inflation final 03 format

8/4/2019 Inflation Final 03 Format

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Inflation

Inflation is the supply of excess money and credit relative to the goods and services

produced, resulting in increased prices. As the layman understands it, inflation results in the

increase in the price of some set of goods and services in a given economy over a period of

time. It is measured as the percentage rate of change of a price index.

Inflation in India is also a grave issue of concern, given the vast disparity between the rich

and the poor on the one hand or the Rural and the Urban on the other. Skyrocketing inflation

robs the poor, and hurts others, though much less grievously. The fruits of the much-talked

about economic growth have not reached large sections, especially in the rural areas.

Under extant conditions, the benefit of high prices paid by consumers does not flow back to

primary producers, but is siphoned away by middlemen and speculators who enjoy a free run

in an economy of shortages. If attention to agriculture has been limited to rendering lip

service, inefficiencies in the physical market remain unattended. With production trailing

demand in recent years, shortages of essential commodities have widened. Imports have

become expensive because of high global market prices.

It may be instructive to remember that inflation is not an overnight phenomenon. It is

begining to the extent that it allows you time to cover yourself. In India, the onus to control

and take control of the situation of inflation is upon the Reserve Bank of India (RBI).


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Measures taken by RBI to control Inflation

The Reserve Bank of India (Amendment) Act, 2006 gives discretion to the Reserve Bank to

decide the percentage of scheduled banks' demand and time liabilities to be maintained as

Cash Reserve Ratio (CRR) without any ceiling or floor. Consequent to the amendment, no

interest will be paid on CRR balances so as to enhance the efficacy of the CRR, as payment

of interest attenuates its effectiveness as an instrument of monetary policy.

The Reserve Bank of India (RBI) follows a multiple indicator approach to arrive at its goals

of growth, price stability and financial stability, rather than targeting inflation alone. This, of

course, leads to criticism from mainstream economists. In its effort to balance many

objectives, which often conflict with each other, RBI looks confused, ineffective and in many

cases a cause of the problems it seeks to address.

The RBI has certain weapons which it wields every time and in all situations to counter any

form of inflationary situation in the economy. These weapons are generally the mechanisms

and the policies through which the Central Bank seeks to control the amount of credit flowing

in the market. The general stance adopted by the RBI to fight inflation is discussed in brief in

part (A) of the paper. Part (B) would raise the question of whether this mechanism used by

the RBI has passed its prime and thus now the RBI needs to take up a holistic approach to the

same. Part (C) would then deal very briefly with the suggestions that may shed some light on

what could be the possible steps RBI could take to control rising prices.

It is interesting to note that the Reserve Bank of India Governor. Dr Y. V. Reddy started his

stint with the aim of cutting down the Cash Reserve Ratio to 3 per cent (from the then 4.5 per

cent) but rising commodities inflation has forced him to raise it now to 6.5 per cent. But even

this 6.5 per cent is way below what would truly contain inflation and it is almost certain that

he will be chasing the inflation curve for the next few years or so.

(A.) Steps Generally Taken By the RBI To Tackle Inflation

According to the Annual Statement on Monetary Policy for the Year 2007- 08, a careful

assessment of the manner in which inflation is evolving in India reveals that primary food

articles have contributed significantly to inflation during 2006-07. At the same time, prices of

manufactured products account for well above 50 per cent of headline inflation. The recent

hardening of international crude prices has heightened the uncertainty surrounding theinflation outlook.

The steps generally taken by the RBI to tackle inflation include a rise in repo rates (the rates

at which banks borrow from the RBI), a rise in Cash Reserve Ratio and a reduction in rate of

interest on cash deposited by banks with RBI. The signals are intended to spur banks to raise

lending rates and to reduce the amount of credit disbursed. The RBI's measures are expected

to suck out a substantial sum from the banks. In effect, while the economy is booming and

the credit needs grow, the central bank is tightening the availability of credit.

The RBI also buys dollars from banks and exporters, partly to prevent the dollars fromflooding the market and depressing the dollar indirectly raising the rupee. In other words,


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the central bank's interactions have a desirable objective to keep the rupee devalued

which will make India's exports more competitive, but they increase liquidity.

To combat this, the RBI does what it calls "sterilisation" it sucks out the rupees it pays out

for dollars through sale of sterilisation bonds. It then sells these bonds to banks. Economists

point out that there has not been much success in such sterilisation attempts in India. The

central bank's attempt to offload Government bonds on banks has not been too successful

inasmuch as the banks sell the bonds and get rupees instead.

