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Executive MBA Module : Macroeconomics & Global Environment Assignment

April 2010

Topic : In the case of Inflationary Pressures and Global Slowdown, do you think RBIs response has been adequate ?
Inflation : Inflation is defined as the rate at which the general level of prices of goods and services falls and consequently the fall in the purchasing power. Inflation pertains to a general price rise in a group of commodities, which is measured by an index computed for the purpose of tracking prices as it affects a given set of stakeholders of an economy. Depending on the group of the stakeholder normally an inflation index could broadly be classified into a consumer index and a producer index that tries to measure inflation at the consumers level and producers level. Inflation in commodities are seasonal and at times persistent. While the food commodities are normally seasonal the rise in prices of metals normally occur in a cycle. In order to control the price levels i.e. inflation, governments across the world look at the central banks and their monetary policy. While monetary policy is one of the tools to control inflation, if the cause of price rise lies in expectations and hence limit the use of money in buying and storing the commodities. Global Recession/Slowdown : A Global recession occurs when there is general slowdown in economic activity over a sustained period of time or a business cycle contraction. The IMF considers many factors while defining a global recession, but it states that economic growth of 3 % or less is equivalent to a global recession. Backgound of the global recession :

Spread to the Indian Economy :

RBI Policy response Conventional & Unconventional: Anatomy of current inflation: The global recovery had led to increased commodity prices in general in commodities other than foods. However, in food commodities the price rise has been attributed to several natural disasters and the low stocks. In terms of energy commodities the price rise is attributed to reasons such as political unrest and expected supply shortages arising out of the same. Hence, inflation in India is arising out of reasons, which partially lies in loose monetary policy. On the other hand, inefficient supply chain leads to a wide variation between price at the producers level and the consumers level. This often blinds one from differentiating inflation arising out of a loose monetary policy and out of concerns that could be attributed to the fundamental forces of demand and supply of commodities. Having said that, RBI has been moderate in its approach to the use of rate policy to tame down inflation. It is also due to the reason that policy rates are already high and anything higher than that would have the potential to result in growth antidote, which is essential at this point in time when the global recovery has been slower. Where lies the cause of current inflationary trends? In the case of global commodities, it lies in reasons other than our own arising out of domestic concerns and hence there is little the central bank can do to contain inflation. Domestic commodity prices are high due to the supply Supply shortages that is chronic to India especially in pulses, oilseeds etc. augmenting the domestic production of these commodities. government and not from the central bank or its monetary policy.

shortages can be redressed by either by importing them at cheaper prices or by Production This has augmentation can only be attained through right policy intervention from the rightly been indicated by both the governor and deputy governor of the Reserve Bank of India from time to time that the cause of todays price lies in reasons other than the monetary policy. Moreover, any solution to supply augmentation would take a longer period in time compared with the effect of monetary policy on price rise, which takes relatively shorter time span to correct the situation.

Hence, the stubborn inflationary situation despite the last policy rate hike indicates that the reason for price rise remains somewhere else. Currency Management An Inflation Control Tool : While the developed world from where the trade demand went into recessionary conditions since 2008 leading to a fear that it might cripple global trade. Any undue damage to the global economy and hence the trade was feared to have a crippling effect on the Indian exporters. Added to it were the currency fluctuations in the global markets that made the currency management a tougher task on the part of the central bank. The Reserve Bank of India has done its best to avoid intervention in the currency markets and believed that the market would correct on its own after currency rate management was left to open markets for the stakeholders to discover. Currency exchange rate, another tool to manage inflation, was again left to the markets than to take the traditional way of managing the currency to counter the inflationary conditions. Seen in the light of several central banks in Asia, which have intervened in their respective markets to manage their inflationary conditions, RBI as a currency regulator was a mute spectator to movement of rupee vis--vis other global currencies. The wisdom of the RBI seemed to have paid as the exports during the last two quarters revived to the surprise of all including the policy makers despite the infrastructure woes that Indian economy still faces. Risks of Fragile Recovery : As the developed economies went into recessionary conditions post-Lehmann collapse due to the contagion effect of the markets that they were interconnected with, it had left the financial markets jittery about prices and quality of various asset classes. Markets reacted out of proportion leading to the build up of volatile conditions which in themselves made planning for recovery more difficult. Taking the path of recovery, US chose to flood its market with money so that the confidence lost during the recessionary period could be brought back among its stakeholders. This saw results in their respective economies except for those nations in Europe such as Greece, Portugal and Iceland which were neck deep in their sovereign debts with strong defiance from

