Inflation in India – Nature and Magnitude
If it all there is a dream in the minds of India’s policy makers and RBI, it is to conquer the unflinching inflation. Of course in a candid tone we can say that it is a pipe dream at least in the context of current times. Inflation needs no introduction. Inflation occurs due to a steep rise in price levels against the normal purchasing level of consumers. In the recent years, more than any issue Inflation has plagued the Indian economy and undermined its growth prospects. Due to high inflation and deteriorating depreciation of Rupee, India has become a dwindling brick among the BRICS nations and has been downgraded in its credit ratings by S&P, Moody and Fitch.
India’s head line inflation which is based on the Whole sale price index has lowered to 7.25% in June 2012 from 7.55% in May 2012. Though Indian government has registered a success in bringing inflation in non-food items in control, it is still grappling with soaring inflation in food, fuel and power arenas. This article contemplates and comments on the causes of inflation and effects of inflation on financial measures such as balance of payments, depreciation, FDI, FII etc. How inflation surfaces and why RBI’s measures are backfiring? Analysis
Inflation generally starts as a demand-pull inflation where a colossal amount of money chases few goods. In order to curb and absorb this colossal money, RBI has been hiking the repo and reverse repo rates. In spite of such a tough stand by RBI, we have not seen a considerable decline in inflation. In fact RBI is held accountable for the dismal growth rate of 6.5% for the year 2011-2012. Most of the corpus money which RBI is targeting at is black money and the black money holders can’t deposit this money in banks (despite attractive interest rates) as they get charged for disproportionate assets case. This money can neither be invested in the capital markets as Income tax department monitors their PAN transactions. So there is no reason for RBI to keep hiking interest rates when it can’t nip the real culprits. Here we can safely conclude that black money holders are contributing majorly to demand-pull inflation. Other reasons for demand-pull inflation are high disposable income and fake currency notes. For obvious reasons, seeing the demand-supply imbalance, producers would like increase the supply of production to gain higher profits. The double whammy occurs when these corporate manufacturers can’t access the money in banks due to higher interest rates. Even though corporate are ready to borrow at higher interest rates, government borrows this money which leads to “crowding out of private investment”. Please note that government spending is an exogenous variable which is insensitive to inflation or depreciation. As the producers can’t get loans from banks they can’t expand their business and even if they get access to limited money this leads to increased cost of production. This is where the “cost-push inflation” sets in. Cost-push inflation is attributed to RBI’s high interest rates, supply chain bottle-necks, increased power tariffs and increased fuel prices. So today what we are seeing is “Cost-push inflation”. Defying the General and Entrenched Assumption
Is Inflation strengthening the Rupee?
The general perception is that Inflation leads to rupee appreciation. It is premised on the reason that inflation is followed by interest rate hikes by RBI. The attractive interest rates (Reverse repo at 7%) would attract the foreign investors to invest in Indian banks and government securities. As the supply of foreign currency increases Rupee automatically becomes stronger. Recently RBI has increased the interest rates on NRE, NRO, FCNR (Foreign currency non-resident) accounts to attract foreign investments. This would have worked out to a certain extent in attracting foreign currencies. But the unfavorable factors like policy paralysis, stalemate on reforms,...