There is the modern dictum about there being nothing like a free lunch. It?s a pretty old idea really, lying at the root of human ideas of morality ? either you pay the bill in the hereafter (in hell) or you are already paying the one for past sins (karma and re-incarnation). Homo sapiens latched on early to the idea that effects have causes and that there is a clear chronology in this; namely, action now causes effects later. In economics it?s called lagged effects, not moral science. So, it is a legitimate question to ask that since it is a tautological truth that the 8 per cent headline inflation of today was the outcome of causes rooted in the past, is it possible to identify whether it arose from global developments or specific domestic ones.
It might be tempting to draw the linkage between today?s headline inflation with the 8.2 per cent growth of last year. But that is plainly untenable ? take away the rebound of agriculture from the depths of the previous year, and what we have is the non-agricultural sector growing at a rate of 8 per cent, which is par for the course. After all, the economy, excluding agriculture, grew at an average rate of 7.4 per cent over the past 11 years. Furthermore, high wholesale price inflation began to show up in the beginning of 2003 ? one-and-a-half year back. So, we need to look at something else.
And that is not difficult to find. There are two sets of factors ? global and domestic. First, the global factors: Weak global demand and distress selling by steel plants in the former Soviet Union had kept steel prices soggy through the 90s. That, in turn, had led to significant capacity closure in the advanced economies and little new capacity being created anywhere else. Over the past few years, with surging deman-d in China making that country turn to the global markets and the run-down former Soviet plants unable to sustain distress selling, we have had a strong surge in steel prices. Cotton and edible oil prices have also experienced global recovery and, of course, India has 65 per cent import duty on edible oil and sugar?to protect the Indian farmer. However, prices of soybean and other oilseeds do not differ much in world and Indian markets, but edible oilprices of course diverge very considerably. One supposes that these tariffs do protect those who finance the farmers? elected representatives ? almost as good perhaps.
Then, of course, there is petroleum, which has had such a rollicking time, given that the geopolitics of the past four years has been virtually stuck in West Asian politics and violence. Some economic recovery in the advanced economies and strong growth in China has certainly made global demand strong ? but the short-term problem is on the supply side. Iraq produced some 2 million barrels per day (mbpd) till 2002, and can produce with minimal investments over 4 mbpd, and currently supplies less than 1 mpbd. What is 1 mpbd? About 2 per cent of world output, some 50 million tonnes and almost half of India?s annual consumption. Yukos, Russia?s largest producer, is broke and its future is up in the air. Bullets are still flying in Najaf and in case you hadn?t read about it, Iran?s defence minister Vice Admiral Ali Shamkhani has said that ?pre-emptive action? was nob-ody?s monopoly and that Iran would attack Israel?s Dimona nuclear reactor if Iran got the slightest inkling that their reactors were likely to be attacked, which news helped push crude up further. After all, the lesson of the very different fates of Kim Jong-Il of North Korea and Saddam Hussain is an obvious one to learn. And whoever knows what Pakistan?s nuclear-military establishment sold in their discount supermarket? Sorry, it was just the solitary Dr A Q Khan ? he even carried the centrifuges and the designs in his very own (no doubt kryptonite powered arms) ? while nobody was looking.
Then there are domestic factors too. And that is about the considerable liquidity that the Reserve Bank pumped into the system since 1999-2000. Almost all of the capital inflows into the economy were not sterilised. As the inflows became larger in 2001-02 ? partly in consequence of the current account turning positive ? the liquidity injections became larger and larger, aggregating some Rs 250,000 crore over the past five years. That?s high-powered reserve money that expands by a large multiple in the form of broad money. So as liquidity was awash in the markets, and private demand for credit remained subdued, the price of government bonds rose and their yields fell: from 11 per cent in January 2001 to 5 per cent by the end of 2003.
Thus, India, the original land of magic, saw one more awesome act. An economy with growth of close to 6 per cent, a fiscal deficit of 10 per cent, underlying inflation of 4 to 5 per cent, managed to have long-term yields that rivalled those in the advanced economies. But magic is transient, an illusion, and must yield to the natural laws of space and time. So, something had to give ? and it was prices (of goods) that did.
Did the excess liquidity creation of yesteryears generate growth? Perhaps, but not much. Private investment did not pick up much, and that perhaps was a good thing. As risk-averse banks parked their money in gilts and corporates focused on restructuring their balance sheets, the excess liquidity did not have the large effects in the private sector that it might have had. But it certainly did have some effect and that without doubt was manifest in the dramatic decline of interest rates, and the accommodation of high headline inflation.
The writer is economic advisor, ICRA Limited. The views are personal