Inflation

Hi guys, I am back with again inflation topic. Now days everybody is talking about inflation. So when I was browsing in the net I got this article, and I felt this is good article to read. I tried maximum to edit it, even after that it fetched to 4-5 pages…

Inflation is no stranger to the Indian economy. In fact, till the early nineties Indians were used to double-digit inflation and its attendant consequences. But, since the mid-nineties controlling inflation has become a priority for policy framers.

While inflation till the early nineties was primarily caused by domestic factors (supply usually was unable to meet demand, resulting in the classical definition of inflation of too much money chasing too few goods), today the situation has changed significantly. Inflation today is caused more by global rather than by domestic factors.

Global imbalance the cause for global liquidity

Global economy is in a state of extreme imbalance. This is simply because developed western economies, are consuming on a massive scale leading to gargantuan trade deficits.

Crucially their extreme levels of consumption and imports are matched by the developing countries having an export-driven economic model. Thus while developing countries produces, exports and also saves the proceeds by investing their forex reserves back in these countries, developed countries are consuming both the production and investment originating from the developing countries.

In effect, developing countries are building their foreign exchange reserves while the developed countries are accumulating the corresponding debt. For instance, the US current account deficit is estimated to be 7 per cent of GDP in 2006 and stood at approximately $900 billion. Obviously, the current account deficit of the US becomes the current account surplus of other exporting countries, viz. China, Japan and other oil producing and exporting countries.

The reason for this imbalance in the global economy is the fact that after the Asian currency crisis; many countries found the virtues of a weak currency and engaged in 'competitive devaluation.'

Under this scenario, many countries simply leveraged their weak currency against the US dollar to gain to the global markets. This policy to maintain their competitiveness is achieve and leading to accumulation of foreign exchange, notably the US dollar, against their own currency.

Implicitly it means that the developing world is subsidizing the rich developed world. Put more bluntly, it would mean that the US has outsourced even defending the dollar to these countries, as a collapse of the US currency would hurt these countries holding more dollars in reserves than perhaps the US itself!

Naturally, as the players fear a fall in the value of the dollar and reach out to various assets and commodities, the prices of these commodities and assets too will rise.

The psychological dimension

But as the imbalance shows no sign of correcting, players seek to shift to commodities and assets across continents to hedge against the impending fall in the US dollar. Thus, it is a fight between central banks and the psychology of market players across continents.

As a corrective measure, economists are coming to the conclusion that most of the currencies across the globe are highly undervalued against the dollar, which, in turn, requires a significant dose of devaluation. For instance, Yen is one of the most highly undervalued currencies (estimated at around 60%) along with the Chinese Yuan (estimated at 50%) followed by other countries in Asia. This artificial undervaluation of currencies is another fundamental cause for increasing global liquidity.

To get an idea of the enormity of the aggregation of these two factors on the world's supply of dollars, Jephraim P. Gundzik calculates the dollar value of rising prices of just one commodity -- crude oil.

In 2004, global demand for crude oil grew by a mere four per cent. Nevertheless higher oil prices advanced by as much as 34 per cent. Consequently, it is this factor that significantly contributed to increase the world's dollar supply by about $330 billion.

In 2005, international crude oil prices gained another 35 per cent and global demand for oil grew by only 1.6 per cent. Nonetheless, the world's supply of dollars increased by a further $460 billion.

Naturally, with all currencies refusing to be revalued, this leads to increased global liquidity. While one is not sure as to whether the increase in the prices of crude led to the increase of other commodities or vice versa, the fact of the matter is that, in the aggregate, increased liquidity has led to the increase in commodity prices as a whole.

What has further compounded the problem is the near-zero interest rate regime in Japan. With almost $905 billion forex reserves, it makes sense to borrow in Japan at such low rates and invest elsewhere for higher returns. Obviously, some of this money -- estimated by experts to be approximately $200 billion -- has undoubtedly found its way into the asset markets of other countries.

Most of it has been parked in alternative investments such as commodities, stocks, real estates and other markets across continents, leveraged many times over. Needless to reiterate, the excessive dollar supply too has fuelled the property and commodity boom across markets and continents.

The twin causes -- excessive liquidity due to undervaluation of various currencies and fear of the US dollar collapse leading to increased purchase of various commodities to hedge against a fall in US dollar (psychological) -- needs to be tackled upfront if inflation has to be confronted globally.

Higher international farm prices impact Indian farm prices

What actually compounds the problem for India is the fact that lowers harvest worldwide, specifically in Australia and Brazil, and the overall strength of demand Vs supply and low stock positions world over, global wheat prices have continued to rise.

Wheat demand is expected to rise, while world production is expected to decline further in the coming months, as a result of which global stocks, already at historically low levels, may fall further by 20 per cent. These global trends have put upward pressure on domestic prices of wheat and are expected to continue to do so during the course of this year.

No wonder, despite the government lowering the import tariffs on wheat to zero, there has been no significant quantity of wheat imports as the international prices of wheat are higher than the domestic prices.

Growth and forex flows

Another cause for the increase in the prices of these commodities has been due to the fact that both India and China have been recording excellent growth in recent years. It has to be noted that China and India have a combined population of 2.5 billion people.

Given this size of population even a modest $100 increase in the per capita income of these two countries would translate into approximately $250 billion in additional demand for commodities. This has put an extraordinary highly demand on various commodities. Surely growth will come at a cost.

The excessive global liquidity as explained above has facilitated buoyant growth of money and credit in 2005-06 and 2006-07. Crucially, 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.

Reserve Bank of India's strategy of dealing with excessive liquidity through the Market Stabilization Scheme (MSS), the increase in repo and CRR rates are policy interventions with serious limitations in the Indian context with such huge forex inflows.

How about the revaluation of the Indian Rupee?

Economic policy rests in the triumvirate of fiscal, monetary and trade policies. Theoretical understanding of economics meant that these policies are interdependent.

Also, one needs to understand that growth naturally comes with its attendant costs and consequences. While these policies are usually intertwined and typically compensatory, one has to understand that the issues with respect to inflation cannot be subjected to conventional wisdom in the era of globalization.

One policy route yet unexamined in the Indian context by the government is the exchange rate policy, especially revaluation of the Rupee as an instrument to control inflation.

It is time that we think about a revaluation of the Indian Rupee as a policy response to the complex issue of managing inflation; while simultaneously address the constraints on the supply side on food grains through increase in domestic production.

A higher Rupee value against the dollar would mean lower purchase price of commodities in Rupee terms. The Indian economy has undergone significant changes in the past decade and a half. With increased linkages to the global economy, it cannot duck the negatives of globalization.

Source…

Rediffmail.com

Author--M R Venkatesh

Chennai-based chartered accountant