December 14, 2013

The Root Cause of Indian Stagflation

Hi Guys,

Two days back, the Economic Indicators of Indian performance in October was out and we reached a new low with CPI Inflation going to 11.24% and IIP dropping to -1.8%. Food Inflation was at 14.72% and Manufacturing growth was -2%. GDP growth was 4.8% for Q2, 2013. RBI is all set to increase interest rates (probably by another 25 basis points) and industries are all set to oppose it.

So, why does RBI want to increase Interest Rates? To understand that, we need to understand Inflation first. Inflation is caused by changes in demand and supply. Generally, Inflation can be said to be a situation where, ‘Too much money chasing too few goods. It can either be a state where too much of money is there in the economy or when the availability of a product goes down.

So, when inflation exists in an economy, a central bank (RBI) tries to play with interest rate. When interest rates are low, people take loans and the money comes into economy. When interest rates go up, people do not take loans. Rather people deposit their money and money supply would be reduced in the economy. This is done in order to bring Supply and demand to Equilibrium.

Generally it is said that Inflation should be lower than Interest rate by approximately 2% in a country. Only then does a business performs well and would be able to sustain its growth. People would not be affected too much by inflation. In India, Inflation is way above the current interest rate. RBI feels that increasing interest rates would reduce money supply in the economy. On the other hand, Industries feel that it would affect the already faltering Industry growth.

So, is RBI right in saying that increasing interest rates would stop the inflation? In my perception, increasing interest rates would have no effect on the money supply. The main reason is that Inflation is not happening due to the increasing money supply from borrowings. The root cause of the problem lies somewhere else.

The central government in the name of Rural Empowerment, provided lot of subsidies and money transfers. The key among them is the NREGA or the Guaranteed employment scheme. As one of my professor says, it unskilled the people. People who were working stopped working for wages were guaranteed. So, he didn’t have any incentive to work and productivity went down.

For any country to grow from Agrarian to developed economy, Manufacturing is important. Manufacturing doesn’t require much of skills and the employment it generates is tremendous. For once, India thought it leapfrogged that stage and can conquer growth based on Services. The main problem with services is that you need to be educated and it does not generate too much of Employment (26.6% of Labor force accounting for 56.9% of GDP).

The NREGA scheme spoiled an entire community of workforce. They got paid for doing literally nothing. As many people would say, the job of this workforce was to dig and fill holes. Government’s intention of ensuring wages was good, but they should have allocated a suitable work. All this money came back to the economy. The rural consumption pattern changed. From normal diet, they moved into protein diet. Food consumption increased and food prices skyrocketed. When growth came down, Government had no idea of what was happening.

Though our Finance Minister says that Food prices are reason behind inflation, I don’t think he has a solution. Now, Government wants to increase the minimum wages in order to improve the rural conditions. RBI increasing interest rates would affect industries and it would be too difficult for them to recover.

Even if a new government comes to power, they won’t have the audacity to pull back all the subsidies and money transfer schemes. One thing that can be done is to improve their skills and make the rural people productive. Pay them, but get some work out of them.

India is into the trap of low growth and high inflation or what is known as Stagflation and it is not going to be easy to come out of it. Let’s hope something good happens.

Happy Reading!

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