Inflation: Can They Kill the Beast?

By Priya Nigam

The Earth seems to be burning up with the heat of inflation. High inflation is a global phenomenon, with world food prices skyrocketing 40% last year. Commodity prices have also soared. And India has not been spared. With the spiraling prices of grains, oils and metals, India's headline inflation jumped to 7.41% in late March, hitting a four-year high. Against this backdrop, the government’s attempts at duty cuts on imported products and export bans appear rather feeble. So, we are now faced with the possibility of the government resorting to more aggressive measures to cool inflation. What’s next in store?

Finance Minister Mr. P. Chidambaram warned that the government may have to undertake fiscal, monetary and supply-side measures to stem the rising prices. The Finance Minister urged individual states to take stringent steps to curb the hoarding of food items. Moreover, Mr. Chidambaram accused cement and steel manufacturers of “behaving like a cartel,” adding that the government “will not hesitate to take tough measures” to break the cartel. The Finance Minister also stated that it would consider sacrificing revenue to control prices. The stock market is already showing signs of worries over what the government will do to contain inflation.

There is widespread speculation of the RBI announcing another hike in the cash reserve ratio (CRR) at its upcoming policy meeting on April 29. The central bank, which was targeting inflation at near 5% for the fiscal year ended March 31, 2008, had raised the CRR by 50 basis points each time in June and October last year. The CRR, which is currently at 7.5%, is the percentage of deposits that banks have to maintain with the RBI. An increase in this ratio curbs liquidity, which in turn curtails inflation. The other weapon in the hands of the central bank is the short-term benchmark rates, which may be hiked to control inflation. A combination of the two tools is also a possibility.

The government should act fast. Having said that, I thought it prudent to add that there isn’t a great deal that the government can do. Inflation or prices are impacted by demand and supply. While demand can be controlled in various ways, the demand side does not seem to be the core of the problem. And there is not much that can be done to immediately increase supply. There is no easy solution. Amidst all this, what is clear, however, is that India's economic growth would bear the brunt of any measure to contain inflation.

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The India Street opinion on how to combat inflation

By Vipin Agnihotri

In my opinion, a penny saved does not necessarily mean penny earned. This is because of the simple reason that inflation eats away the value of every rupee earned. Even worse, it is quite tough to forecast inflation.

No one will argue with the fact that the bull run on the bourses has been unprecedented, yet there exists a vast majority of risk averse investors who are interested in playing safe and opt for assured return schemes. This very class of investors is more exposed to the menace of inflation.

Taking this into account, bulletproofing one’s portfolio against the threat of inflation necessitates the need to come up with a portfolio that includes some inflation hedged investments. This in turn will make sure that you get sufficient returns even after factoring in high rates of inflation.

It is worth mentioning in this regard that inflation indexed bonds give you return at a fixed rate, and yet incorporate the ability to combat inflation. Interestingly, such kinds of bonds were allowed by Reserve Bank of India way back in 2004.

According to experts, Reserve Bank of India’s proposal in 2004 would have benefited investors who desire predictable real cash flows despite inflationary pressures, but such instruments never caught on. There is a buzz in the market regarding the possibility of similar capital indexed bonds being reintroduced.

Initial signs are that even infrastructure companies are looking at the bond route to meet their big financing requirements. On the other hand, for households and individuals such bonds hold the key to bridging the gap between risk and return over the long term.

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Inflation and innovations in the financial markets of India

By Vipin Agnihotri

Inflation reduces the purchasing power of money. For example, if the rate of inflation is say 10 percent per annum, the purchasing power of money declines by 10 percent per annum. In such a situation, an income increase of 10 percent per annum is needed to protect investors real income.

Likewise, if the rate of inflation is 10 percent per annum, the rate of return on investment must be at least 10 percent per year to avoid erosion in real wealth. To earn a positive real rate of return in a situation like this, the nominal rate of return must be greater than the inflation rate, namely 10 percent.

