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!
