On October 25 2011, the Reserve Bank of India (RBI) raised its repo rate (the rate at which it lends to banks) by 25 basis points to 8.5%. A similar 25 basis point hike was announced in the reverse repo rate (the rate it pays banks for deposits). This latest increase marks thirteen successive rate hikes over the last eighteen months in a bid to dampen spiralling inflation. While the eurozone is suffering from the threat of sovereign default and the US from spiralling public debt, India's problem is galloping inflation. Food inflation, in particular, has reached a nine month high of 12.21%. Inflation is nothing but an increase in general price levels in the economy. Now, it's basic common sense that prices will reduce either when demand falls or when supply increases. Since the government seems to lack the political will to free clogged up supply, it is forced to adopt the other less desirable solution - arrest demand. This has been done by tightening interest rates and making money supply dearer. They hope that higher rates will halt the demand-push price rise and help arrest spiralling inflation. However, this strategy comes at a cost. Higher rates also translate into slower growth. Capital is the lubricant that commerce functions on. When capital becomes expensive, industry in general is forced to slow down. Expansion plans or fresh commercial activity is naturally put on hold. Existing earnings get diluted on account of higher input costs and interest outgo. Already, FY 11-12 earnings estimates for India Inc are down to a single digit figure. Lower earnings translate into lower stock prices. The domino effect, as it were, doesn't end here. Manufacturers and lenders typically pass the burden of the higher costs on to the consumers. So at the retail level too, due to this transmission of policy rates, the outgo on consumer, auto and housing loans increases. The common man, already under duress, feels further squeezed. All this is in the hope that at some point in the future, inflation will come down.However, food inflation, which is the main cause of distress and of prime concern to the common man, cannot be influenced only by the monetary policy. Recently, the finance minister suggested that one of the reasons why food prices are rising is because of economic growth and consequent increase in purchasing power which in turn is resulting in rising demand for all food products, including rice, grains, eggs, meat and milk! However, as mentioned earlier, it is not so much an increase in demand as much as a constraint in supply that is the main cause of the problem. While it is true those schemes such as NREGS (National Rural Employment Generation Scheme) as well as the sixth pay commission wage hike has indeed augmented the overall disposable income in rural India, the more immediate causes of skyrocketing prices are the distribution bottlenecks as well as manipulation in food supply. For example, it is common knowledge that the producer/farmer gets a small fraction of the price that the end consumer pays, with the middlemen pocketing most of the difference. While, on the one hand, we are paying through our noses for the food on our table, there have been regular reports of farmers committing suicide due to financial distress. In the meanwhile, the supply chain is laughing all the way to the bank. The irony is that tonnes of food grains rot in government warehouses for lack of proper storage and distribution facilities. The loopholes in the PDS (Public distribution system) are well documented. However, successive state and central governments have done precious little to address the issue. Organised retail would benefit the farmer as well as the consumer. Unfortunately, vote bank politics has taken precedence over reforms in a sector that is in dire need of improved infrastructure.
Rupee depreciation
The other issue which is complicating the situation further is that of the falling rupee. Though currency fluctuation is beyond the control of the government, the fact remains that a fall of nearly 10% over the past couple of months has seen the rupee drop to almost Rs. 50 to a dollar. This has essentially happened on account of the aforementioned heightened perception of sovereign risk across the eurozone resulting in an across-the- board-appreciation of the US dollar against most international currencies. Thankfully, a simultaneous drop in global commodity prices is partly offsetting the negative impact of an expensive dollar, but a depreciating rupee will only fuel the value of imports. Manufacturers would typically pass on the price rise to the consumers further fuelling inflation.
To sum it up
Though the official speak is that the effects of the monetary policy manifest with a lag, it's already over 18 months and 13 hikes, with possibly more in the offing. So far, the tightening has not had the desired effect on inflation, all it has resulted in is the stifling of growth. The RBI view is that any change in its stance would dilute the impact of past policy actions. So unless there were firm signs of downward movement in the inflation trajectory, it would be imperative to persist with the current anti-inflationary stance. Be that as it may, unless the leadership shows political determination and the ability to look at the big picture, no amount of tinkering with the rates is going to solve our problems.
----- The writer is director, Wonderland Consultants.(DNA)
