An Agenda For Inflation A Prescription For Increasing Productivity



Inflation happens when too much money is chasing too few goods and services. That is why Milton Friedman once said that “Inflation is everywhere and always a monetary phenomenon”. At this point, when the monetary authority (the RBI) has just passed on the (inflation fighting) baton to someone else (the Govt), it would be appropriate to evaluate this statement again.

Declaimer: This article written was originally in March 2013, and some of the data points may be outdated.

In India, we have to contend with red-hot demand for everything, particularly food and energy, besides incremental money supply. We are perhaps the only part of the world that has regular bouts of demand-side inflation; Mr. Friedman was probably referring to the much saner developed world when he talked about Money Supply as the only driver of (supply-side) Inflation.

I cannot fault the RBI for anything they have done in Monetary Management. Given the recent standards by which we should judge them (Greenspan/ Bernanke/ ECB), our Governors at the RBI have uniformly shown much more character. The fault, it would seem, lies in what the rest of Govt has done to produce the things that are in short supply.

Starting with energy. We went down the thermal (coal) route, rather than renewables, in particular Solar. A high capital cost for energy can be managed with a high Savings Rate, which we have. Big fiscal incentives for driving savings into Solar, will reduce the Cost of Capital. Now more than ever, with the cost of Solar dropping to a more affordable Rs.7.5 per unit, we should drive huge investments into Solar. This will cover both the energy deficit and reduce the blended cost of energy.

The floodgates of FDI should be thrown open. There is enough money waiting to come in, given the massive investments ($ 500 bn) already going into renewables globally. Given the context of the Durban agenda, it is now clear that China and India will also be launching aggressive emissions reduction programs, instead of fighting for their “right to pollute”. This will clarify the way forward for industry; Solar is going to be the way to go…

The cheap money available in the US should act as a spur to investments in India. The money coming in, should not be debt, but Equity. Investors can leverage themselves in the US but should be invested in Equity here in India. This will insulate the country from currency risk (an especially topical issue at this time). There should be no dearth of investments if the right enabling climate is created. Big companies like Reliance should be encouraged to launch super-ambitious investment plans; they have the debt capacity needed to even fund it off their Balance Sheet.

The gestation period for these projects can be brought down to 1 year, if some specific SEZ-type initiatives are taken, to ensure plug-and-play projects for smaller players. These can even be consolidated by the big Infrastructure cos (GMR has something like this in Chennai). The short point is that if there could be one single reason for an Indian resurgence, it would have to be the dropping cost of energy.

Worldwide, other trends are kicking in. US production of shale gas has gone up 700% this last decade and is set to increase further. All this will affect the cost of coal, the dirtiest of the fuels. Oil, too, will eventually come under pressure, but only provided China and India perform disproportionately on the static energy front. The very fact that the US and Europe are trying to shut off oil revenues for Iran (leading to higher oil prices for everyone) shows that they now care less about the price of oil than they did earlier. This will also have geopolitical implications.

The next is food, which is both dependent on the cost of energy and is far more complex. First, the cost of intermediation (the non-food cost of food) should be brought down. The value chain in food has a very large storage and logistics cost, which is soaked by traders and intermediaries. If these are handled by fragmented markets, costs will be high. Integrated (or organized) supply chains will do a far better job of reducing costs. I don’t know whether a protected Indian retailing industry is better, or foreigners will really bring in technology and good practices (our experience with Banking would suggest that it doesn’t make much difference eventually, but the entry of foreigners would act as a catalyst).

But food and agriculture need some serious structural reform. Look at how the inflation problem is going to get intractable. If this (food inflation) continues, it will push up inflationary expectations to the lowest level, fuelling wage inflation. This will set off a spiral. The old and the weak will be the worst affected. Since food inflation shifts pricing power to big farmers and traders, both of whom are almost entirely outside the tax net (the former officially and the latter unofficially), it will ensure that, over time, the tax:: GDP ratio will drop, increasing the Govt’s Fiscal Deficit. There will be a cost-push on a variety of industries, which will set off another inflationary spiral. All in all, not a pretty long-term picture.

Productivity can only improve if we bring in serious (corporate) investments into agriculture. I know this sounds completely (politically) impractical, but we need to liberate (land) leasing laws, to allow long-term leases, which allow corporates to get into Corporate Farming. This is in everyone’s interest; the tiller, the absentee landlord, and the customer (read: the population of India). It would allow serious investments into wasteland development, water management, and soil rejuvenation. New technologies, especially those that use low-cost energy (Solar again?) for water and logistics management, will drive up agricultural productivity. Just ask Brazil how they transformed agriculture within a decade.

These two components make up core inflation. If you look at any manufacturing Cost Sheet in India, you will find that the cost of energy and wages make up at least 30% of total Value Added. Managing these 2 costs will decide the company’s Internal Inflation Rate, i.e. the actual Inflation in the company’s input costs, which might be sharply different from the average reported across the entire economy.

For example, right now, a textile exporter would be seeing very low inflation in input costs (with cotton prices sluggish because of reduced offtake from the spinners), even as he sees an increase in Dollar realizations from Sales. On the other hand, power producers would be seeing sharp increases in the cost of fuel (especially coal), even as price realizations stay sluggish.

This would be a good way to evaluate the prospects of companies. Each company has to focus on its Internal Inflation Rate and focus on the components of its Inflation. This should be set off against ‘beneficial inflation’, i.e. the price increases it gets from the markets it faces. Setting this equation would give it some sense of its future profitability, and its future strategy (to manage its profitability).

India’s savings are currently invested in a lop-sided manner. It is the (energy)- consuming industries that are investing incrementally, not the energy-producing ones. The same goes for food. We have the savings flow to fund our deficits domestically; those that interest foreigners should be left open to them, while we drive our domestic savings into investments in Corporate Farming cos, for example. It is not very difficult; we have the tea companies as a shining example, and internationally, there is the Brazilian model in sugar, to learn from.

The old argument that markets are self-correcting mechanisms does not hold just now. There is a clear price signal coming from the raging food inflation, yet the market is unable to respond. We don’t even know whether the current food inflation is because of falling productivity, that comes from a lack of adequate investments and a complete stagnation in technology. We do know that some of this is because most Indian agriculture continues at the subsistence level, with no scale, and absolutely no technology investments in mechanization, energy usage, and input management. All of this would need organized effort, as much into knowledge and management, as into physical assets. At the moment, that is well beyond the capability of the India agriculturist; but politics will ensure that reform here will be left pending till the crisis is well over our heads.



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