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Inflation in India

By: Dr.Dipak Basu
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(The author is a Professor in International Economics in Nagasaki University, Japan)

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Inflation in India is still rising. Between March 2006 and March 2007, year-on-year wholesale price index inflation excluding food and energy rose from 2 per cent to 7.9 per cent.

Leading indicators of inflation point one-way: continued price pressures. Excess capacity has shrunk to a 14­year low (according to the NCAER). In addition, there are signs of overheating in real estate and labour markets, with surveys showing the salaries of skilled workers rising by around 15 per cent annually. The Public Distribution System has virtually collapsed and the means that were available at least in theory to protect poorer sections of society have disappeared.

How does India calculate inflation?

Most developed countries use the Consumer Price Index (CPI) to calculate inflation but India uses the Wholesale Price Index (WPI) because the government cannot collect quickly the data to create the CPI. The main problem with WPI calculation is that more than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view. Retail prices are normally much higher than wholesale price.

That is the reason when the people on the streets are experiencing at least 30 percent increases in prices the published figure from the government indicate only 7.4 percent increase. Consumers are currently paying as much as 60 per cent more than the wholesale price of essential commodities, which marks a threefold increase over the normal average difference between retail and wholesale prices. Farmers had also been hit hard due to the huge difference in wholesale and retail prices because the middlemen and traders normally benefits from these price increases.

International Situation:

Rising demand due to buoyant economy in developing nations, production shortfall, higher crude oil prices and diversion of food crop for bio-fuel have all contributed to the runaway trend of commodity prices. These developments are largely demand driven, being the result of the increased demand from China. However, the extremely sharp increase in prices in recent months is not easily explained. Even though global stocks have been falling, they are still at a comfortable 114.8 million metric tones. The sharp increases in food prices are mainly due to the diversion of food for fuel production and the role of the "Future Market for Commodities" played to increase the speculative activity on the world scale. In 2006 the US diverted more than 20 per cent of its maize production to the production of ethanol; Brazil used half of its sugarcane production to make bio-fuel, and the European Union used the greater part of its vegetable oil production as well as imported vegetable oils, to make bio-fuel. This has naturally reduced the available land for producing food.

Although India government and Indian observers are holding international situation as the culprit, such developments across the world have no relevance for India, except for the increasing price of crude petroleum. India is not a major importer of food but the second biggest exporter of rice. The government is holding down domestic energy prices using massive subsidies so that it is about to borrow Rs.70, 000 crores from the public to finance these subsidies. It may allow some increase in petrol prices, just as it did in 2004. That will certainly fed the inflation, but we cannot blame it for the recent increase in inflation rate. Inflation in India is mainly due to the wrong policy of the Indian government, when too much money is fueling speculative drive.

Growth of Money:

The source of money that is fueling inflation in India has three main sources: (a) money from the parallel economy; (b) money from abroad through short-term borrowing and investments; (c) foreign multinational companies.

The parallel economy is just as big as the visible economy. According to some estimates, the government could not collect Rs.120, 000 Crores of taxes. The banks could not collect Rs.150, 000 crores of unpaid loans from the defaulters. A significant factor in the spiraling of prices in sectors like real estate, and the hoarding of commodities for speculative gain, can be attributed to this parallel economy.

India is experiencing an unprecedented surge in short-term capital inflows. Net capital flows into the country rose from an already high $23.4 billion in 2006 to $44.9 billion in 2007. Net inflows of foreign institutional investments into India"s stock and debt market that had risen significantly starting 2003. Only over the first 10 months of 2007 about $18.6 billion came to India, whereas during 2003 to 2006 only $8.8 billion a year on average came.

Indian companies have been exploiting the liberalized external commercial borrowing policy of the Reserve Bank of India and borrowing massively abroad. Figures for the January to May period indicate that borrowing totaled $15.3 billion in 2007, with $10.8 billion and $3.4 billion during the corresponding periods in 2006 and 2005 respectively.

Foreign exchange reserves that stood at $76 billion at the end of financial year 2002-03, nearly doubled to touch $151.6 billion by March-end 2006 and have risen to $199.2 billion by end-March 2007 and $266.5 billion on 2 November 2007. As a result the Reserve Bank of India has lost control over the supply of money.