their parliament to take the prudent path to recovery while keeping their borrowing costs lower. On the other hand, the quantitative easing path chosen by US led to flood of low interest rate money into emerging markets seeking out better returns in the light of high risk/low return conditions that existed in their respective economies. Indian economy also saw its own pressure such as foreign currency inflow leading to temporary pressure on the currency side. Thanks to RBIs policy of leaving the price and currency forces test their might in the markets lead to the emergence of a trade friendly currency regime in the economy. This was in contrast to the actions of its east Asian counter parts at Malaysia, Indonesia and South Korea choosing to use their markets might to determine their currency rates to contain the inflationary conditions. It is important to note here that most of the currency flows belonged to the volatile short-term nature i.e. for participation in the countrys stock markets at a time when the stock market in itself was volatile. The external stakeholders chose to turn their short-term interest in taking their share of the Indian growth process seemed to have made it a medium-term one given the watch-from-thefence policy of the RBI and the Indian governments renewed interest to go ahead with the reforms in full steam. Thanks to the resilience of the Indian corporates and robustness of the economy, despite the financial crisis inducing pressures on their balance sheets, industry was able to solidify the volatile capital flows keeping alive their participation in Indias growth story. The only outlier Crude Oil Prices : Crude oil prices seemed to be climbing to the pre-crisis levels making it tough for the emerging nations such as India to manage their price levels. This has particularly been so since part of the economic growth story of the country could be attributed to the easy and cost effective access to energy especially that of the transport sector which is highly dependent on crude oil and its derivatives. With a slow shift to cost effective alternatives such as natural gas, ethanol, etc. and the politically sensitive issue of subsidy removal, the current rise in crude oil

prices seems to be the only outlier. The solution to this can not be with the administered pricing policy regimes as currently practiced by the policy makers. In an economy plagued by infrastructural inefficiencies, and aspiring to take its place on the global stage, fuel use efficiency would matter a lot. This can be achieved only if the crude oil price rise is fully passed on to the consumers and are absorbed by the consumers rather than pass it on to the economy back in terms of higher prices of most other commodities in whose production or marketing, energy plays a significant role in the form of transportation. The long term effect of the complete dismantling of the administered pricing mechanism (APM) and consequent removal of subsidy would work for price stability in the economy rather than the short term price masking actualized by the current subsidization policy of the government. Thanks to the central banks liberalization policy for the commodity stakeholders to manage their risks in markets abroad, risk management as a procedure is now catching up with the corporates leading to an inflationary cushion between the producers and the consumers. In addition, the launch of currency derivatives in the economy also helped Indian corporates to stabilize earnings at a time when the financial crisis unfolded to impact their export prospects and their bottomlines. Overall, the Reserve Bank of India did its part to prevent the international contagion of financial crisis from spreading into the Indian Economy. At the same time, it also unveiled global best practices in economic management and liberalization putting the economy and its stakeholders on the path of progress. Though the financial crisis and the fragile recovery forced the Reserve Bank to bite the bullet, it had safely held itself away from all the temptations to adopt the traditional path of using monetary tools and currency rate management. This is in contrast to the US Fed Reserve which introduced structured products such as Collatarised Debt Obligations (CDO), Asset Backed Commercial paper (ABCP) etc eventually leading to the sub-prime mortgage crisis which lead to the global recession. What is the path ahead for India in terms of inflation management?

The very fact that, inflation management tools in the monetary side are an antidote to growth makes it cautious on the part of policy makers to manage the inflation risks better since these can always negatively impact the growth prospects of the economy as well. Growth is essential at this time of fragile global economic recovery, which is dependent largely on the growth of emerging nations including India. With prices being pushed to the ground during the onset of the financial crisis, prices had the potential to increase on recovery signals coming out of the developed economies in particular. In addition, natural disasters such as the earth quake and Tsunami in Japan, socio-political crises that have swept across the Middle East and North African region added to all the incentives for the market stakeholders to make commodities the costlier asset class in the wake of potential supply disruptions and the additional demand that would be generated in the global economy. The better way to manage these external forces where we are exposed to is to pass on the full effect to the stakeholders who will manage the same in a seamless manner without a significant pass on into the economy or the economic activity. In the case of domestic commodities, with policy rates at a high it makes sense for policy makers to focus on investment in long-term supply augmentation measures so that the supply deficiency can not be left to the evil forces of markets that have always tended to outweigh the real impact of such shortage. Strategic reserves to tide over supply shortages, investment in production capacities and productivity improvements, passing on the price impacts to consumers which would promote adjustments in consumption rather than administered prices which would augment the pent up inflationary pressures in the economy, are the best way to move ahead towards a more stable economy. While such measures may prove out to be politically unattractive, in the longterm these will prove more effective to keep our economy well insulated from forces of economic destabilization such as recession, volatile global markets, etc.

References : 1. www.investopedia.com

2. 3. 4. 5. 6.

www.rbi.org.in www.financialexpress.com www.icrier.org www.business.mapsofindia.com Blogs of various economists