| Inflation has reared its ugly head once again. From a low of 3.07% for the week ended October 13, 2007, wholesale price inflation (WPI) in India accelerated to a high of 7.41% for the week ended March 29, 2008, led primarily by high food prices. It moderated slightly to 7.14% for the week ended April 05, 2008. The rise has been particularly sharp over the last 4 months with inflation rising by 430 bps since the week ended Nov 24, 2007 when it came at 3.11%. The sharp rise can be attributed to rising food and commodity prices such as food grains, fruits, vegetables, edible oil, iron ore, steel, cement, etc. Whilst the inflation in food prices and commodities has been a global phenomenon, price rise in manufactured products such as steel and cement has partly been a result of higher input prices and partly due to inadequate supply to meet the demands of an economy growing at a robust pace. Rising oil prices have also put indirect upward pressure on prices of other products, even though the government has not hiked domestic fuel prices in tandem with global oil prices. Government had last hiked petrol and diesel prices by a meager Rs. 2 and Re. 1 per litre respectively, in mid-February this year, though the average price of India's crude basket rose from $65.54/bbl in April 07 to $92.37/bbl in Feb 08. Since then, the price of India's crude oil basket has risen further and presently rules at 102.15/bbl in April, 2008. POST MORTEM - What is the cause of the recent spike in inflation?
After peaking in Mar 07, inflation went down steadily till Oct 07 due to the statistical impact of a higher base. After stagnating for almost a month, it started moving up sharply since end Nov 07, led by sharp hikes in the prices of certain commodities. The table given on the next page shows the major constituents that contributed chiefly to the spike in WPI inflation since Nov 24, 2007 to Apr 05, 2008. Contrary to popular belief, primary food articles and cement did not play a major role in the recent spike in inflation. Rather, non-food articles (oil seeds), Minerals (metallic minerals), Coal, Minerals (Crude Oil), Food products (common salt, edible oils & oil cakes), Chemicals (both organic & inorganic) and basic metals & alloys (Iron & Steel and their products and alloys) were the chief contributories to it. Metals, right from primary metallic minerals to finished steel and steel products to other ferro alloys, have given the biggest thrust to inflation. Food and Non-food Articles
Primary articles comprise of food articles, non-food articles and minerals. Even though prices of food grains, vegetables and fruits have gone up the world over, they remained relatively muted in India over | 
| the period in question i.e. from Nov 24, 2007 to April 05, 2008. Prices of non-food articles such as oil seeds have been on a tear, rising 13.7% in the 4 month period. The reasons behind the spurt in global food grain prices have been the recent droughts in Australia, hailstorms in China, cold weather in Europe, etc. But the main cause is the diversion of arable land from producing food grains to bio-fuel producing crops such as corn, sugarcane, etc. The relentless surge in crude oil prices (crude oil prices rose from $66/bbl at the end of March 07 to $116/bbl at present, a rise of approx. 76% in the last 12 months) has forced countries to look for alternative sources of energy. Since, bio-fuels can be used in place of crude oil with relative ease, a number of countries dedicated huge tracts of arable land to crops such as corn and sugarcane. This led to a shortage of food grains and skyrocketing food prices in many parts of the world. Record breaking crude oil prices kept the demand for bio-fuels strong, pushing up the prices of corn, sugarcane, etc. despite increased production. In fact, prices of wheat, rice and soya bean almost doubled over the last 12 months, rising 102%, 139% and 81% respectively. Graph B shows that agricultural production in India has lagged behind the real economy and per capita income in terms of growth, over the last 7 years. Robust economic growth and the consequent rise in per capita income also brought about a change in consumption patterns as well as the overall consumption levels. However, with agricultural output failing to keep pace with the demand, there was a shortage of food grains which manifested itself in the form of high prices being faced today. Metals
Minerals and particularly metallic minerals have been the biggest driving force behind the recent rise in inflation. Robust global economic growth over the last 4-5 years has increased the demand for industrial commodities leading to a massive bull run in their prices. In fact, the CRB Index has risen by 36.4% since April 2007, a rise which was accentuated by a steep fall in the US dollar since the US sub-prime crisis broke out in July 2007. Growth has been particularly strong in emerging economies such as India and China which have seen an explosive rise in demand for metals, oil, etc. to sustain the high levels of growth and to build the requisite infrastructure. This led to a rise in prices of metals, both ferrous and non-ferrous, across the globe. Prices of metals and metallic minerals rose in India too, on the back of rising import costs. Iron and Steel have seen the most spectacular rise amongst all and the vociferous demand for steel both at home and from abroad (China) has led to a rise in prices of metallic minerals such as iron ore, too. Rising demand for energy and fast depleting reserves have also led to a surge in coal prices recently. Coal prices have risen globally, partly due to increased demand and partly due to floods in the coal mining regions of Australia and hailstorms and consequent transportation bottlenecks during the winter in China. In fact, coal prices are likely to double over the next 12 months or so. Impact - The dark side of inflation
