supply resulted in the inflation.
This programme has been implemented without ensuring the productive output and has become just a cash distribution system, as quoted by Kiran Shah, a famous businesswomen and the founder of Biocon. World Bank too viewed MNREGA as a barrier to economic development.

(8)    Availability of easy credit
Post-liberalization financial sector developed a lot owing to vital reforms. Many private and players entered in the field and interest rates too started falling. Easy credit boosted the demand and instead of saving people started to splurge. Earlier, during last years of the service people used to think about owning a house or property while presently just after couple of years of the first job people are opting to own property.
Earlier people used to save to buy capital assets like house, car or high value gadgets but now a day’s people get the same on easy credit.
Easy credit has boosted the consumption resulting in higher demand and subsequent inflation.

(9)    Deficit financing: Deficit financing is nothing but government spending in excess of the revenue. Now the question is – from where this excess money comes? 
And you guessed right- Money Printing. Money printing is a practice where money is created by an electronic credit entry without backing of any security or gold. This is generally used to boost the economy and when economy starts running well another counter balancing electronic debit entry eliminates this false money from the system.
It’s just like your saving balance in a bank which is just Rs. 10 lakh (1 million) becomes Rs. 50 lakh (5 million) with a credit entry of Rs. 4 million. Now you can expand your business with this extra 40 lakh (4 million) rupee. When your business turns profitable, a counterbalancing debit entry of rupee 4 million wipes the Rs. 4 million from your account.
You shall call it wonderful but impossible.
But this is not impossible in case of governments across the world.
Bu wait- if this electronic entry is not wiped from the system within time currency devaluates like anything and inflation goes on fire.
Following pictures aptly tells what happened in Zimbabwe!

Money printing is not always done with the electronic entry only but issuing bonds which promises to pay in future is nothing but money printing.
Indian government usually issues oil bonds to downstreamcompanies to meet under recoveries. Be it in any form, money printing raises the inflation.


(9)    Black money

 Black money that already flowing in the nation is predominantly invested in Real estate and gold. And it is the bitter truth that India survived the 2008’s global financial crisis due to this parallel economy of black money. As black money can’t be parked in the main system, it unofficially circulates among the few players at very higher interest costs and this is the reason despite having seen real estate prices going multifold no ‘Property Bubble’ took place in India like the one in the USA.
Black money transactions ensures lesser money flowing into government’s coffers and government is forced to borrow money 
Not only money generated and circulating in the Indian economy but the black money parked abroad is finding its way into the nation through back door. P-notes or fake export transactions are the common ways used to bring back black money into Indian shores. Sudden jump in transactions with countries like Bahamas raises the suspicion.

(10)Hike in taxes 

 Barring a few services, almost all major services attracts the service tax and hike in the service tax makes services expensive. In this budget service tax was increased to 12% from earlier 10 %.  Phone/mobile bills, cable bills, bank draft fees, locker fees and all services which attract service tax became expensive. Similarly hiking the excise duty or customs duty ads to the cost of the products and service; Businesses and service providers when pass on this extra burden on the consumers, general inflation rises.



There are many other reasons responsible for the rising inflation but I discussed only a vital few that can be understood easily without going into unnecessary details. Many of the aforesaid mentioned reasons are interlinked and often work in tandem.

NB: MNREGA was discussed for the information purpose only and in no way this post indicates author’s bias against it but he expects its effective and productive implementation to needy people only.




3 Comments:

be rich in simple step said...

Awesome facts , real truth and a eye opening.
why one should stop using paper money and get back to the system of converting money in real gold . so its value keep rising rather than going down like a 100RS meant a lot 15 year back but now days it can not do nothing good rather than jumping red light and paying challan.

Anonymous said...

Wonderful Article. Please keep writing more of the kind.

Rakesh gangani said...

HI,
Wonder full Article .. why don't you write about various step that a individual or a government should take ..

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