The question now arises: What innovations have occurred in financial markets in response to inflation? The following have been the important inflation-induced innovations in financial markets:

• Flexible interest rates

• Lender’s participation in equity

• Financial futures

Traditionally, lenders have offered fixed-interest loans to investors. Under this arrangement, when unanticipated inflation occurs and interest rates increase in response to it, lenders suffers and investors gain. To cope with this, lenders can opt for flexible interest rate home mortgages with interest rates based on some index of cost of funds. In addition, adjustable interest rates are also found in many kinds of debt contracts.

As compensation for bearing inflation risk, lenders may seek participation in equity. This essentially implies that lenders partake in increases (or decreases) in the value of assets financed by them. The most common type of such participation is the Shared Appreciation Mortgage (SAM) found in real estate financing.

In a typical SAM the interest rate is one-third lower than the prevailing standard mortgage loan. In return for this sacrifice, the lender gets one-third of the appreciation in the real estate when it is sold-in some arrangements, the lender can collect its share of appreciation after a certain period, even though the property may not be sold.

An agreement between two parties to exchange an asset for cash at a pre-determined future date for a price that is specified today is referred to as a futures contract. A financial futures contract represents a futures contract for financial assets like currencies, treasury bills, bonds and commercial papers. Financial futures may be used to speculate on changes in security prices caused largely by changes in interest rates.

Inflation has been a persistent feature of the Indian economy. Hence, it should be properly considered in capital investment appraisal. In practice, however, adjustment for inflation is rarely, if ever, made. The use of current price structure is deemed satisfactory and the reasoning offered runs as follows:

Inflation is expected to raise the revenues and costs of the project in a similar fashion. Hence, net revenues after adjustment for inflation would be equal to net revenues in current terms. The above argument, however, overlooks the following considerations, which cause distortion:

• The depreciation charge is based on historical costs and hence the tax advantage arising from depreciation charge does not keep pace with inflation.

• The cost of capital used for investment appraisal contains a premium for anticipated inflation.

It’s Crucial to Value Assets by its Replacement Value in India

By Vipin Agnihotri

In an inflationary period, the book values of assets, typically reflecting historical cost less accumulated depreciation, do not reflect their true values. Hence, in my opinion it is worthwhile to consider revaluation of assets periodically so that the asset values shown in the balance sheet reflect economic reality more accurately.

Revaluation of assets is undertaken with one or more of the following objectives in mind:

• To attract investors by indicating to them the current value of assets

• To make depreciation provision which will enable the firm to meet replacement needs adequately

• To provide a more reasonable and accurate perspective regarding the true worth of assets in the event of a possible takeover or merger.

• To help management in assessing the true profitability of different divisions and formulating a more sensible dividend policy

• To enhance the borrowing capacity of the firm

It may be noted that irrespective of the objective sought by a firm from the revaluation study, an important advantage of such an exercise is that the capital asset records of the company are streamlined.

For purposes of valuing assets, the following concept, championed eloquently by JC Bronbright is widely followed:

“The value of a property (or asset) to its owner should be identical to the loss, direct and indirect, the owner might expect to suffer if he is deprived of the property (or asset)”.

This concept appears to be the obverse of the economic concept of opportunity cost according to which the cost of an action is “the gain foregone by sacrificing the best possible alternative course of action in order to adopt the proposed course of action.”

While the opportunity cost reflects the cost of a proposed course of action, the value concept, as suggested by Bronbright, reflects the value of something, which has been acquired in the past.

The question now arises: How should the value of an asset, as represented by loss on deprivation be measured? Three broad categories of measures you can use:

Replacement cost: This is the cost that will be incurred to replace the asset. It may be measured in terms of gross current replacement cost or net current replacement cost.

Realisable value: This represents the value that can be realised on the disposal of the asset. It may be measured as the current open market sales value of the asset or the forced sale value of the asset, that is the amount likely to be obtained for the asset if the same is sold under condition adverse to the seller.

Economic value: This denotes the value derivable from the economic use of the asset. It may be calculated as the value related to the earning potentials of the asset.

What it means for you

For investors, as the realisation value exceeds the economic value, it is advantageous to dispose of the asset rather than use it. However, the maximum loss suffered by the firm, using the ‘deprivation principle’ in these cases is the replacement cost, not the realisation value, because by buying another asset of the same type, the firm can restore the deprivation suffered by it. Hence, it is of paramount importance that the value of the asset should be measured by the replacement cost.