Due to the liberalization of rules regarding foreign capital inflows and the reduced taxation of capital gains made in the stock market monetary policy is now controlled not the government but these flows of foreign capital.
To control this massive supply of money coming from abroad, Reserve Bank of India has initiated programme to sell government bonds to take out some money from the system, but it was too late and too little.

It has started the Market Stabilization Scheme in April 2004, under which it has sold government bonds worth Rs. 60,000 crore. In November 7, 2007 the target was raised for 2007-08 to Rs.2, 50,000 crore, but it is still inadequate to control the flows of money to the economy.

Food Situation:

India has produced 227.32 million tons of food grains, including 76.78 million tons of wheat during 2007-08. The increase in output was due to good rainfall distribution and favourable temperature during Rabi season. Other crops, which saw a good harvest in 2007-08, include rice, maize, tur, urad, soyabean and cotton. Rice production is estimated at 95.68 MT while coarse cereals like maize, bajra and jowar have increased to 39.67 MT from 33.92 MT. Pulses production has also reached an all time high of 15.19 MT this year. Thus, there is no crisis on the food production at all.

Total imports was of $600 million, which is again due to the wrong policy of the government to give foreign farmers prices which are 1.5 to two times the procurement price offered to domestic farmers. The government also has to pay continuously rising prices for the commodity. As compared with the weighted average price of $205 per tonne paid for wheat imported in 2006-07, the average price paid on June 26, August 30 and November 12, 2007 was $326, $389 and $400 per tonne respectively. This takes the weighted average price paid in 2007-8 to $372 per tonne or 80 per cent higher than in 2006-7.

As the government is not interested to maintain the public distribution system, it is not willing to give proper prices to the domestic farmers. That has created the shortfall in procurement and increased imports to a country where enough is available if the government is prepared to raise the procurement prices for the Indian farmers.

Future Market on Food:

The "Futures Market" intensified the speculative activity in the food market in India, which is novel for India. Speculators see much gain in betting for the future prices of various commodities, including rice and wheat. The Economist (September 6, 2007) recently reported: "Trading in agricultural futures, once a backwater, has boomed in recent years. In addition to agri-businesses, more institutional investors, ranging from hedge funds to pension funds-are investing. Last year nearly $3 trillion in grain futures was traded on the Chicago Board of Trade (now part of CME Group), the world"s largest such market."

The Food and Agricultural Organization also reports an increase in speculative activity in agricultural commodity markets. In a recent assessment, the FAO argued that market-oriented policies are creating financial opportunities in agricultural markets at a time when financial markets are awash with liquidity. This abundance of liquidity has, in its view, "paved the way for massive amounts of cash becoming available for investment (by equity investors, funds, etc.) in markets that use financial instruments linked to the functioning of agricultural commodity markets (e.g. future and option markets)." Speculators are looking to such markets, "as a way of spreading their risk and pursuing of more lucrative returns. Such influx of liquidity is likely to influence the underlying spot markets to the extent that they affect the decisions of farmers, traders and processors of agricultural commodities."

India was until recently insulated from the effects of these global trends. However, the government"s decision to allow private multinational firms to speculate in the Indian "Future Markets" has created havoc in the Indian food prices. These private companies like ITC, Cargill, AWB India, Britannia, Agricore, Delhi Flour Mills and Adani Enterprises, procured about 20 lakh tonnes of wheat during the recent Rabi marketing season (April-July) in 2007. That affected the ability of the government to procure supplies to refurbish its reserves to supply the public distribution system, when the "Future Market" has pushed up the prices.

Even though production of wheat during 2006-07 is estimated at close to 75 million tonnes as compared with 69 million tonnes in the previous year, procurement fell short of expectations because the procurement price of Rs. 8.5 a kg ruled well below market prices that have ranged between Rs.10 and Rs.12 a kg. By July 2007 procurement was at 11.1 million tones, way below the levels of 16.8 and 14.8 million tonnes recorded in 2004-05 and 2005-06. With the possibility that buffer stocks of the government could fall below comfort levels, "Future Market" pushed up the speculative prices much further.
To dampen this speculative tendency the government decided to import grains fueling further speculation and increased price.

