04 A What, in your opinion, were the factors, both domestic and global, that led to the inflationary trend

in India in early 2007? India and Indian economy has always suffered from inflation. Till the early nineties (the beginning of the liberalisation era), inflation rate of 10% and over was somehow considered acceptable mainly because Indians had never lived without it. Till the early decade of 1990-2000, inflation was mainly caused by internal or domestic factors. The relative shortage of goods produced put a premium on those available lot of money and too little to buy with it hence the inevitable price rise. By 2007, Indias place and role in affecting the global economy had changed considerably. Indias internal woes were no longer the only factor for creating inflation. India now had considerable help from other countries in sustaining a high rate of inflation. All this was of course primarily caused by the Indian economy itself undergoing massive structural changes, post the effects of liberalisation kicking in. Internally, India was facing the problem of inflationary pressure because of the increase in Demand while Supply was relatively constant. The inflationary pressure faced by Indian Economy was due to Demand-Pull inflation i.e. Demand > Supply. Blame it on Others In early 2007, the developed nations, particularly the US, were, and still are, victims of massive amounts of trade deficits. Consumption within the US was very high, leading to this situation of trade deficit. This ready availability of large consumer markets had provided the necessary inventive to the developing economies, including India, to tilt heavily towards an export driven economic model. India was thus building large amounts of forex reserves, while US was building up a current account deficit (estimated to be about 7% of GDP or about 900 billion $)i. To support and grow this export model, Indian policymakers found it convenient to effectively devalue the Rupee, to increase the export incentive. To help maintain the weakness of the Rupee, RBI intervened in the currency market as necessary, to help accumulate more forex reserves. The depreciation of the Rupee was thus engineered by RBI to help improve the margins of export focused sectors like software and textiles. Fearing an impending devaluation of the US Dollar, many players began to invest in commodities, causing an increase in the price of these commodities. Further, undervalued currencies in the developing countries including India, increased global liquidity and consequently the prices (more money available). We can not forget that India was in 2007, and is today, very nearly completely integrated with the world economy. As the world economy was booming, so was inflation rising worldwide. Prices of many commodities had tripled or quadrupled in price since 2003, especially metals and fuels. On the agricultural front, price of wheat available in India rose considerably. This was a combination of reduced production in India, a reduced production in the major wheat producing countries like Australia and Brazil and an ever increasing consumption of wheat in India. Wheat was also being increasingly used for producing ethanol for motor vehicles, leaving limited amounts for human consumption. Futures trading in Wheat further fuelled speculation. The govt in India did, to some extent, mismanage the production and distribution of wheat by offering a low minimum support price which led to its failure to build up sufficient stocks to provide timely relief

from low production and also to help smoothen price fluctuations. An increase in price of wheat was calamitous event just waiting to happen. A close Look Inside Indias success story itself became the harbinger of bad news. With increased per capita income, and a large population base, the rise in demand for commodities was unprecedented. A price rise in these conditions is inevitable. Record economic growth, boosted by the fastest increase in bank loans in more than three decades, was taking its toll. The heavy inflow of forex reserves, as mentioned above, provided the source of credit outflow by Indian Banks increasing the purchasing power and, by consequence, the inflation. Demand from consumers was relentless. Practically all of India's manufacturers were operating at full capacity, as consumer demand has risen and companies have been slower to respond. Many factory expansions and new factories were coming up, though it would be another 12-18 months before their output would begin to match the demand. This was a transitional period for the economy. White collar salaries were rising faster in India than in other developing nations in Asia. Over the last one year salaries had risen by an estimated 13.7 percent. ii This was a major cause for rising consumption. Clearly, in purely economic terms, it was impossible to couple a rising stock market and a realty market with low inflation rates. Growth was expected to come at a price and it did. Money was growing at a rate of about 20 per cent year-on-year. With GDP growing at about 14 per centiii, this was a gross imbalance between money and goods available - a classical breeding ground for inflation. Bulk of the increase in inflation, as measured in wholesale prices, in the period ended 27 January 2007, had been brought about by the surge in prices of food items including cereals, pulses and oilseeds, all of which saw hikes of more than 10%.iv With the production of foodgrain being below expectation, speculative pressure on foodgrain pricing was growing. The low levels of international foodstocks also restricted the govts ability to counter the pressure with increased imports. In January 2007, food prices were 10 per cent higher than what they were a year ago. The price of wheat, which is the staple diet of most of the population, had risen by 12 per cent. Edible oils prices had gone up by 43 per cent and the reduction in excise on them had not made any difference.v Among the different groups that contribute to inflation, primary articles impacted the inflation level the highest at this time. Wheat, pulses, milk, oilseeds and raw cotton were the major drivers among the primary articles for inflation. Pulses were higher by 12.5 per cent (which was incidentally on top of 33.3 per cent rise during the previous year). Raw cotton prices increased by 21.9 per cent against a marginal decline in global prices.vi Indian agricultural production had been flat for the last few years, while demand had been increasing as incomes rose, pumping up food prices. In fact the low level of attention to agricultural productivity enhancement over the last two decades was taking its toll now. Other than taking some populist measures such as fertilizer subsidy and tax holidays, the govt had done little to boost agricultural yield to a level where it could cater to the ever increasing demand pressures. Yield per hectare of fertile land was reducing. Increased industrialisation and urbanisation had reduced the scope of putting more land to agricultural use. Modern agricultural practices like crop

