Monday, 1 September 2008

Inflation, India and Policy

This was written In April 08, when inflation touched 7.4% and everyone drew in their breath in horror:

The country is led by two eminent economists of considerable intellect in two key slots: that of the Prime Minister and the Finance Minister. Their statements that the government will act to curb inflation adds weight to the view that all economics is political economics.

Inflation will not go away. The effect of oil prices on factor prices lags by anywhere between 4 to 6 months. Therefore, the price spike we see today has more to do with the oil price levels of end-2007. Oil has moved further since then, currently ruling at $ 120 – 140 per barrel. The impact of these levels will be seen in the next few months.

To bring down the impact of oil prices in Q3 of 2008, action would have been required in Q1 2008 – if not earlier – a time when no attention was paid to this key problem.

That oil is a significant cost driver in the economy is an oft-repeated statement. Yet, market participants have been oblivious to this in the closing months of 2008. Oil had been rising right through the year; it didn’t just spike up one fine morning. The inflationary impact was bound to surface.

Once inflation rules, interest rate hikes are inevitable. The implications for the banking sector could well have been anticipated – sectoral prices for banking stocks should have been in decline well before. Yet significant P/Es were awarded to banking stocks on the specious argument of forward looking EPS estimates: wrong estimates.

There is more to the impact of factor prices than just oil prices; there is the response to oil prices. And this is where we as a nation have been tardy.

There is an implicit cost to the broad and general inefficiency that can be seen in the working of our economy. Inadequate infrastructure in the urban industrial centers lengthens commuter times and that adds to costs. There is no effective transportation policy to manage the demand side of oil. Barring New Delhi, no Indian city has an adequately viable mass rapid transit system. While Mumbai does have the local train it doesn’t do enough. The city needs drastic urban renewal if it is to head-off decay.

Tragically, current infrastructure development in the IT centers Hyderabad and Bangalore focuses on freeways for cars. The same engineering effort and disruption of existing infrastructure could have been directed to building MRTS’ on the path that is now being carved for more cars.

What the government is unwilling to do in an election year is raise fuel prices to a point where demand gets managed. When prices fully reflect costs, people will change usage patterns. Car pools, public transport, buses deployed by employers are better at solving problems – and the impetus must come from making consumers face up to the prices.

Not increasing the oil price will only hide the problem elsewhere in the fiscal system. That will lead to deficit financing which is a direct cause of inflation anyway, not to mention currency devaluation.

What do businesses do when faced with the prospect of increased operating costs? They pass it on to their customers. Increased costs for customers is what we mean by price inflation in the first place.

Those who are exulting on the weakening rupee and its salutary effects on the exporting sectors would do well to remember that apart from oil prices going skyward, oil is denominated in dollar prices. So a weakening rupee is adding to the bill to be paid.

Nor is the government of the day able to push through the nuclear deal within the ambit of a larger energy policy. We refuse to learn from Brazil which saves well over $70 billion in oil imports (at 2006 prices – so you can imagine the savings today) by blending ethanol in petrol. Finland, meanwhile, is building the world’s largest nuclear plant to eliminate external fuel dependence.

So, India’s current inflation problem is a factor of several things. In the first instance, oil prices. In the second instance the lack of an energy and transportation policy – which cannot be solved in one or two quarters; it takes vision and several years. The third is the inefficiency inbuilt in the economy a part of which comes from the first two factors.

All you need to do to know that we are an inefficient economy is to compare the prices that we pay with the prices a consumer pays in Sri Lanka. Or in London.

An instructive signal emerged from the international oil markets last week. Oil briefly dropped to $122 a barrel as soon as Malaysia, India and a few others raised domestic fuel prices. The reason cited was expected lower demand from these countries.

Are we listening?

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