The government's response to rising inflation is relatively quick but will not be effective in the long run. The need of the hour is a change in policy stance.
AFTER a long lull, evidence of inflation has returned to haunt the government. As on August 28, the point-to-point annual rate of inflation as measured by the Wholesale Price Index (WPI) stood at 8.33 per cent. The climb to that figure has been consistent, starting from 4.2 per cent on an annualised basis on May 1.
A remarkable feature of this inflationary spurt is the fact that it is in large part accounted for by a few commodity groups. Specifically, the sharp rise in the inflation rate is attributable to fuel, primary articles and steel, with sugar playing a small role as well. At the beginning of May, this set of commodities contributed a total of 2.7 percentage points to the 4.2 per cent inflation rate. By August 21, they contributed 5.2 percentage points to the 8.2 per cent inflation rate. Thus throughout the period of the inflationary spurt, these commodities accounted for between 63 and 71 per cent of the annualised inflation rate computed every week.
Further, since fuel, power and lubricants are in the nature of universal intermediates, the sharp increase in oil prices relative to the corresponding period of the previous year would have raised the costs of production and therefore the prices of all commodities, including those that are implicitly being categorised under the residual `Others' category in this discussion. Thus, any assessment of the factors underlying inflation has to focus on the factors that led to the rise in the prices of this set of commodities.
OF these commodities there are two, oil and steel, for which domestic inflation is obviously driven by international price trends. In the case of oil, a host of developments varying from the war in Iraq, the troubles in Venezuela and the controversies that dog the Russian oil industry, have ensured that prices continue to rule well above the $40-a-barrel level. Given the much lower levels at which oil prices prevailed during the corresponding months of the previous year, the figures yield a high annualised increase in international oil prices.
Given the decision to link domestic oil prices to the international price, the global trend has been reflected in sharp increases in domestic prices as well. The price increase has been partly moderated through a reduction in duties imposed on petroleum and petroleum products. But so long as the view that domestic oil prices should keep pace with international values prevails, there are limits to which the domestic inflation rate can be insulated from the effects of international oil price trends.
It could be argued that given the high share of imported crude and oil products in domestic consumption, some link between domestic and international prices is inevitable, if the government is not to be subsidising oil consumption indiscriminately. But the same argument can hardly apply to steel where domestic prices have risen sharply, led by international price trends. According to official sources, the domestic price of hot-rolled coils had increased to Rs.29,875 a tonne in May 2004 from Rs.20,500 a tonne in January 2003 and Rs.15,500 a tonne in January 2002. Similarly, the price of cold-rolled coils had risen to Rs.34,300 a tonne in May 2004 from Rs.26,000 in January 2003 and just Rs.19,500 in January 2002. Cost increases do not explain the price spurt, which has resulted in huge profits for the steel producers.
These price increases have resulted in steel contributing as much as 1.5-1.7 percentage points to the 6-7.5 per cent rate of inflation between mid-June and end-July. The government has sought to deal with this problem by reducing duties and forcing domestic producers to hold and even cut their prices. But while such efforts have made a small difference in recent weeks, the fact remains that steel has been a surprisingly significant contributor to the inflation problem. All in all, India's dependence on imports of crude and its integration into the world steel market, combined with a more market-driven pricing system, have contributed in substantial measure to the current rate of inflation.
Unfortunately, this has been combined with an indifferent and uneven monsoon that was delayed substantially in many parts of the country. While this is not expected to result in output shortfalls of the kind witnessed in 2002-03, production is not likely to equal that in 2003-04. Fortunately, given the current food stock position, this would not result in any imbalance between demand and supply. However, the uncertainties over the monsoon have provided the basis for speculative price increases in the case of a number of primary commodities, resulting in a significant inflation in the wholesale price indices for primary articles. As a result, this too has contributed to the sharp rise in prices.
Finally, in the case of sugar, a decline in production over two years has resulted in a significant fall in the level of stockholding. This has triggered a price increase, fuelled by speculation, even though international prices in this case have been subdued.
THE congruence of this set of factors explains the return of inflation, which once again is grabbing headlines. It must be said that, compared to its lethargy in most other areas, the government's response on this front has been quick and varied. This response has included duty cuts on petro-products and steel, some effort to hold back price increases in steel, a 50-basis-point hike in the cash reserve ratio and relaxation of the norms with regard to sugar imports. Raw sugar imports are now allowed duty-free with the obligation to export from domestic production within 24 months.
Thus the government's response is three-fold in nature. First, it attempts to moderate the effects of global price movements on domestic inflation by making compensatory reductions in domestic duties and persuading domestic suppliers to hold their prices. Secondly, it attempts to dampen speculation by reducing liquidity in the system through measures such as the hike in the cash reserve ratio. And, thirdly, it seeks to reverse domestic price increases by facilitating larger imports.
None of these is likely to be effective enough to deal with the problem. So long as increases in the international prices of oil and steel persist and the link between domestic and international prices is not sought to be directly broken, measures such as duty reductions can only serve as short-term and partial palliatives. It is also unlikely that half-hearted measures to reduce liquidity can make any difference to speculation. And, finally, easier imports can make a difference only in the case of commodities like sugar and edible oils, the international prices of which are subdued. But their contribution to the inflation rate is the least. Hence, unless there is a change in policy stance, inflation is likely to persist so long as international prices of oil and steel remain buoyant and speculation is not directly dealt with.
The danger is that this inflation driven by international price trends and speculation rather than by demand-supply imbalances would provide an argument for further fiscal contraction, even though food stocks, foreign exchange reserves and unutilised capacity warrant an expansionary fiscal stance. If that happens, the still slow progress on implementing the National Common Minimum Programme (NCMP) would soon be halted.