rotation, use of soil friendly pesticides and mechanical farming were used sparingly. Agricultural yield thus reduced considerably below the optimum or desired levels. Low agricultural production was partly caused by a sub-normal NE monsoon in the previous quarter. North-east monsoon normally is a major period of rainfall activity during OctoberDecember. According to an RBI report, the cumulative rainfall was 21% below normal as compared with 10% above normal, during the corresponding period of the previous year (OctoberDecember05). Deficient rainfall during the north-east monsoon season seriously affected the rabi output especially in pulses like tur and gram, oilseeds like rape/mustard and sunflower, and foodgrains like maize and rice. An increase in the world oil prices was another trigger for an overall inflationary environment in India, as the govt passed on the increase in price to the consumer. Apart from the direct increase in price of fuel sold, an indirect fallout came in the form increased transportation cost of vegetables to areas that are distant from the farmlands. An increase in price of diesel also raises the cost of farming where tractors and other mechanical farming equipment is used. Cement companies raised prices as much as 6% because of higher taxes imposed by the government in the budget. Indian car makers also increased prices after the government imposed an additional education surcharge. Farm produce was of-course not the sole culprit here. Core inflation, excluding volatile items like oil and food, had been steadily climbing in the recent months. Prices of industrial goods was another major contributor to inflation. The problem here was the lack of domestic capacity to meet credit induced demand. The recent capex boom was expected to show results only after a year or two, as new factories start operating and more steel, cement, cars, television sets and suchlike reached the market. Till then, the choice was between keeping a check on demand growth through higher interest rates and tolerating high inflation. Other significant, but less publicised, reasons for inflation included populist govt policies and heavy deficit financing by the govt. In summary, events like low agricultural production, low industrial production, excess money supply, a runaway economy and uncooperative weather gods probably came together in the period Dec06 to April07 to give Indians a glimpse of what the future could look like in an environment of increased globalisation and the somewhat reluctance of the govt to change its ways.

