Many businesses may believe that inflation may not be a bad thing as long as they can pass on the cost increases to their customers as price increases. And these businesses are not wrong as inflation does have beneficial effects. Company revenues increase not only in nominal terms but also in real terms. This can result in a positive effect on wages and employment, which can lead to further demand and more economic growth. For governments with unsustainable debt overhang, it can lower the real burden of servicing debt. However, any benefit from persistent high inflation is an illusion, and, in fact, has serious negative impact on businesses. It retards productivity growth as managerial decisions fall prey to the so called money illusion (for a more detailed discussion of the topic, please read the Boston Consulting Group white paper, Why Companies Should Prepare for Inflation, November 2010) or the tendency to mistake price increase for real gains. Because managers believe they are doing better than they actually are, they become complacent and do not take a hard look at their businesses. Inflation also encourages underinvestment and distorts allocation of resources as depreciation allowances, based on historical costs, prove inadequate.
BCG research shows that despite initial positive economic effects of inflation, total shareholder returns (TSRs), which combine share price appreciation and dividends, are typically disappointing, particularly when measured in real terms. Also, companies that destroy more value relative to their peers during inflationary period are much less likely to catch up and compensate their shareholders when inflation falls.
Thus, inflation creates losersand winners of those who manage its risks well. Inflation can change the rules of the game by establishing new sources of competitive advantagefrom advanced pricing and sourcing strategies to superior asset productivity. When hit by inflation, companies with the highest capital can end up as big losers as they are unable to generate additional inflationary cash for their high asset-intensity businesses or to replace old assets and end up making sub-optimal capital allocation and investment decisions. The sure winners are those companies that increase price faster than rate of inflation to provide for not just cost increases, but also increased valuation of assets and thus protect gross margins from erosion by inflation.
It was just a little over 24 months ago that the country was patting itself on the back, having come out strongly from the economic crisis of 2008 that had severely crippled the economies of many developed countries. Inflation was negligible and the country was looking forward to accelerating GDP growth towards double digits. Within 6 months, the economy hit the inflation bump, with the headline (WPI) inflation rate going over the 9% mark. Twenty months later, despite several rate hikes by RBI, we see no respite. No wonder Subbarao was forced to make his comment. For Indian businesses, this raises a fundamental strategic question: When will the inflation moderate, and how aggressively should they react to it
Many experts believe that we are in for a period of sustained inflation
due to an unprecedented combination of global and local conditions. Clearly, India faces major supply-side issues that are driving inflation, particularly non-food manufacturing inflation, which has remained high even as food inflation has
moderated somewhat in recent weeks. This is unlikely to change in the near term, unless the slowing investment cycle reverses itself and global commodity prices fall significantly. Crude oil prices are, of course, a fly in the ointment, and can have a dramatic effect up or down on headline inflation.
This only strengthens the case for Indian companies to make their business models inflation proof. To do so, they have to adopt a four-step programme. The first step is to assess the risks, and develop a detailed understanding of potential exposure to different inflation scenarios and identify the specific areas of weakness, which may vary from business to business or one product to another. The second step is to know the real costs and pricesand avoid money illusion mentioned earlier. Companies should closely track inflation-adjusted financial indicators that track the real performance of their businesses. The third step is to protect gross margins. The key to this is superior pricing strategies and processes, which could range from creative contract design to pass inflation risks to customers, eliminating price leakages, reacting quickly and frequently to raw material price increases and reducing price sensitivity of customers by unbundling products and services, etc. The fourth and final step to become an inflation winner is to safeguard investments, which is particularly relevant for high capex companies. This calls for adopting a conservative financial policy of low leverage, increase asset productivity and carefully prioritise planned investments.
The last time Indian companies faced inflation rates close to current levels for a prolonged period of time was 20 years ago. Very few of the leaders who had navigated through that period remain at the helm of their companies. If inflation is going to become a given in the medium term in India, todays business leaders have to learn not just to live with it, but how to win in the market place. As Bruce Henderson, the founder of BCG, said in one of his essays, while the negative impact of inflation is quite clear with real profits being squeezed despite higher profitability, it also offers unique opportunity to differentiate ones performance. The winners are those who will find the way to profit from inflation!
The author is managing director, the Boston Consulting Group, India