Thus, price increases have nothing to do with increasing demand due to increasing affluence of the Indian people. The data from the National Sample Survey Rounds on consumption expenditure tells us that per capita calorie consumption, far from rising, has actually decreased, even for the poorest groups. Per capita food grain consumption declined from 476 grams per day in 1990 to only 418 grams per day in 2001, and even aggregate calorific consumption per capita declined from just over 2200 calories per day in 1987-88 to around 2150 in 1999-2000. The latest NSS survey suggests further declines in calorie consumption.

Foreign funds in the stock market :

India has witnessed over a decade of portfolio flows and with each passing year, portfolio flows have gained in their significance and have played a key role in the overall Indian economy. Although investment by foreign institutional investors are typically synonymous with portfolio investments in India, investments in Global Depository Reserve and offshore funds should be included in any analysis relating to portfolio flows.
The year 2002-2003 was highlighted by significant events; both locally and internationally that had a bearing on the Indian economy. By end March 2003, cumulative portfolio investments totaled nearly US$16billion, which constituted nearly 11 percent of the country"s stock market capitalization.

The Union Budget 2003 announced that dividends would be exempt from tax in the hands of a shareholder. Henceforth, dividends declared by an Indian company would not be liable to Indian taxes. Further, long term capital gains arising on transfer of equity shares (held at least for one year) in a listed company, acquired between March 1, 2003 and February 28, 2004 would be exempt from tax. These initiatives were specifically targeted at attracting portfolio investments into India. India has emerged as the most favoured private equity (PE) destination attracting $2.21 billion of private equity investment in 2006 as against just $1, 992 million in 2005. India was followed by China with $1.72 billion. Singapore came third with $1.53 billion.

Foreign funds in Real Estate:

India"s Foreign Direct Investment inflows have doubled to $2.9 billion during April-July 2006 as compared to the $1.5 billion during the same period in 2005. Sensing the demand of foreign investors, the Indian government has liberalized the laws relating to FDI in February 2005. Now Non Resident Indians (NRI"s) and Overseas Corporate Bodies (OCB"s) can invest up to 100% in the real estate sector.

Foreign Direct Investment in real estate is now possible without the need for permission by the Foreign Investment Promotion Board. So, the liberalized FDI regime, coupled with the strong potential of the industry is going to help pump money into the sector. Currently, FDI in India is targeting township, housing, construction development projects, built-up infrastructure etc. The Indian government repealed the Urban Land Ceiling Act in 2001 and a large quantum of land is now free for construction. Investment is now also allowed for smaller projects of just 25 acres.

Low interest rates and a stronger Rupee have boosted consumer demand. The excessive flows of money have facilitated buoyant growth of money and credit in 2005-06 and 2006-07. For instance, the net accretion to the foreign exchange reserves aggregates to in excess of $50 billion (about Rs 225,000 crore) in 2006-07. Crucially, this incremental flow of foreign exchange into the country has resulted in increased credit flow by our banks. Naturally this is another fuel for growth and crucially, inflation. These sustained flows of foreign money, thanks to the excessive global liquidity in the world, has fuelled the rise of the stock markets and real estate prices in India to unprecedented levels.


Thus, the inflation in India is the direct results of flows of money through short-term borrowings and speculative activities that is being sustained by these flows of money. Introduction of multinational companies in the commodities market has increased the speculative activity and reduced the ability of the government to procure enough essential food-grains to sustain the public distribution system. It was certainly a mistake for the government to run down the public distribution system where the majority of the population are poor and cannot afford the increasing market price. Short-term borrowings are highly volatile element and normally create a speculative bubble, which can be burst soon creating serious recession in the economy even bankruptcy. The experience of Thailand and South Korea in 1978 showed very well the damage these short term flows of foreign money can cause. It normally push up domestic prices so that exports prices will go up causing increased balance of payments deficits. As a result Rupee would start falling causing an outflow of these short-term money. That will lead to further fall of Rupee and very soon the government will be unable to repay the foreign debt. Situation like this has ruined Thailand and South Korea for many years. India may be heading for such a catastrophe.

Dr.Dipak Basu

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