04 B Critically analyse the measures taken by the Indian Government and the RBI to control inflation. What impact odes the tackling of inflation through monetary means have on economic growth? To be fair to Indian policymakers, inflation rate in India was considerably lower than many other developing countries. It was, however, higher than the rate in China Indias competitor for foreign investment. India did witness and experience the direct negative fallout of high growth rate, in the form of spiraling prices of everyday commodities. High growth rate itself was brought about by a liberalisation of the economy in the early 1990s unlike the 1980s when India had one of the worlds most highly regulated economies. With this built-in correlation, it is also inevitable that economic growth will suffer as attempts are made to reduce inflation through monetary means only. This is the precise reason that new way of thinking is required if India wants to enjoy the best of both worlds. India does not have a properly structured monetary policy framework. RBI is primarily focused on exchange rate control, and is not held accountable for price stability. Monetary policy transmission is also weak. When RBI changes short term interest rates, it is a considerable amount of time before its effects are seen in the money supply system. This is due to the various capital controls and regulatory prohibitions that are in place. In an attempt to stem the price rise and build up stockpiles, the govt banned the overseas sales of grain till the end of 2007. This probably had a very limited impact on the overall cost/surplus situation as India exports only very small quantities of wheat. Along with this, India also banned the export of milk powder until September 30. On 15th Feb 2007, govt cut the retail prices of petrol and diesel by 4.5% and 3.2% respectively, to control the accelerating inflation. In the middle of February 2007, govt decided to release an additional four lakh tonnes of wheat in the open market. Same time the govt allowed the import of pulses at zero duty upto August 1 of 2007. Earlier in January, the finance ministry had cut import duties on several products ranging from sulphur to steel. Prices of steel came down after the govt asked steel companies to limit price increases and the Indian steelmakers agreed to lower prices to help curb inflation (less than a week after raising them). Import duties on certain essential items like food, steel, cement were reduced. Earlier, the central bank raised a key short-term interest rate by a quarter-point to 7.5 percent to help stem inflation. The lagging effects of interest rate increases over the past year had not yet fully worked their way through the economy. Ring in the New The causes of inflation had undergone myriad changes since the beginning of the 1990s decade; still the response of Indian policymakers was still rooted somewhat in traditional methods of inflation control.

In the matter of balancing inflation rate and economic growth, the ideal combination, which has been achieved in all mature market economies, is one involving low inflation, which is also predictable and non-volatile. Low inflation volatility also ensures low volatility of GDP growth. In socialist India, the way to deal with an outbreak of inflation was to have the government interfere in commodity markets. This is inherently distortionary. In this particular case milk exports were banned, and milk prices fell. But milk farmers had to pay the price for a macroeconomic problem of inflation. If milk prices had been allowed to rise, then more labour and capital would shift from unproductive cereals to high-value milk production. If the govt continues to meddle in every industry, a sophisticated industry system, that is entirely governed by supply and demand, will never develop. There is something very wrong about a government that interferes in what can be imported and what can be exported. The RBI Act of 1934 is considerably dated in view of prevailing modern monetary policies. It is the lack of proper foundation for monetary policy that forces the country to undergo distortionary mechanisms for inflation control. In the era of globalisation, new methods of price control were needed. Making the Rupee Stronger One of the correct responses by the govt, against a rapidly spiraling inflation was to make the Rupee stronger vis--vis the US Dollar. India had built up about 300 billion $ in reserves, which was considerably in excess of that required for stability. Maintaining this build up involves some fiscal costs which could be reduced by shedding some reserves. More importantly, RBI had to use a lot of Rupees to buy up this amount of US Dollars, which led to an overabundance of Rupee in the market (too much money available) and hence the inflation. By selling some forex reserves, RBI effectively managed to choke off the supply of Rupees. Simultaneously, selling of reserves also supports monetary tightening that helped fight inflation. RBIs role or lack of, in tackling inflation According to the constitution of India, RBI can not prevent the govt from indulging in deficit financing. RBI also must purchase all the foreign exchange brought in by foreign investors. RBIs influence extends only to controlling the Cash-Reserve Ratio (CRR), Repo rate, Bank rate, sale and purchase of govt securities and Statutory Liquidity ration (SLR). All these measures eventually target only one factor the amount of money that commercial banks will have to provide credit. Monetary Policy can be defined as the process by which the govt or the central bank controls the supply of money and interest rates in order to control inflation and stabilise the currency. Effectively, the Regulator controls the cost of money in order to control the amount of money that is spent. In line with Indias monetary policy, RBI on 13th February 2007 increased the cash reserve ratio, ordering commercial banks to keep cash equivalent to 6 percent of deposits starting 3rd March instead of the earlier 5.5%. The measure was aimed to drain as much as Rs.14,000 crores from the banking system. Earlier RBI had raised the overnight lending rate on 31st January, for the fifth time in a year, to cut money availability. The steps were intended to send a signal to the commercial banks to increase lending rates to reduce the amount of credit loaned.

