Rajan magic helps markets rally, but can he control inflation too?

If India has to get back to high economic growth, inflation needs to be reined in

Vivek Kaul November 15, 2013 08:44:30 IST
Rajan magic helps markets rally, but can he control inflation too?

On November 12, the rupee touched 63.70 to a dollar. On November 13, Raghuram Rajan, the governor of the Reserve Bank of India (RBI) decided to address a press conference. "There has been some turmoil in currency markets in the last few days, but I have no doubt that volatility may come down," Rajan told newspersons.

Rajan was essentially trying to talk up the market and was successful at it. As I write this, the rupee is quoting at at 63.2 to a dollar. The stock market also reacted positively with the BSE Sensex going up to 20,568.99 points during the course of trading today (i.e. November 14, 2013), up by 374.6 points from yesterday's close.

But the party did not last long. The wholesale price inflation (WPI) for October 2013 came in at 7%, the highest in this financial year. In September 2013 it was at 6.46%. In August 2013, the WPI was at 6.1%, but has been revised to 7%. The September inflation number is also expected to be revised to a higher number. The stock market promptly fell from the day's high. A major reason for the high WPI number is the massive rise in food prices. Overall food prices rose by 18.19% in October 2013, in comparison to the same period last year. Vegetable prices rose by 78.38%, whereas onion prices rose by 278.21%.

Rajan magic helps markets rally but can he control inflation too

AFP

Controlling inflation is high on Rajan's agenda. "Food inflation is still worryingly high," he had told the press yesterday. In late October, while announcing the second quarter review of the monetary policy Rajan had said "With the more recent upturn of inflation and with inflation expectations remaining elevated... it is important to break the spiral of rising price pressures." If Rajan has to control inflation, food inflation needs to be reined in. The trouble is that there is very little that the RBI can do in order to control food inflation.

A lot of vegetable growing is concentrated in a few states. As Neelkanth Mishra and Ravi Shankar of Credit Suisse write in a report titled Agri 101: Fruits & vegetables-Cost inflation dated October 7, 2013, "While the Top 10 vegetable producing states contribute 78% of national production, the contribution of West Bengal, Orissa and Bihar is much higher than their contribution to overall GDP. For example, despite being just 2.7% of India's land area and 7.5% of population, West Bengal produces 19% of India's vegetables, dominating the production of potatoes, cauliflowers, aubergines and cabbage. In fact, for almost each crop, the four largest states are 60% or more of overall . In particular, Maharashtra dominates the onion trade (45% of national production by value), while West Bengal produces 38% of India's potatoes, 49% of India's cauliflower and 27% of India's aubergines (brinjal). "

The same stands true for fruits as well. As the Credit Suisse analysts point out "Maharashtra (MH) dominates citrus fruits (primarily oranges), Tamil Nadu (TN) produces nearly 40% of India's bananas, Andhra Pradesh (AP) is Top 3 in all the three major fruits, and Uttar Pradesh (UP) produces a fifth of India's mangoes."

Hence, the production of vegetables as well as fruits is geographically concentrated. What this means is that if there is any disruption in supply, there is not much that can be done to stop prices from goring up. Given the fact that the production is geographically concentrated, hoarding is also easier. Hence, it is possible for traders of one area to get together, create a cartel and hoard, which is what is happening with onions. (As I argue here). There is nothing that the RBI can do about this. What has also not helped is the fact that the demand for vegetables has grown faster than supply. As Mishra and Shankar write "Supply did respond, as onion and tomato outputs grew the most. But demand rose faster, with prices supported by rising costs." Hence, even if food inflation moderates, there is very little chance of it falling sharply, feel the analysts.

This is something that Sonal Varma of Nomura Securities agrees with. As she writes in a note dated November 12, 2013 "On inflation, vegetable prices have not corrected as yet and the price spike that started with onions has now spread to other vegetables. Hence, CPI (consumer price inflation) will likely remain in double-digits over the next two months as well." The consumer price inflation for the month of October was declared a couple of days back and it was at 10.09%.

Half of the expenditure of an average household in India is on food. In case of the poor it is 60% (NSSO 2011). The rise in food prices over the last few years, and the high consumer price inflation, has firmly led people to believe that prices will continue to rise in the days to come. Or as economists put it the inflationary expectations have become firmly anchored. And this is not good for the overall economy.

As Varma puts it "For a sustainable decline in inflation to pre-2008 levels, the vicious link between high food price inflation and elevated inflation expectations has to be broken. The persistence of retail price inflation near double-digits for over five years has firmly anchored inflationary expectations at an elevated level. The role of monetary policy in tackling food price inflation is debateable."

What she is saying in simple English is that there is not much the RBI can do to control food inflation. It can keep raising interest rates but that is unlikely to have much impact on food and vegetable prices. Varma of Nomura, as well as Mishra and Shankar of Credit Suisse expect food inflation to moderate in the months to come. But even with that inflation will continue to remain high.

As Varma put it in a note released on November 14, "Looking ahead, we expect vegetable prices to further moderate from December, which should lower food inflation. However, this is likely to be offset by other factors. Domestic fuel prices remain suppressed and the release of this suppressed inflation (especially in diesel) will continue to drive fuel prices higher. Also, manufacturer margins remain under pressure and hence the risk of further pass-through of higher input prices to output prices, i.e., higher core WPI inflation, is likely."

What this means is that increasing fuel prices will lead to higher inflation. Also, as margins of companies come under threat, due to high inflation, they are likely to increases prices, and thus create further inflation.

All this impacts economic growth primarily because in a high inflationary scenario, people have been cutting down on expenditure on non essential items like consumer durables, cars etc, in order to ensure that they have enough money in their pockets to pay for food and other essentials. And people not spending money is bad for economic growth.

If India has to get back to high economic growth, inflation needs to be reined in. As Rajan wrote in the 2008 Report of the Committee on Financial Sector Reforms "The RBI can best serve the cause of growth by focusing on controlling inflation." The trouble is that there is not much that the RBI can do about it right now.

(Vivek Kaul is a writer. He tweets @kaul_vivek)

Updated Date:

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