In standard IX, I read that inflation was a situation when too much of money supply was chasing too few of goods, causing prices to rise, popularly known as Inflation. The great recession of 1929 was caused by Germany’s massive printing of paper currency creating exactly the situation of too much money supply chasing too few of goods. This text book malady has a text book remedy, reduce the money supply and bring equilibrium between money supply and availability of goods. The other more desirable alternative of increasing supply of goods was impractical and beyond control (and probably even imagination) of the regulators.
Contraction of money supply is done in two ways,
One, reduce the liquidity with the banks so that they have that much less to lend, and automatically, money supply in the market would reduce. Reserve Bank, the only empowered authority to control inflation in India, achieves this by increasing Cash Reserve Ratio (CRR) being the amount of funds all banks are obliged to park with RBI free of cost. This is a percentage of total deposits of any bank that must be kept in cash with RBI. Currently, CRR is 6%. It means, for every Rs 100 deposit with a commercial bank, Rs 6 must be kept with RBI leaving only Rs 94 with the commercial bank to lend. During inflationary times, RBI deems it necessary to increase CRR and thereby, reduce the availability of lendable funds with the commercial banks, and thus, hope to strike a balance between the money supply and supply of purchasable goods and services.
Two, increase the cost of funds to the banks and thereby, make it costlier for people to borrow, and at the same time, make it more lucrative for the people to keep money in bank deposits as they will attract higher interest as well. This is done in three ways,
i) Making CRR completely interest free so that bank has to cover its cost of funds and then, strive for profits from the left over funds only. It is besides the point that RBI makes huge money out of these interest free CRR funds by lending them to the government or investing them in government securities, and pose with hefty balance sheets and heft dividend cheques for photographs and pat their own backs.
ii) Increasing Repo rates, being the rate of interest at which RBI lends to other commercial banks. The Repo rate currently is 6%. If any bank ever needs funds for any purpose (including for parking them with RBI as interest free CRR should the actual amount any day fall short of the statutory limit imposed by the RBI), it can borrow from RBI by paying 6% interest. By increasing repo rates, RBI makes money costlier, and by reducing this rate, it makes it cheaper, and this way, it tries to achieve the desired contraction or expansion in the money supply for dealing with inflation.
iii) Increasing Reverse Repo Rate, being the rate of interest at which other banks could park their surplus funds with RBI. Currently, reverse repo rate is 5%. When RBI wants to reduce market liquidity, it increases all rates whether one by one or together and hopes to achieve contraction in money supply, and vice versa.
When tight monetary policy is announced by RBI, all lending rates go up which tend to discourage borrowings. This discourages demand for money and thereby, discourages further investment as well. Newspaper headlines each time higher CRR/Repo rate is announced, are invariably like “HOME LOANS TO BE COSTLIER, CAR LOANS TO BE COSTLIER etc etc”. This reduces consumer confidence and tends to shrink demand for homes or cars etc. This RBI thinks is controlling inflation.
What goes without scrutiny invariably is that all existing loans whether they are for business (term loans, working capital loans etc) or for consumers (home loans, education loans, car loans etc) become costlier as well. Higher interest needs to be paid for existing loans. For a consumer, it makes him poorer as it reduces high savings by increasing his EMI obligation. For a business, it reduces its profit margin by increasing the cost of operations. In order to maintain same profit margins, they increase price of their products which is what we are all used to seeing in the market. This pushes up the prices that go into inflation index. RBI thinks it has not done enough, and responds by yet another dose of monetary contraction and this game goes on being played, till some day, nature relents with good monsoon increasing supply of goods and/or new factories are set up to take advantage of higher demands for goods and services which create a natural balance between demand and supply of goods and services where prices finally settle down.