Raising of interest rates made India more attractive for foreign investors (interest rates were about 4% in USA and close to 7% in India), that induced more capital flows into India, thus raising money supply and consequently the inflation. In March 2007, RBI resumed the sale of market stabilization bonds after a gap of almost two years to mop up excess cash from the banking system. RBI in this case tried to follow a contractionary policy i.e. it tried to decrease the total money supply. By raising interest rates, and increasing the reserve requirements, RBI attempted to reduce the size of money supply. In that sense RBI exhibited a tight monetary policy, which is in direct opposition to a policy required for economic growth. Under this policy, controlling the inflation will inevitably put the brakes on economic growth. It has been argued among economists that if the increase in economy arises as a result of increases in real wealth, (i.e. increases in goods and services), why should this lead to higher prices? The answer to that of-course is that if economic activity rises as a result of an increase in consumption of goods and services without the corresponding increase in the supply, this will lead to general rise in prices. This is what happened in this case. While RBIs efforts may have achieved part of the objective, of slowing down credit growth, it should have also looked towards a mechanism to increase the supply to meet the requirements of the consumers and thereby combat inflation. Indian economy had proved in the past that monetary measures are not sufficient to control inflation and often have a longer time lag. Supply side constraints need to addressed too. An increase in interest rates, a natural anti-inflationary measure under the RBIs monetary policy, also tends to squeeze the profit margins of companies by pushing up their cost of production. There is an inherent lag in the actual stabilisation of prices from the time the steps of the monetary policy are implemented. For this reason, a certain amount of wait and watch period should be allowed, lest the measures put in place become too severe. This happened during the last quarter of 1990s when RBI tightening led to an undue slowdown of the economy. Lost growth is costly. Keeping the growth momentum and investments inflow may be worth a slightly elevated inflation in the short run. RBI, to its credit, did manage to strike a balance between growth rate and inflation. In January 2007, growth in India was around 9%, but inflation was around 6%. After rebalancing the supply and demand factors, in January 2008, India achieved a growth of 8.5% and the inflation was brought down to below 5%.vii On a different note, the start of global recession in the middle of 2007 had a fortuitous effect on RBIs plans as capital inflows began to slowdown that reduced the availability of money and had a significant decelerating effect on inflation. How the numbers add up To understand the relationship between growth, inflation and money supply, it is very useful to look at a very basic, but very profound, equation of exchange that applies to macroeconomics in all conditions.

MV = Py, where M is the money supply; V is the velocity of money that is, the speed at which money circulates; P is the price level; and y is the real output of the economy (real GDP). A few facts are readily evident from this equation: a way to reduce inflation (P) would be to reduce the money supply (M), as RBI attempted to do in this case. if money supply is increased, and growth is not sufficiently high, inflation is going to rise (a devils alternative for RBI). Money supply is a driver for growth, provided other conditions are kept in check. P and y are on the same side of the equation this means that these could well operate independently of each other provided the supply side of commodities is kept under control If money supply in the system is increased (RBI buying up foreign exchange in this case), and if this money is not used for economic growth (deficit financing by the govt. or adopting populist moves), then inflation is going to rise as clearly happened in India in early 2007