Economists also contrast this with the successful experience of China, where the state-owned

banks strictly abide by the central bank's dictates and absorb the sterilisation bonds. That

discipline is lacking in India. The net effect is that the RBI has to resort to indirect methods

of sterilisation, such as raising interest rates and raising CRR to contract liquidity. This makes

India more attractive for foreign capital flows that seek better returns and a vicious cycle

follows. RBI has to buy more foreign currency and sterilize. The cycle becomes worse.

(B). Consequences of RBI Policy

The economy was growing at a stupendous 9 per cent, second only to China worldwide,

however the brakes have been firmly pressed by the RBI due to their anti inflationary

policy. If the CRR and REPO rate are hiked frequently, the economy may take a U - turn, as

most commercial banks religiously increase their lending rates, without actually studying the

impact.

These measures generally taken by the RBI do not effectively tackle inflation but on the other

hand effectively stunts the growth pattern of the economy. The RBI seems to believe that by

merely reducing the credit flow and money flow in the economy, inflation can be curtailed.

Inflation is a consequence of increasing demand vis a vis the supply in the economy. The

demand must be effectively curtailed or pushed down, which the present CRR policy is not

managing to do effectively. The RBI, in an ideal world, would have also looked towards a

mechanism to bolster the supply forces to meet the requirements of the consumers and

thereby combat inflation.

There are two major drawbacks in the CRR REPO policy adopted by the RBI to combat

inflation.

Firstly, monetary tools have proved more effective in economies with greater financialinclusion. They are less effective in economies such as India's, where the majority of the

population still has no access to banks, and those with access barely have the resources to

open bank accounts.

The increasing cost of funds and rising interest rates are of little consequence in the economic

life of a financially excluded population. The impact will be critical on smaller segments and

will take a while to yield results for the economy. Much more remains to be achieved on the

financial inclusion front. To cite Mr V. Leeladhar, Deputy Governor of the RBI, from a

recent speech:


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As a result, lendable resources of the system will be reduced to that extent and bank credit

will be dearer. This hike will result in increase of the lending rates, whether for production or

consumption. The RBI can address only the demand side through such an approach. The need

of the hour is to curb only consumption credit and not production. On the other hand there is

urgent need to increase supplies of food products and manufactured goods, for which creditflow to the farm sector and industry must increase.

The combined effect of the CRR hike and the REPO rate hike will tell upon expansion of

productive credit as well and this is not desirable at this stage.

The monetary measures are meant to increase the cost of funds for banks, make loans dearer

and temper the demand for credit. While there is a greater possibility of banks passing on the

increased costs to the consumer, it is debatable whether this will choke the demand for funds

in some specific inflation-impacting sectors.

The RBI paradox Impact on prospects of growth of economy

Today, the prime lending rate (PLR) of the banks varies between 12.75% and 13.25%. That

means no SME can get working capital loan at less than 15%. Compare that with the rest of

Asia. China has a negative real interest of 2.64 % (interest rate on three-month loans at 3.86%

minus inflation at 6.5%). South Koreas real interest rate is 3%. Thailands is 1.45%.

Malaysias is 1.72%. Taiwans is at a negative 0.5%. Even neighbouring Pakistan has a real

interest rate of 3.28%. In fact, it is well understood that real interest rates in excess of 3.5%

universally hurt competitiveness and growth.

Our high interest rates are not only hurting business, but have become a magnet for foreign

portfolio funds. Which, in turn is rapidly appreciating the domestic currency, and givingforeign institutional investors (FIIs) and their P-note beneficiaries a double bonus: first

through returns on their investment and then on the appreciating exchange rate.

Between 2 January and mid-October, 2007 the rupee has appreciated 12.5% over the US

dollar. Only the Thai baht has risen more at 13.2%. As a result, we are creating a bizarre

situation where portfolio investors have been enjoying the fruits of an equity-led bull run,

while those who work their backs off to produce goods and services are getting badly

hammered by high interest rates.

Suggestions and ConclusionBased on the data and opinions mentioned above, this paper comes to the conclusion that, the

CRR REPO mechanism adopted by the RBI has overshot its utility. No doubt, the RBI is

the only authority which is empowered as well as capable to handle the situation. It is also not

disputed that the monetary policy is important to fight inflation. But the point is, is it enough?

Right now, the RBI seems to be concentrating only on the Demand end of inflation, as a

result the entire perspective of supply is completely ignored. Inflation may also be curtailed if

the supply is bolstered to meet the demands of the people. With the increase in supply, prices

would inevitably come down and thus inflation may be controlled.