India’s inflation rate expected to drop: IEG

By Avadh Singh

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It has come into the notice of The India Street that the India's inflation rate based on wholesale prices, the commonly used benchmark to track price levels, is expected to drop even further after hovering around Reserve Bank of India's (RBI) targeted level of 5 per cent for the next three months. If the Institute of Economic Growth (IEG) is to be believed, industrial growth will also slow down. The institute's monthly report on the economy for May says industrial growth, which was 12.9 per cent in March over the same month a year ago, powered by manufacturing, capital and consumer non-durable industries, could have been helped by high expectations in industry, but will come down in the coming months. The IEG has forecast an average growth of 9 per cent in industrial growth over the next three months. It says the increased interest rates, a decline in exports and a slow-down in consumer durables and construction activity would constrain industrial growth. It says it expects a deceleration in money supply following a drop in demand for credit by the commercial sector. It expects prime lending rates and the foreign exchange rate to be stable over the next quarter. It is worth mentioning in this regard that the inflation rate fell to 5.09 per cent in the week ended May 19 from 6.09 per cent a month earlier. IEG is of the opinion that retail prices for consumers will soften from the current levels. "The moderation in IEG view is mainly due to the recent monetary policy stance that controlled demand-side inflation," pointed out Rehmat Ali, renowned Indian economist. But fact remains that the rise in the prices of food and primary articles show that there are still supply side constraints. The report says inflation will decline further in coming months as the full impact of a squeeze on money supply takes some time to be revealed, while the forthcoming monsoon rains will influence commodity prices. Rising global oil prices are also a matter of concern.

Technorati : India Inflation, Inflation rate

Indian govt may cut customs duty to keep inflation below 5 per cent

By Vipin Agnihotri

Indian government may minimize custom duties on number of items to keep inflation below 5 percent. Finance Minister P Chidambaram, while talking to The India Street said government was ready to take further fiscal steps to control inflation and keep it below 5 percent.

It is worth mentioning in this regard that inflation had crossed 6.7 percent in starting of the year- the highest level seen in more than two years. Though, due to number of measures taken by government and Reserve bank of India (RBI), it has since softened to 5.7 percent by the end of April.

“It is still above the tolerance limit. Our objective now is to keep inflation between 4 and 4.5 percent. We will make every effort to bring it down,” pointed out Chidambaram. The pivotal factor here is that if government’s fiscal measures would not be adequate, the central bank would also take further monetary steps towards this end.

If experts are to be believed, government’s determination to check inflation between 4 and 4.5 percent and not allowing rupee to depreciate, in turn, will see continuation of tightening of the money supply. From the starting of the year, government has taken various measures such as reducing custom duties on the import of pulses, edible oils, steel, cement and other essential commodities.

In addition, Reserve Bank of India also took a number of measures to restrict the money supply. These sorts of steps led to rise in interest rates, which affected sectors like real estate and consumer durables. Statistic wise: In the last three months, home loan interest rates have increase by around three percentage points to 12 percent from 9 percent. What’s more, the consumer loan rates have also increased substantially. The increase in the interest rates have also raised interest burden on the companies.

“To contain inflation through restricting money supply, Reserve Bank of India almost stopped buying dollars from the market. This has led to steep appreciation of rupee by around 8 percent since the starting of the year,” pointed out Dr Suvrokamal Dutta, renowned finance expert.

This move has affected exporters very badly. But one thing is for sure; it has helped the government to contain inflation. In other word, as rupee appreciated, the prices of imported items in rupee term declined, which has forced the domestic producers not to increase prices of their products.

At the same point of time last year, inflation had moved up in the range of 5 percent, lots of analysts were of the opinion that it would automatically come down to around 5 percent in the next two weeks because of the base effect. But, fact remains that if government is interested in bringing down inflation in the range of 4 percent to 4.5 percent, the high interest rate regime would continue for some more time.

Finance minister has already said that high global prices of crude oil and metals were due to rising demand in India and China, besides stagnation in Indian agricultural production, were the main reason behind high inflation. “There is no short cut to bring down inflation. Prices will not come down unless we augment supply of food grains including wheat, rice, pulses and edible oil,” pointed out Chidambaram.