Accounting Maneuvers Indian Finance Ministry was also at this time, concerned by a growing current account deficit (in simple terms this could mean a difference between domestic savings and investment, or, when viewed from another perspective, a difference between net imports and exports). While the Indian savings rate has risen dramatically in the past five years (from around 24% of GDP in 2002 to around 32% of GDP till end of Q1 2007) investment has grown even faster. The rising current account deficitviii was telling us that the economy was expanding and domestic savings were insufficient to fund it. India was thus dipping into fund of reserves to do so. Perhaps fewer dollars would have been needed to fund this deficit if commodities like oil had been cheaper. High oil prices had simply increased the size of the deficit. While tightening the monetary policy, as RBI responded with, will no doubt control the deficit, it had the expected effect of in turn slowing down the economy. It was a well accepted theory then, as it is now, that a current account deficit need not necessarily be a cause of concern, if there are sufficient forex reserves to finance this deficit. India clearly had the exceptionally high reserves at that time. An obvious antidote to this scenario was to raise interest rates to bring the demand down a prescription that RBI dutifully followed. Alternatively, of course RBI could have been bolder and let the current account fall a little, and made sure that the growth engines continues to charge ahead. Interrelation between inflation and economic growth is complex. It is now increasingly clear that economy reacts to inflation and govt currency policy it does not create it. We need to remember that inflation is a reduction in the purchasing power of a unit of currency. As a currency declines in value, more of it is needed to buy consumer goods. Strengthening the currency is therefore paramount.ix

A large segment of the population is affected by inflation instantly, while the benefits of economic growth take time to accrue. It then becomes a matter of political correctness for RBI to place greater emphasis on price control, even if it comes at the cost of reduced growth. Raising interest rates to control money supply and hence inflation is not a solution that will pay in the long run. It is well understood that real interest rates (interest rates minus inflation rate) in excess of 3.5% universally hurt competitiveness and growth. In todays economic environment, running a business with capital borrowed on a real interest rate of 9.5% (current rate) is an invitation to court disaster. The Real Moves The govt needed to, and still does, control inflation by first principles i.e. strike at the basic causes. While the govt can not control the price of oil internationally, its impact in the domestic market can be reduced by lowering the taxes on import of crude oil and the excise and sales tax on the production and sale of the distilled products to the consumer. On the agricultural front, self sufficiency and high agricultural output on a given (fixed) area of land will have to be the major targets. Agriculture can not be neglected for too long. In fact, aggressive policies are required to increase the investment in agriculture. Cost to agriculture needs to be reduced, so the farmer gets an automatic incentive to indulge in farming. Improving supply chain efficiencies can give farmers better prices without raising prices for consumers. Buffer stocks of major foodgrains need to be maintained (safely), while ensuring that the stock is constantly rotated by periodic depletion and restocking. This will have a twofold benefit stock is not spoiled by excessive storage or carelessness, and stock is periodically released to dampen the price fluctuations. For the last two years India has come perilously close to reaching a stage of stagflation i.e. a coupling of low growth rate with high instantaneous inflation. This is a completely undesirable situation that needs to be avoided at all costs. Indias current growth rate is robust, but a drastic monetary squeeze must be avoided. Expanding food supply and insulating domestic food prices, to the extent possible, from international prices will help. The weight of food is 46.2% in the CPI-IW, 15.4% in the WPI; petrol and diesel have a lower weight only 5% weight in the WPI.x An exchange rate appreciation for the Rupee will help towards reducing food import costs. Since exports continue to do well, depreciation is not necessary, and appreciation lowers the impact of global price rise. Productive growth is the way for India to avoid the past stagflationary trap. Given the sensitivity to food prices, the better performance of agriculture is the way forward. The best that RBI can do is to try and keep growth at a level which is easily allowed by the limitations on the supply side. If RBI attempts to increase growth beyond this permissible level, by lowering interest rates, it will result in runaway inflation. If however interest rates are kept unduly high, no doubt inflation will be under control, it will only come at the cost of undeveloped potential in the economy. Finally, India needs to remove the unnecessary controls and rigidities in the markets to make it easier to do business and make investments. This is the only way to make peoples lives better in the long run.

www.rediff.com/money Keith Bradsher (www.iht.com) iii www.rediff.com/money iv Paromita Shastri - livemint v www.zmag.org vi The Economic Times vii www.livemint.com viii When a country needs foreign investment to breach the gap, that country has not enough savings produced domestically. It is just like a person, when a person needs to borrow is because he/she spends more that what he/she earns + has saved. The current account deficit means that the value of the country's imports is larger than the value of its exports. ix Singapore is a fine example. It has enjoyed decades of high economic growth coupled with low unemployment and consistently low inflation because of a stable currency. x The Economic Times
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