South Asia struggles to control inflation

Business Times - 02 Apr 2008

South Asia struggles to control inflation

Countries in the region are using various methods to check rising prices - well aware of the consequences if they fail

By M SHAHIDUL ISLAM

AFTER enjoying low inflation for more than one-and-a-half decades, many countries are now faced with exorbitant price hikes in fuel and non-fuel commodities. Since early 2007, oil and many agricultural commodities have been witnessing abrupt price increases.

In much of South Asia, the hikes have exposed the vulnerability of the low- and middle-income groups as well as government exchequers. Inflation has surged in many of the South Asian countries due to low per capita domestic production; the central bank's lax monetary policies or lagged effects of earlier monetary expansion; undervalued exchange rate policies (in economies other than India); and internal political instability. According to the Economist Intelligence Unit (EIU), the consumer price index (CPI) inflation in Sri Lanka was 17.5 per cent in 2007, followed by Bangladesh (9.1 per cent), Pakistan (7.6 per cent) and India (6.4 per cent).

For the South Asian countries, the challenges of inflation are two- pronged.

Firstly, galloping inflation could significantly destabilise key macro- economic variables, including GDP growth. Higher oil import bills that most economies in the region absorb through subsidies could further swell their fiscal deficits.

Regressive tax

Secondly, price volatility poses political dangers. South Asia has the largest number of poor people in the world and the poor spend a relatively high proportion of their income - up to 80 per cent - on food.

Rising food prices are thus effectively a regressive tax. If the past is any guide, price volatilities of South Asian staples like rice and wheat could result in political instability in the region.

India is relatively less vulnerable to the current inflationary shock, thanks largely to its higher domestic agricultural production capacity and the recent appreciation in its currency. Nevertheless, in his 2007-08 Union Budget speech, Finance Minister P Chidambaram acknowledged pressure on domestic prices of food articles in India. He contended that, 'managing the supply side of food articles will be the most crucial task in the ensuing year and keeping inflation under check is one of the cornerstones of our policy'. In India, inflation based on the wholesale price index soared to a 12-month high of 5.92 per cent on March 8, which is above the 5 per cent limit set by the Reserve Bank of India (RBI) for this fiscal year.

The other major economies in the region (Pakistan, Bangladesh and Sri Lanka) - which are largely dependent on international markets for fuel and, to a lesser extent, non-fuel commodities - have been facing much more daunting challenges than India to contain inflation. The point-to-point inflation in these three countries is now double-digit. According to the Central Bank of Sri Lanka, the New Colombo CPI reached 21.6 per cent in February. In Bangladesh, the central Bangladesh Bank reported that inflation was 11.43 per cent on a point-to- point basis in January whereas food inflation hit 14.2 per cent in the same period. In Pakistan, the year-on-year consumer price inflation reached 11.3 per cent in February while food inflation was 18.3 per cent - the fifth consecutive month of double-digit increase, according to the EIU.

Furthermore, inflation in India, Pakistan, Bangladesh and, to some extent, Sri Lanka could have been far worse had their exchequers not absorbed a substantial portion of the oil import bills via subsidies. Only Sri Lanka has revised its administered energy prices upwards in several stages since 2000. As a result, the oil price hike has had a direct impact on the economy's CPI inflation. Fiscal deficits in Pakistan and Bangladesh are swelling due to oil subsidies. In India, however, the petroleum subsidy is an off-budget item and it does not affect the government's fiscal book.

The price hike of fuel and non-fuel commodities in international markets is widely blamed for the current inflation in South Asia. Secondly, the monetary expansion or the lagged effects of higher-than-programmed money and credit growth during the fiscal year 2007 and excess liquidity have also played a part in raising prices in the region. Thirdly, imported inflation in Sri Lanka, Pakistan and Bangladesh has soared as their domestic currencies have weakened in recent years.

The nominal effective exchange rate (NEER) and the real effective exchange rate (REER), except for the Indian rupee, have been moving in opposite directions. Generally, NEER and REER move quite closely together, except in high inflationary environments. If the nominal exchange rate does not sufficiently appreciate, real exchange rate adjustment only happens through the increase in the price level over time, relative to trading partners. The Chinese economy also experienced a similar situation recently until the yuan was allowed to appreciate.

Furthermore, the supply side of the commodity market has been disrupted by internal political unrest and emergency rule in Bangladesh and Pakistan. The former also faced two major natural disasters in 2007 which damaged standing crops, among others. In Sri Lanka, ethnic conflict exacerbated inflation. To compound these problems, the growth of the agriculture sector in many parts of South Asia in recent years has been sluggish.

If the US dollar continues to slide, oil prices remain high, strong demand for commodities persists and more and more oil-seeds and staples channel towards bio-fuel production, the South Asian economies may witness even higher inflation in the coming months.

India's inflation is still at a tolerable level. Moreover, the country is expecting a record harvest in 2008. To avoid food inflation, the authorities have banned exports of several commodities and fixed higher prices for exportable agriculture produce. Nevertheless, the potential risk of price hikes in the economy may arise from three avenues.

First, foreign portfolio investors' increasing appetite for the Indian market will continue to put upward pressure on the rupee. If capital inflows are not fully sterilised, the economy will have excess liquidity that can induce inflation. The cuts by the US Federal Reserve to deal with the sub-prime crisis have put pressure on the RBI to revise its key interest rates downward. However, the dilemma for the RBI is that lowering interest rates will fuel inflation.

Secondly, roughly 10 million public sector employees in India are likely to get a 50 per cent pay rise this year. If wages go up, prices are also set to increase.

Thirdly, the country is preparing for a parliamentary election early next year. Government expenditures tend to increase in election years, adding to inflation.

If all these issues are left unchecked, India's inflation may surpass the RBI's expectations in the coming months.

Currency appreciation

Most emerging market economies are now fighting inflation either by appreciating their currencies or hiking policy rates or both, depending on the macro-economic conditions. In India, currency appreciation continues to be used as a major instrument to contain imported inflation, though a widening current account deficit is a concern for the policy makers. Nevertheless, as most of India's competitors, including China, are now appreciating their currencies to contain inflation, competitiveness concerns for India are less pressing.

Despite the latest Fed rate cut, the RBI may increase its key policy rates slightly. In an election year, the current United Progressive Alliance government may prefer to check inflation even if this would slow down India's economic growth slightly, by containing credit and money supply growth.

Bangladesh can afford to keep its currency slightly stronger, thanks to its favourable current account position. The Bangladesh Bank has already tightened the broad money supply and credit growth. The monetary policy should be more contractionary even if it affects the country's economic growth. Sri Lanka and Pakistan have to rely on interest rate hikes, as the current account deficits in these economies have been widening.

Fiscal policy tools, including reductions in import and excise duties, could be applied to contain imported inflation. Indeed, such tools have been applied in Bangladesh. Lately, import duties on a number of essential commodities (in particular, edible oil) have been reduced in India. Sri Lanka had earlier reduced import duties but later re-imposed them because the revenues generated were too important to forgo, even temporarily.

Apart from fiscal and monetary measures, it is important for the South Asian countries to address domestic supply-side bottlenecks to enable international prices to converge with domestic prices.

The writer is a research associate at the Institute of South Asian Studies, an autonomous research institute within the National University of Singapore.

Singapore Real Estate and Property updates

EastLiving.com.sg
Contact
Stuart Chng: (65) 9691 9907

stuart.chng@eastliving.com.sg

EastLiving - Singapore Property and Real Estate DB