Since RBI’s monetary policies have pushed the prices to much higher level and new suppliers for goods and services have created new capacities reckoning their profitability at this increased level, whole market get used to this price level and this whole ho-halla on inflation is consigned to history. Even if inflation rates have come down substantially, prices never come down because inflation rates only mean how much more prices are increasing prospectively. Unless inflation rates are in negative for long enough, old price level will never be achieved.
Besides, India being a great democracy, every individual or every authority believes in complete freedom unless specifically limited. It is far too common to observe situations where RBI is adopting tight monetary policy by increasing CRR as well as the interest rates and contracting money supply in the market, and soon, finance ministry announcing decisions to provide massive additional capital to banks so that their liquidity could increase and they could lend much more in the market! In March-April this year, RBI was tightening money supply and soon, government of India announced plans to provide additional Rs 15000 cr capital to public sector banks which would increase their capacity to lend by Rs 185000 cr! Imagine, when the total CRR is worth about Rs 300,000 cr, this move of the government effectively means, reducing CRR by two third. I wondered who was mad, RBI or the Finance Minister? Or, whether it was simply a game that babus and netas play in India which knows nothing about accountability in public sector anyway?
Mistrust the government data and look around. Demand for everything has gone up many times over in last 10 years, from vehicles to food products to textiles to entertainment services and so on. When India’s most perfect film, MUGAL-E-AZAM could make only Rs 3.5 cr from music sales, today’s averages films collect close to Rs 40~50 cr in the first week itself, and it is when lot of people do not visit cinema halls these days. The fact is that supply of goods has not kept pace.
In simple economics, propensity to consume is more with the poor. When the poor whose existing demand for even basics was meager due to poverty, their entire increase in income goes to higher consumption of these basic items such as food items, bikes, petrol/diesel, textiles etc. Evidently, supply of goods has not kept pace, and the consequence is nothing but inflation. No tight monetary policy can control such inflation. It can only kill the growth in the process, little realizing that its tight monetary policy is resulting in boosting the cost push inflation already.
The solution for a professional to deal with this situation should be something like:-
LONG TERM SOLUTION
There is only one way, increase supply of goods and services. India’s success story is 200% success of its private sector minus 100% failure of its public sector, net 100% success of its corporate sector. When Rajeev Gandhi, official policy of India changed from socialistic to capitalist till Narasima Roa and there was status quo in ideology with Deve Gowda and Vajpayee. Manmohan Singh has taken a left turn once again. The result is, the massive growth we see in telecom, civil aviation etc which could easily have been duplicated in many other sectors such as Power, Railways, Highways, Seaports etc has been missed. All FDI in power sector announced during Rao’s time, have quietly withdrawn and there is not even a talk about it as if any reform in public sector is a taboo (just like population).
The key is to
1) Treat agriculture at par with business – there is nothing sacrosanct about agriculture. If a farmer is producing rice, a mill owner is producing cloth and so on. Both do it for making a living. If a farmer does not find wheat profitable, he moves to pulses or to sugar cane. Profit motive is the only determinant of his activities which is the way it should be. Let him be treated as a businessman, and be encouraged to be globally competitive, pay taxes just like other businessmen and look forward to the fruits of prosperity.
2) Decontrol sugar, food grains etc – Let economics do its job. If there is surplus prodn of sugar or food gains, there is no harm if they are exported, and vice versa. Cement was black marketed when it was in control. It has prospered only after decontrol. Same will happen to other items. Govt procurement should be limited to its actual needs for PDS demand. Govt does not need to support farmers by simply buying foodgrains to let it rot, at the huge cost of taxpayers.
3) Make agriculture globally competitive – unfortunately, our yields are about 1/3rd the world average which means by focusing on productivity, we have potential to increase farm production 3 to 4 times.
4) Privatise Power sector – so that India could become a power surplus country and see phenomenal growth like telecon and civil aviation.
5) Reform railways and other PSUs – first by making them joint sectors and gradually withdrawing from business completely. This will improve productivity and efficiency of capital utilization while releasing lot of resources for infrastructure building.
