India and the perils of a high-cost economy

In a country where half of its population is living below the poverty line and an average adult earns below Rs 50 a day, continuous rise in prices, generally known as inflation, is certainly a slow killer. Inflation is the worst tool of exploitation because farmers and workers in the unorganised sector cannot wrest higher remuneration when cost of living goes up, unlike organised sector’s employees who get some protection by way of inflation-linked wage hikes.

Controlling inflation by raising interest rates is a desirable and necessary policy action for the Reserve Bank of India (RBI). But most economic observers feel that the RBI is overdoing the rate hikes and there is not much of resultant impact as the rate of inflation continues to rule high at around 9 per cent.

The RBI has raised interest rates a record 10 times in the last 15 months, cumulatively raising rates by as much as 425 basis points which translated into 4.25 percentage points increase in the policy interest rates. And this is not the end of it as bankers expect at least two more rate hikes of 25 bps in the next three months.  

Harming growth

Since money to business is like blood in human body, when it becomes more expensive the business starts to gasp. The signals are loud and clear: the country’s industrial growth rate in the last three months has slowed down and the crucial manufacturing sector, representing factory output, is the worst sufferer seeing big dips in year-on-year growth.

The industry representatives are naturally worried. In a letter, the Federation of Indian Chamber of Commerce and Industries (FICCI) has urged the central bank to take a fresh look at its monetary policy stance. “Any more tightening of monetary policy will further destabilise industrial growth, weaken GDP growth and limit employment generation” wrote FICCI Chairman of Corporate Finance Udayan Bose. “Such a situation would have social repercussions as well, for we need to generate to close to 12 million jobs annually and a large part of it has to come from industry particularly the SME sector.”   

The fact that rise in interest cost, along with higher cost of raw materials, has already slowed down the borrowings is evident from a sharp fall in total credit off-take. Since April 2011 till June 20, 2011, all banks together lent Rs 42,000 crore – only a third of Rs 1.23 lakh crore they lent in the April-June quarter in the previous year.

The country’s largest bank, the State Bank of India, for instance, has already lowered its credit growth projections for the current financial from 19-22 per cent to 16-19 per cent. Said Chairman and Managing Director of a Bangalore-based PSU bank, “We have no choice but to pass on increased interest costs to borrowers, but there are clear signs of resistance from them as their businesses are becoming unviable.”  

Potentially dangerous

A recent report from the leading credit rating agency CRISIL, pointed out that among the sectors seeing pressure on margins due to high cost are auto, realty, steel, cement, consumer goods, etc.

When businesses see falling margins and an uncertain future, new investments suffers the most. No wonder, the rate of capital formation in the country, an indicator of investment for the future capacity and job creation, has considerably slowed down in the recent months.

According to a CRISIL study the gross capital formation in the country has dropped steeply from 15 per cent in the first half of 2010-11 to 3.7 per cent in the second half and by the last quarter of the last financial year it had dropped nearly to zero. Writes CRISIL Managing Director  and Roopa Kudva, “Underpinning the investment slowdown were a rising interest rate environment and policy concerns relating to issues such as land acquisition, environmental clearance, etc.”

Commenting on hike in interest rates FICCI President, Harsh Mariwala said, “In the last few months we have seen a fall in the announcement of new projects and also a large number of projects both in private and Government sector are stalled for various reasons. As a result the growth of the crucial manufacturing sector is slowing down consederably. This has disturbing implications.”

Supply side constraints

The RBI’s hawkish stance on curbing inflation through interest rate hikes had limited impact so far because one of the main reasons for high inflation is due to high rate of food inflation. There are two primary reasons for high food inflation: rising standard of living and supply falling short of demand. Strong economic growth in the past has led to economic prosperity, which has led to higher consumptions of non-staples like meat, fish, egg, milk and their products.

This is what the economists call ‘Protein Inflation’ that happens in every economy when it transforms from developing to developed, as people start rising from the subsistence levels. In fact, in the basket of food inflation protein products and fruits are the largest contributors to price rise. Inflation is also high because of shortage of fruits and vegetables, whose consumption has gone up far more than the supply constrained by the absence of commercialization of cultivation.

“The current spell of inflation, being largely associated with supply-side bottlenecks and imported commodities, cannot be addressed by monetary tightening alone,” said CII Director General Chandrajit Banerjee.

Auroch Investment Managers, Founder and CEO Raj Majumder feels that the reason RBI has struggled with the rate rises so far has been due to excess global liquidity and a high spending fiscal policy. “Impact of rate rises typically plays out with a lag. That is the reason most analyst want the RBI to take a pause and wait for the impact of past rate hikes to play out before tightening further,” says Majumder.

Another reason for demand outpacing supply is the income generated in the rural economy through various welfare schemes of the government. In the 2010-11, for example, around Rs 40,000 crore was spent on rural employment guarantee schemes.
The government also spent close to Rs 56,000 crore on food subsidy and on minimum support price for major food grains. Such spending improves standard of living for poorer people, and create more income through multiplier effect, experts say.

Import of inflation

Since 70 per cent of India’s oil consumption is imported, high global oil prices is adding to our domestic inflation through imports. When the finance minister presented his budget in February this year all his calculations for the government’s earnings and subsidies were based on the crude price at $75 a barrel, but as the price was ruling above $100 a barrel the government was forced to raise oil product prices several times, adding to the inflation. In the latest round of price increase last week, the government, however, took a hit of Rs 49,000 crore by cutting duties.

As many expect the global crude prices to hover around $120, India can do very little to escape the threats of inflation. No wonder, the International Monetary Fund (IMF) in one of its recent reports said that high oil prices are significant risks to economies like Indian and China, which in turn is bad news for global recovery.

Disappointing global scenario

In a globalised world, economic situation in other large countries, specially developed economies like USA, countries in Europe, Japan, determines the global economic growth.
Here the picture is quite gloomy. US’s economic recovery is far slower than expected despite pumping nearly $1500 billion dollars in the economy by way stimulus packages. Recent fall in new job creation numbers and higher unemployment rates are pointers to this.

Europe is in trouble as weaker EU countries like Spain, Ireland, Portugal, Greece are not able to recover although billions have been pumped in.

Now some of these countries are in need of fresh bailout packages creating economic tension in the whole region. Devastated by an earthquake and a tsunami, Japan will take long to recover. Even China, the fastest growing economy in the world, is slowing down as the government is taking several measures to cool down the ‘overheated’ economy.