Perspective
By Venkatesh Raghavan
Though the government of India has largely succeeded in keeping retail inflation pegged at 4%, the fuel inflation that is taking place in India, partly due to the OPEC countries and Russia tightening their grip on their crude supply chain and largely due to the fact that nearly 80% of India’s crude oil supply is a result of imports is posing an ominous situation. The fuel inflation till recent months stood at the 3% mark. While the opposition is crying foul over excessive taxation on part of the Centre, the treasury benches seek to justify their actions, stating that government needs to compensate for the shortfall in revenues during the early months of lockdown owing to a weak demand situation.
In the current economic scenario that witnesses a shrink in economic activity in the country resulting in a sharp reduction in both exports and imports, India’s central banker Reserve Bank of India (RBI) has a crucial role to play in the form of intervention that can facilitate an improved cash flow situation. In simple words, the RBI has its role cut out for facilitating commercial banks in the country to get clients who will avail their credit facility, invest in their businesses and generate revenue both for the industrial units and the banks. The problem our banking regulator RBI faces is that despite already cutting down on the lending rates to banks (repo rate), the banks are still unable to utilize this initiative to promote credit offtake from prospective customers. The situation prevails owing to constraints on the sourcing from reliable supply chains across the country for procurement and processing the business and industrial units for them to stay operational.
Take for example the Indian textile industry. Now the problem India faces is that it has a fragmented value chain in its textile domain. Raw cotton besides ginning is carried out in Gujarat and neighbouring Maharashtra’s Vidarbha region. The processing units that manufacture ready made garments (RMG) are however, located in far away Tirupur and Coimbatore regions of Tamil Nadu. When we talk about supply chain disruption, it means the sourcing of cotton and other raw material from the western region of our country is not able to make it to the floors of the industrial RMG units down south. Textile is the largest generation of employment in our country, next only to the agricultural sector.
How does this factor affect inflation? When economic activity grinds to a halt, and banks lowering their credit rates to encourage entrepreneurial ventures are faced with a lack of adequate demand or response, it results in a surge in prices of commodities including food, fuel and modes of transport that includes local commutes. In this scenario, RBI’s intervention and well-meaning efforts in the direction of reining down inflation has not met with much success. As the bleak picture of our central banker, RBI’s control over inflation being blunted owing to supply chain disruptions emerges, it also becomes clear that any attempt to ease the country’s inflation target is not going to help either.
Currently, there is an on-going debate between the Principal Economic Advisor Sanjeev Sanyal and Chief Economic Advisor (CEA) K V Subramanian over the Centre’s proposed remedy of keeping the inflation target unaltered. What it means is to allow for banks to operate at lower credit take offs for their clients even if it results in an inflationary surge. While Sanyal favours that the inflation band be allowed to stay in the 2 to 6% range, with 4% as a central median measure, the CEA contends that the situation calls for refinement. Subramanian pointed out that the Reserve Bank of India (RBI) was focusing on honing the situation that caters to demand-side factors. Whereas, the country’s inflation figures are subject to tracking of food prices which rely on fluctuations and disruptions on the supply side. In this context, the CEA pointed out that tightening the monetary policy would fail to address the anomalies that result from rising food prices that are precipitated by shortage situations.
To demystify the jargon, it means the RBI is lowering its repo (lending rates to commercial banks) rate to favour the banking institutions’ being able to create demand for the off take of credit to its borrowers. However, inflation is getting affected not because of weak demand for credit, but because of spiralling of food commodity prices owing to shortages or scarcities that result from the disruptions that are caused in the supply chain. In this context, tightening the money policy, meaning direct reduction in interest rates is not going to help. The CEA expressed his opinion that the situation warranted the government laying focus on core inflation, meaning it leaves out the pricing fluctuations in food and fuel.
The CEA might have in all probability borrowed from the wisdom of the central bankers who pronounced much the same opinion way back in 2016. The history of spiralling prices owing to supply constraints or disruptions playing spoilsport with the government’s ability to control inflation figures traced to decades back. This merely by itself does not warrant a shift in the monetary policy. To understand the root of the problem we need to focus on the actual value of the rupee. Why does the actual value of the rupee affect the money policy? It’s simply that there’s a lot of money that needs to be spent and very few products that can be had in exchange. It means sticking to the core theory that inflation has always been a monetary phenomenon. The fact that supports this theory is that ever since our country faced double-digit inflation nearly a decade and odd back, our Central banker RBI’s timely intervention has brought it well under control in recent years.
Currently, owing to the fiscal moves initiated by the government in the recent past, the RBI is faced with a new challenge. The Central Banker has to keep the inflation range well under check by adopting a proactive measure that ensures credit offtake. This is expected to help India find a sure-footing on the pricing levels, enabling significant gains on the fiscal count. The government’s recent policy is a reference to the easing of fiscal and monetary clutches that result from announcement of stimulus packages besides encouraging access to cheap credit with an economic revival in view.
The economic revival initiative will ensure that the country goes easy on the cash flow situation. At the same time, India is also faced with a reduced inflow of capital from foreign investors. The government stimulus, needless to say, will expand the economic output of the country. However, turning to the assistance of low interest rates or heading towards negative interest rates is something that can cause a serious economic crisis from the long-term perspective. To term it simply, this can lead to resource misallocation, meaning a situation in which capital and labour get poorly distributed. This implies that less productive firms will garner a bigger quantum of capital and labour than they merit. The risk is that if it is allowed to happen unabated, prices may well slip out of control leading to an inflationary trend that might well reverse the fruits of all the efforts that the government made in the past half-a-decade.
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