6) Replace bureaucracy with professionals – Confine babus to only administrative jobs and all commercial jobs should be handed over to professionals like CAs, ICWAs, MBAs etc. There is no reason for a PSU to be headed by an IAS and nation to pay for their incompetence in business. The job is better done by professionals who could be rotated to ensure higher accountability.
7) Accountability in public life – today there is no accountability of govt whatsoever. Anybody can get away with anything (believe me, Kalmadi with get away with CWG fiasco just like Sharad Pawar has got away with IPL frauds anyway). Without accountability, no should expect performance.
8) Give up on Kashmir – believe it or now, we don’t need it at the huge cost of peace, lives and money that we have been paying for Kashmir. Hold a plebiscite and allow them to go if this is what they wish. India without Kashmir would be insignificantly smaller but far more peaceful and prosperous.
9) Judicial reforms – to ensure that a case does not take more than 6 months. This will boost livability index of India and its economic growth as well. Without efficient system for contract enforcement, business cannot grow fast.
10) Attack corruption – make some drastic changes such as compulsory audit of all govt employees income tax returns with cash flows, rotating of their auditors, public scrutiny of their returns, mandatory asset seizure and sentencing for any proof of corruption and so on. Corruption is root cause of conception of wrong policies and wrong implementation of right policies. Everything is ineffective with corruption.
SHORT TERM SOLUTION
1) Cut down bank finance to hoarders – during inflationary times, traders take bank finance and hoard goods/commodities. RBI should not be content with general price index alone. It should focus on sectoral price index and see prices of what products/goods are going up and whether it is also due to artificial shortage created with hoarding. If so, bank finance for stocks of such commodities could be cut down in phasewise manner which will demotivate hoarding and ease pressure on supplies.
2) Tariff concessions for import of items which are under inflationary pressure. This should improve supply position.
3) Cut red tape – lot of hurdles are in place to slow down business activities (road permits for entry of goods into most states, C forms, etc) which lead to slower turn around time and increase costs. By cutting red tape, turn around time could be improved, reducing costs which should help ease pressure on pricing as well.
4) Substitute “Revenue Consideration” with “GDP Consideration” - the currency tendency of looking at everything from revenue consideration must change. SEZ is good even if it does not contribute direct revenue to the govt. It does increase economic activities, improve prosperity of the country, and even contributes revenue indirectly in so many ways through its activities. It is foolish to curb SEZ and EOUs for want of taxes.
5) Evaluate of effect of policies on inflation – this is completely missing. Before administering next doze of monetary policy, govt must measure the impact of its policy on prices.
Since RBI knows only one text book solution of fiddling with CRR and interest rates only, it can never succeed like it has never succeeded in past. Poor Indians will get used to ever increasing price levels. It is already high time a drastic corrective action is taken, but is that feasible? Sorry, don’t think so myself!
Footnote:
BULK OF ECONOMIC GROWTH GOING TO DOWNTRODDENS CONTRARY TO PUBLIC BELIEF
It is fashionable to talk of “Inclusive growth” because that shows one in good light with the poor (read, vote bank). The reality is opposite. When Ambani’s wealth is increasing several thousand %, it is not that poor are not gaining or gaining only little. Ambani’s worth represents value of shares of his companies where poor people work and get salaries. These companies produce goods and services which create further market for more employment. Govt. gets more taxes and spends more on development (sorry, can’t mention, kickbacks) which further generate employment. More employment creates more demand for goods and services which lead to more factories and so on. The factory owners’ worth is highlight of newspapers but would it really increase without more turnover, more costs being defrayed which cannot happen without more employment?
All talk of rich getting richer and poor getting poorer is rubbish regardless of govt data. it is theoritically impossible. Rich cannot get richer without employing more people, doing more business and in the process paying more taxes and generating more income for the poor. The talk of “inclusive growth” is a misnomer. That it should come from an economist’s government is a national shame.
CAclubindia