While a low and steady rate of demand-fuelled inflation is healthy for an economy, being a sign of strong domestic consumption and propelling manufacturing growth, an overdose of it might cause irreparable damage to growth and stability in the economy. Rising prices are bad news for consumers and might force them to cut down discretionary expenditure. High inflation adversely impacts a country's economy as it reduces the purchasing power of people and can lead to social and political unrest particularly in developing economies like India and China. The recent spike in inflation becomes all the more dangerous as it is being led by a sharp rise in prices of primary articles, both food and non-food. People in emerging economies such as India, China, etc., particularly those in the lower income strata, spend more than 50% of their incomes on food. With rising food prices, their disposable incomes are likely to fall, forcing them to cut down their discretionary spending. This might lead to an overall decline in consumption of manufactured products, thus hurting economic growth. The poor, particularly those near to or below the poverty line, are affected more as they spend almost 80-90% of their incomes on food. This might force the government to adopt harsher measures such as sharp interest rate hikes, to bring down inflation even at the cost of sacrificing growth, in order to prevent an electoral backlash. Measures to counter inflation
Monetary measures
There are no short cuts to control the current spike in inflation. Raising interest rates, tightening money supply, etc. beyond a certain point, are bound to affect growth. Remember, inflation generally remains high for 3-6 months and starts moderating after that as fresh supplies hit the market and fresh capacities come on-stream. One simply cannot afford to let growth be affected in the whole process, as growth is hard to come by and once it slows, can take a long time and an enormous effort to bounce back. The recent hike in inflation has been due to supply side constraints both on the agricultural and manufacturing side. An environment conducive to facilitate investment in capacities needs to be created and availability of easy finance is the key to it. High interest rates and monetary tightening can lead to a fall in interest in investment due to high cost of funds and falling demand for goods. Moreover, demand for food is not price elastic. People will have food, no matter how much costlier it gets. Rather they will cut down on discretionary expenditure thereby affecting the fortunes of other industries. Fiscal measures
Though fiscal measures are better than monetary tightening measures, they are unlikely to have a lasting impact on inflation, particularly in a scenario when prices are rising across the globe. In the long run, some of the drastic fiscal steps/policies might adversely impact a sector and cause irreparable damage to its fortunes in the medium term. This might affect growth in the long run. Fiscal measures are best used in small and quick doses for a limited period of time as they can be easily reversed. Hence, measures such as cut in import duties, hike in export duties, etc. can be very effective in certain cases. However, the present dilemma is that global prices of most of the commodities are even higher than their prevailing domestic prices and hence imports are not likely to help much. The need of the hour is long term, goal oriented steps from the government to improve infrastructure, both agricultural and industrial. The present shortage of food is a result of years of neglect of agricultural infrastructure, massive underinvestment and lack of proper land reforms along with use of obsolete technology. Focused investment is needed in sectors such as road infrastructure, irrigation, agricultural equipments and agri-implements such as high quality seeds, fertilizers and pesticides to improve the lot of agriculture. Graph C, shows a decline in the production of oilseeds since 2005-06 which has led to the present run-up in prices. The production of pulses had similarly fallen during the period 2002-03 to 2004-05 and the lost ground was not regained till 2006-07, thus leading to high prices even now. A close scrutiny of sugarcane production shows that it had fallen in 2002-03 and 2003-04, leading to a bull run in sugar prices. Agri-commodities are inherently cyclical in nature. Hence, it is likely that the production of oil seeds and pulses goes up in the near future, latest by 2008-09, if not in 2007-08. This should increase supply and hence soften prices going ahead. Last, but not the least, there should be a serious clampdown on black marketers and hoarders as was done recently in Delhi. A fast, efficient and effective public distribution system is also an important step in improving the food situation in India. As regards metals, crude oil and coal, there is not much that can be done other than ramping up domestic production capacities and securing the raw materials by entering into strategic tie-ups or owning the raw material resources located abroad. Moreover, it is clear that a bubble is being formed in commodities. This bubble is likely to burst soon as slowing global growth slackens the demand for commodities going ahead. A ban on futures trading in agri-products is definitely not going to help as there is no statistical evidence of it leading to a rise in prices. Trading in Exchange futures of food grains in India has been stopped since the last year. However, that did not preventprices from rising over the last few months! Investment Strategies in the current inflationary environment
Despite all the arguments against it, monetary tightening and interest rate hikes are bound to take place as this is the easiest way of expressing one's frustration against inflation. Hence one would do well to stay away from interest rate sensitive sectors such as banks, real estate, automobiles and consumer durables till the time inflation expectations moderate. Also, sectors such as edible oils, iron ore, coal, steel, cement, etc. are in the limelight for the recent surge in prices. They might be subjected to harsh regulatory measures and increased government intervention which can adversely affect their medium term prospects. Investors would do well to stay from such sectors too. The other strategies are as follows: 1. Avoid long term debt. 2. Invest in call and money markets through liquid funds. Fixed Maturity Plans are also attractive as short term rates are expected to rise following the recent hike in bank CRR by RBI. 3. Avoid commodity stocks particularly metal stocks. 4. Invest in sectors that are less capital intensive and have huge cash surplus or cash flows for e.g. IT, FMCG, etc. - Invest in sectors that are price in-elastic such as pharmaceuticals, healthcare, etc. (The author is Senior Manager - Research, BCCIR.)
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