Stuck On Slow

INFLATION has fallen. But that's no reason to pop the champagne corks. Rather, start worrying: for, low inflation means low demand, low sales, low employment opportunities. Ironically, the government announced this low rate with aplomb. For the week ending November 1, 1997, inflation stood at 3.23 per cent.

Economists have always contested the government's method of calculating inflation which takes into account the wholesale price index (WPI) related data. Reason: the government controls the wholesale prices of 60 per cent of the basket of commodities—like petroleum products and foodgrains—considered for measuring inflation. It can, if it wants, clamp down on these prices and keep the WPI down.

But by the time many of these goods reach the average consumer, their prices are far higher than the government-administered price. For instance, anyone not buying his rice or atta from a ration shop pays a higher retail price than the government-prescribed one. According to economists, the proper method is to take into account consumer price index statistics—this gives a realistic picture of inflation and the economy. So, inflation calculated on the basis of the consumer price index of industrial workers and agricultural workers may be a far better measure of ground realities for urban and rural India respectively. Of course, consumer price index-based inflation has also fallen.

That, however, may not be cause for joy either. Reason: inflation rate is dependent upon demand. And the major force pushing demand is government spending. Given the poor state of government coffers, that's fallen. This fall has come about more in Plan expenditure—the money the State spends on investment projects like roads which have a multiplier effect on the economy.

Take a 100 km stretch of road, for instance. At Rs 3.6 crore per km, the cost of making the road would work out to Rs 360 crore. Once the road is built, the land around it could turn into industrial townships. With the road in place, the problem of moving goods from these plant to the market goes. Maybe, a handful of tourist resorts come up. And so on. Thus, an investment of Rs 360 crore on that road could bring in more than 10 times that much from private entrepreneurs, generating goods—and jobs.

But with a cut in Plan expenditure, none of this happens. On the contrary, the industry cuts production: if the government is not building a bridge, where will industries like steel or cement sell their goods? So, a cut in government spending leads to low industrial growth. D.H. Pai Panandikar, economist and advisor to the RPG group, feels that at the root of the lack of demand is the lack of spending from the government. "The lack of demand is stemming from a depressed sentiment in the feeder industries for the core sector, i.e. steel and cement. This is having a cascading impact on a number of related industries. All this can be checked if the government increases its spending as it has been promising to do."

On its part, the government has its hands tied. While it has to balance the fundamentals of the economy, it has little choice in the matter of expenditure planning. Today, a very high percentage—38 to 40 per cent—of the government's spending goes towards debt and interest servicing. A high percentage of the remainder finances essential social sector spending. This leaves little room for planning developmental expenditure to manipulate economic peripherals. As a result, demand gets further subdued, bringing down the general inflation level though the price level remains more or less stable.

"This," says Suresh Nanda, vice-president, ICICI Bank, "is a dangerous trend and needs to be corrected before the situation becomes unmanageable with extremely low inflation rates without supporting peripherals." Consider this: Two years ago, Japan, one of India's developed Asian neighbours, registered a zero rate of inflation and landed itself in a negative growth path.

"A low rate of inflation combined with a robust industrial growth and a good demand and supply situation is an ideal state of affairs. But this is not our case," says Dr Shashanka Bhide, chief economist with the National Council for Applied Economic Research (NCAER). He too is blaming low demand. "The lack of growth of demand appears to be the major factor keeping inflation low," he says.

In his view, the overall demand pressures are unnaturally low as a result of significant fall in investment demand and export demand has come down due to international recessionary conditions. As globalisation hit one country after another, international competition pushed prices down. All countries wanted to export. This resulted in surplus capacity the world over. India, China, Latin America, Eastern Europe—all of which hit the international market in the last five years—are now looking at the same market. There is, thus, a typically-market situation, where there are many goods and no buyers.

THE fall in demand, says Bhide, is not a very healthy sign and will result in the economy recording a low growth for the year. Against a growth rate of 11.2 per cent during April to August 1996, the Indian industry has seen this figure fall by 6.5 percentage points to 4.7 per cent this year. Says Panandikar: "The growth in the industry has been patchy. Automobiles and white goods have done particularly bad."

 Low inflation in itself is not bad. After all, who wants the prices of goods to rise? Not consumers who buy the goods retail. Not businesses who buy from one another. It is the lack of accompanying factors that's truly worrying. Take interest rates. True that they've fallen by a couple of percentage points: the prime lending rate (PLR)—at which banks lend to blue chip companies—stands at 13.5 per cent. But real interest rates adjusted for inflation remain high.

Last year, when the PLR stood at around 15 per cent, inflation was 10 per cent. Thus the real interest rate then was 5 per cent. Today, though the PLR is down, the fall in inflation rate has been far sharper. The real interest rate—and, therefore, the cost of money to a businessman—works out to 10.3 per cent. The ideal rate should be between 6 and 7 per cent. Taking the upper limit, either the PLR has to come down to 10.2 per cent, or inflation should rise to 6.5 per cent. Or something in between the two. As things stand, with the real interest rate high, entrepreneurs are not setting up new projects.

"For a developing country like India which needs to grow at around 6 to 7 per cent, a low inflation of 3.2 per cent without supporting factors, is unrealistic," says Nanda. According to Nanda, the low rate of inflation was not accompanied by other essential factors like an active demand-supply scenario and low interest rates which induce borrowing thereby encouraging industrial activity. "Today, no one is prepared to take investment decisions or take commercial risks. Banks are not ready to lend to any company which does not have a AAA or A+ rating," he says. And probably these companies do not need to borrow.

Adds Bhide: "Real interest rates which should have normally come down with the  decline in inflation, are still  higher in India than in other countries who have higher inflation rates and lower interest rates." So we have a paradoxical situation: banks are flush with funds, but the rate at which they want to lend finds them with no takers. Panandikar is a shade harsher: "It is quite ironical that the RBI which was earlier justifying high interest rates on the plea of high inflation, is not trying to justify the low inflation by bringing down interest rates, despite taking credit for this decline in inflation."

The high real interest rates, however, are not on their way down. According to Nanda, real interest rates, will continue to be high until there is a proper integration of the monetary market. "Due to imperfection in flow of funds into India, we are still considered a high-risk country. Till this impression is corrected, there is little chance more funds will flow in and interest rates will be brought down." Besides, some economists question the very composition of the basket used by the government to measure infla-tion. For one, it is skewed towards goods, at the cost of services which comprise a third of India's GDP. At another level, the commodities themselves are outdated. Phones and computers have become more relevant while calculating inflation today. Had these been included in the calculation of WPI, inflation rate would have been even lower.

However, most economists and industrialists predict a revival in the second half of the current fiscal and say that demand will improve towards the end of the current financial year. NCAER itself has predicted in a survey that the second half of the year will see inflation bouncing back to around 6 to 7 per cent as a result of improvement in industrial performance and demand.

Today, the economy is slowly spiralling towards a full circle: inflation is low, but interest rates are high; banks have money, but there are no takers. "The bottomline is a lack of demand that's forcing industry to postpone investments, says Panandikar.

While the government is patting its own back for recording low inflation figures, in the absence of demand and proper industrial activity, it might prove to be counterproductive. And if immediate steps are not taken to increase government spending, thereby increasing industrial activity and inducing demand, finance minister P. Chidambaram's dream of achieving a 6 per cent growth might just remain a pipe dream.