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Curbing inflation in 2011

RBI has hiked its policy rates seven times so far this fiscal to rein in rising inflation. It raised

its key lending rate, or repo rate, seven times by a total of 175 basis points since March 2010.

One basis point is one-hundredth of a percentage point.

Wholesale price-based inflation eased in January to 8.23% from the 8.43% reported in

December, according to data released by the government on Monday.

However, the figure is still above the 7% year-end inflation projection set by the central bank

for the fiscal year ending March.

Its earlier projection was even lower--5.5%.

In its January policy, while raising its inflation projection, RBI also warned off a possiblespillover of high food and energy prices to more generalized inflation.

Successive hikes in RBI's key rates have begun hurting the common man as most banks have

increased their base rates, or the lending rate below which they are not allowed to lend, at

least twice in the last two months.

For instance, the country's largest lender State Bank of India has raised its base rate to 8.25%

through two hikes since January.


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Highlights of RBI Monetary mid quarter Policy Review for march 2011

Repo and Reverse Repo rates increased by 25 basis points to 6.75% and 5.75%

respectively with immediate effect.

March 2011 Wholesale Price Index (WPI) inflation expected to be at 8%.

Current Account Deficit (CAD) expected to fall to be 2.5% of GDP for 2010-11.

Non food credit growth is at 23%, higher than RBIs expectations of 20%.

Liquidity deficit gradually reducing.

RBIs mid quarter Monetary Policy Review

The RBI in its mid-quarter monetary policy review held on 17 March,2011 has increased the

Repo and Reverse Repo rates by 25 basis points to 6.75% and 5.75% (One basis point is one

hundredth of a percentage). With this hike, the RBI has raised the policy rates 10 times since

January 2010. Similar to the previous few hikes, this rate hike was expected because of the

WPI inflation which still continues to rise instead of moderating. The WPI Inflation for

February 2011 rose to 8.31% from 8.23% in January 2010. The RBI chose not to hike rates in

the mid-quarter policy meet held in December 2010 as inflation had fallen to 7.48% in

November 2010 from 8.58% in October 2010.

There has been no change in the other policy rates; the CRR, SLR (Statutory Liquidity

Ratio) and Bank rate have been kept at 6.0%, 24% and 6.0%.

Chart 1 highlights the rate hikes undertaken by RBI since 2010.


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Growth and Inflation

The economy has been affected due to the rate hikes in 2010 as well as the continuing rate

hikes in 2011, the volatile IIP numbers form the evidence of the affected growth. Currently,

the RBI sees the presence of growth momentum. On the contrary, further evidence of slowing

growth has come from the weak performance of capital goods sector in the IIP which

suggests slowing investment momentum. This slowdown in the investment momentum

within the capital goods sector can mean that the future growth of economy for the next few

years may be impacted.

The RBI expects the inflation for March 2011 to be at 8%, which would be 1% higher thanthe target rate of 7% for March 2011. Even with all the rate hikes, inflation refuses to

moderate. The inflation numbers for February, showed moderation in food inflation.

However, the rising crude oil prices along with fuel price deregulation and increase in

manufactured product prices has led to inflation mounting rather than moderating.

The RBI may be running out of options to control inflation as many external factors like

crude prices, food prices are affecting the inflation but, RBI is in no position or authority to

control the food or international crude prices. The situation may become grim if RBI

continues to hike rates. The slowing investment momentum in the capital goods sector is an

early warning of the things to come.

Deficits and Liquidity

The fiscal deficit numbers have brought cheer to the market as the government is expected to

borrow lower than the market expectation. With a new road map for fiscal deficit reduction,

fiscal deficit is not a concern anymore.

Additionally, on account of recent higher exports from India, the RBI expects the Current

Account Deficit (CAD) to reduce to 2.5% of GDP, lower than its earlier estimation of 3.5%of GDP. Financing the CAD in the current year is not a problem for the government, but the

government should focus on increasing long-term capital flows - Foreign Direct Investments

(FDI) to be used to sustain the Balance of Payments. Such a move will also prevent the

possibility of reoccurrence of the Balance of Payments crisis as witnessed in 1991 wherein

the government had to airlift its gold reserves to be pledged with the IMF for loan.

On the liquidity front, the liquidity deficit is reducing as seen from the net liquidity injection

done through Liquidity Adjustment Facility (LAF). It has reduced from about Rs. 93,000

crore in January to Rs. 79,000 crore in February, to Rs. 68,000 crore in March (as at 16March 2011). However, the RBI expects the liquidity deficit to increase in the second half of


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March 2011 on account of advance tax payments.

inflation final 03 format

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