Recent increase in inflation: No cause for alarm

China Business News

March 17, 2008

In recent months higher rates of inflation have been experienced by many countries. The rate of inflation has also increased in China, India and Russia. There are fundamentally three factors which are responsible for these higher rates of inflation in these countries. While some of these factors are common to other countries, some are specific to these countries. The three factors responsible for the acceleration in inflation are the relative decrease in the production of many important food crops, increases in the prices of many raw materials including oil and balance of payments surpluses.

The decline in the production of many food crops is because of weather conditions, decline in the use of fertilizers, the prices of most of which have increased phenomenally in recent times, and diversion of land to production of crops for bio-fuels. The increase in the price of fertilizers has not been restricted to oil based ones. Obviously, weather conditions will change. But there is no indication as yet as to whether the increase in the prices of fertilizers is a short term problem or is likely to persist for a number of years. The diversion of land to production of bio-fuels is likely to be long-lasting. The only long term solution to the problem of food output is technological change which raises land productivity. But there has been a slowdown in the spread of technological change in agriculture. International research in new technologies has slowed and more and more of the research is being conducted by private companies. The adoption of new technologies produced by the private sector is costly and therefore slow. Also, in many countries the extension service which would help in the dissemination of new technology has been allowed to deteriorate. Therefore, farmers now are very often dependent on seed or fertilizer sellers or agents of the companies for technical advice. This technical advice could be self-serving and often creates problems for farmers. For instance, cotton farmers in India did not have the proper advice for the adoption of the high yielding seeds and so used inappropriate methods. Also, the price of good quality seeds was very high, and the farmers bought spurious seeds at a lower price from unscrupulous sellers. So many farmers experienced very low outputs. A large number of such farmers committed suicide as they were not able to repay the loans they had taken.

High growth rates experienced by China and India have raised the demand for many raw materials. Chinese growth based on manufacturing has created more demand for raw materials than the Indian service sector based growth. In particular the construction boom in China as it built the infrastructure for the 2008 Olympic Games raised the price of many materials. Prices of cement and steel increased quite sharply in India, and it was claimed that this was due to the demand from China. But since now this demand is over, one should see some moderation in the demand for raw materials. A long decline in the prices of raw materials over almost three decades had resulted in very little investment in creating new production capacities of these raw materials. One can expect a supply response only after a lag, and till that time prices of raw materials are likely to remain high. While this may be bad for inflation in the short term it is likely to lead to a revival of economies in Africa. As it is many economies in Africa have experienced much higher rates of growth in recent years as compared to the decades of the eighties and nineties. The period 1953-1973 was a period of high rates of growth in the world economy and when commodity prices were relatively stable. African countries benefitted from the stable commodity prices and participated in the prosperity of that period. Recovery of the African economies is in the long-term interest of countries such as China, India and Russia.

The third factor, balance of payments surpluses, has been important in China, India and Russia. When a country experiences a surplus, it can either let the exchange rate appreciate or the central bank can intervene and purchase the currency being offered in the foreign exchange market. Appreciation of the currency reduces the rate of inflation as imports become cheaper. This is what India and Russia have done. For instance, the Indian rupee has appreciated almost 20 percent against the dollar over the last couple of years, though this exaggerates the extent of appreciation as other currencies have also appreciated vis-à-vis the dollar. This appreciation of the rupee has slowed down export growth and also overall growth, particularly of the manufacturing sector. China, on the other hand, has chosen to accumulate more dollars and its currency has appreciated much less. While China's export and growth performance has therefore been less affected than India's, it has experienced a higher increase in the rate of inflation than has India. Ultimately, whether the exchange rate appreciates or the country experiences a higher rate of inflation, its exports will lose competitiveness and will be adversely affected. When the currency appreciates the effect is more immediate. When the loss of competitiveness occurs because of inflation, the effect is postponed.

The sub-prime crisis which started in the US is going to slow the growth of the world economy. This will reduce the demand for raw materials and thus the increase in their prices. Some moderation in the rate of inflation and some slowing down of the rate of growth in the rapidly growing economies of China, India and Russia can then be expected. But this can only be a temporary reprieve. As soon as the world economy recovers or these rapidly growing economies adjust to the new circumstances the first two factors will again start to operate.

Policy makers in these economies should not be unduly alarmed at the increase in the rare of inflation. The increase still leaves rates of inflation lower than what these economies have sometimes experienced in the past, and the rates of inflation are in no way at an alarming level. Furthermore, the expected slowing down of the world economy would reduce the rate of inflation. Thus there is no need for these economies to use traditional monetary and fiscal policies to reduce the rate of inflation. Contractionary monetary and fiscal policies would reduce the rate of growth in these economies, a reduction that is not warranted. The Indian Government tightened monetary policy for a very brief period. At the moment there seems to be no inclination on the part of the Government to adopt restrictive policies.

A better way in which these countries can help the world economy reduce the rates of inflation would be to encourage investment in natural resource sectors. Russia could undertake such investment internally. China and India, which are relatively resource poor, could invest in natural resource industries in other countries. Both, but China much more than India, are beginning to do this. Such investment would help to increase the supply of raw materials which should reduce the increases in their prices. But there is an additional advantage to China and India. Such outward investment would reduce the balance of payments surplus. This would reduce the appreciation of the Indian rupee in one case and the increase in the money supply in the case of China. Such actions would thus arrest the deterioration in the competitive position of these economies which would otherwise occur. Such a policy is preferable to the use of contractionary monetary and fiscal policies. Such investment policies are also more beneficial to other economies, whereas adopting contractionary policies would only add to the slowing down of the world economy and prolong problems.

In the immediate future while inflationary pressures would remain there should be some moderation as the world economy slows down. In the longer the increase in the prices of raw materials will invoke a supply response which will moderate the price rise of raw materials. China, India and Russia can help this process of adjustment by investing in natural resource sectors either in their own countries or in other countries.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

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