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Inflation in India - The failure to control black money

Mumbai, Thu, 17 Nov 2011 ANI

Mumbai, Nov.17 (ANI): November reports indicate that inflation has exceeded nine percent for eleven months straight and the appreciating dollar is probably adding, and will be continue to add, to the nation's woes.


The Reserve Bank of India (RBI) has been actively raising interest rates (13 times since March 2010) and their efforts seem to be for nought. Just last month, the RBI signaled that it is looking to end its monetary tightening but it looks like it will be forced to re-evaluate its position if inflation stands at its current exorbitant levels.


The issue is that by increasing interest rates, all that the RBI has succeeded in doing is to slow down the output of goods and services while not necessarily driving demand down.


The increasing cost of debt is actually causing companies to shelve their expansion plans and this in turn is resulting in FIIs selling their stakes and repatriating their money abroad. Of course, this puts pressure on the rupee and pushes up the cost of imports.


The fact is that any further tightening is almost certain to lead India into the slippery slopes of a vicious stagflation cycle that would be very hard to break.


It is important for us to note that inflation, while a function of growth, is actually caused by money supply growing faster than the rate of economic growth. In essence, Inflation is directly correlated to more cash flowing in the system than required to maintain market equilibrium. It is understood that in developing economies like ours, money supply grows faster than economic growth but the reality is that the RBI has greatly slowed down the growth of money supply in the last year.


India's M3 money supply growth slowed to 14.4 percent as of Oct. 21, against 17.1 percent same time last year and year-on-year reserve money growth stood at 11 percent as of Oct. 28 against 25.1 percent the same time last year. Even currency in circulation dropped to 15.8 percent against 18.6 percent last year.


While the drop in money supply is disproportionately greater than the slowdown in our economy, inflation is yet to show any signs of abating. The RBI and we need to realize that the inflationary pressures that we are dealing with are not being caused by this money supply but in fact by a whole other parallel system.


Historic precedent indicates that Interest rate hikes have successfully reduced inflation as they make money expensive to borrow and profitable to save. The RBI has been acting essentially on this principle but today's inflation has no historic precedent in terms of the mechanics at play. Besides what is documented, money supply is being heavily impacted by freely flowing black money that is estimated to be anywhere between 70 - 200 lakh crores (besides the 1.4 Trillion USD estimated to be sitting in Swiss Banks).


While the numbers are wild estimates at best and may vary greatly in reality, the fact remains that there is an obscenely large amount of undocumented cash in circulation. Over the last 10 years or so, there has been a visible shift in the movement pattern of black money and it is now being used to acquire assets or international currency rather than being sat on.


A lot of black money was being funneled out of India and it actually kept money supply in control but nowadays, this money is reentering the Indian market via the assistance of financial managers who aim to provide annual returns of between 10 percent - 20 percent. We need to note that it is only common sense to reinvest this money in a market like India, via assets like stocks, bonds, and even real estate rather than let it accrue interest at a paltry one to two percent a year in Switzerland.


As an example, let us consider the real estate market which is one of the favorite destinations for undocumented black money. We know that real estate prices have sky rocketed in India and a decent flat in Mumbai costs nothing less than a mostly unaffordable 1.5 crores. It is no secret that real estate developers routinely ask for 30 percent - 40 percent payment in black and investors when reselling these properties follow the same pattern.


These are large chunks of wealth that are changing hands with no paper trail whatsoever and they quickly go back into the market as it makes no sense to lock them up in a cupboard. A great validation for this pattern can be seen in the fact that while hikes in interest rates have adversely impacted other industries like the auto sector, real estate is still booming and there seems to be virtually no indication of a foreseeable slow down. Based on the government's colossal failure in arresting real estate prices, we can conclude that no amount of monetary tightening is going to pull this money out of circulation.


The Indian economy is now suffering more from the lack of supply than from excess demand. Consider the fact that farmers are now selling off their agricultural land due to declining returns because the cost of cultivation, especially wages, is rising faster than their sale prices. Buyers of this land are investors who are betting on the scarcity created by tough land acquisition and land usage laws and not on higher profits from farming.


Consider the recent case of the Awachat family demanding reliance for 1.6 crore per acre of their rural farm land near Nagpur. 1.6 crore per acre for a 11.5 acre plot that generates only five lakhs in revenues a year sounds ridiculous to any business professional and when we consider the fact that the original rate paid to other farmers was 25 lakhs an acre, this starts to border on the absurd.


But, this one piece of land cuts through reliance's planned coal supply line for its 600 MW plant and this is the perfect ransom opportunity for a farmer to essentially retire with a 16 plus crore bounty.


While at first glance, this appears to be a case of the small man standing up to big corporate, the reality is that such unreasonable demands exist simply because there is considerable precedent of over inflated real estate transactions. Not only are we paying for this via electricity bill hikes, but we also lose the farmer (however greedy) himself. Lesser farmers, lesser land, lesser food, 20% plus food inflation is the current state of affairs and there is simply no policy aimed at correcting this situation.


The reality is that it is time to mandate some severe policy changes aimed at boosting supply and arresting the free flow of black money. Interest rate hikes now need to be accompanied by reduction in taxes and investment regulations. Cash transactions need to be banned above a set value (say 10,000) and for starters, organized retail should be forced to implement the same.


The government needs to crack down on hoarders of perishable commodities (however minimally successful) like it during the recent onion crisis. Wastage and spoilage of perishable goods needs to be arrested through cold storage and an efficient farm gate to market system like in the case of dairy cooperatives.


We need to open up the agricultural sector to organized players and we need land reforms to address land fragmentation and low agricultural productivity. The RBI may even need to demonetize currencies of higher denominations like it did in 1946 and in 1976 and essentially wipe out a large chunk of notes that have been hoarded in black.


A move so radical will certainly be a shock to the system and possibly put quite a few businessmen and politicians out of business but it just might be the exact shock that our economy needs at this moment. The reality is that the value of money is being destroyed through insufficient and inefficient monetary policy and in essence this is eroding the trust that we have in our hard earned money. While the government simply can't give us more money, it needs to pull its pants up and at least try to live up to our expectations of getting value for what we pay. By Madhu Varshitt (ANI)


Read More: Nagpur | Bank | Inflation

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