Inflation

Inflation in India has been beyond the comfort of the political class and the central bank since 2006. While large proportion of the political class did not care until growth rates continued at high levels and rural transfers kept pace. In the recent years it has become an entrenched problem with no end in sight.

Well, this is how it has worked through in the system:

• If we look back, to 2005-2006 the flow of easy money before the 2008 crises resulted in the country's GDP growth expanding to 8-9% levels. This opened a significant gap between supply capability and demand with prices of industrial products like cement, steel, capital equipment experiencing high price growth;

• Sharp increases in international commodity prices first driven by growth and then post 2008 by low interest environment;

• Food inflation driven by overall change in food habits in emerging markets but especially in India driven by gross mismanagement of the farm economy - persistent hikes in MSP (minimum support prices) and procured quantity without encouragement of any investment in supply chain (reduce wastage), Food Corporation continuing to store grains far in excess of capacity (>3 times capacity) etc;

• This first bout of inflation drove households into real assets like gold and real estate to protect the value of their money. Massive scale corruption further resulted in further increasing real estate prices (largest sector of the economy to hide black money). Higher real estate prices in turn translated into higher prices of delivered goods and services;

• Continued inflation in the last 7-8 years has created very high household inflation expectations (>10%) keeping wage growth at high levels;

• High fiscal deficit and household affinity to gold has created pressure on the currency which in turn makes imported goods more expensive.

During this period urban households have borne the brunt of higher inflation as continued wealth transfers by various social schemes has resulted in higher rural consumption levels and higher rural prices of farm inputs (i.e. labor, land).

While inflation continued, the Reserve Bank post the crises has tried to manage interest rates at relatively benign levels to ensure government debt cost was under control. As it did so, it punished the savers and consequently we have seen a decline in savings rate of the economy from 37% in 2008 to a likely under 30% number this year. This has implications on the long-term investment capability of the economy (domestic + imported savings = investments).

While the government and industry clamor for lower interest rates, they did not want to pay for the excesses i.e. over-leveraging. Significant reliance on global savings to fund this leverage has resulted in the recent currency debacle.

The massive distortions created by the government (i.e. farm and fuel prices) need to be resolved while incentives need to be provided for infrastructure creation. Banking reforms need to be undertaken to allow quick resolutions of bad assets to allow capital assets to be used productively. Reserve Bank needs to correct its policies favoring negative real interest rates. This will ensure long-term stability of the banking system, creating incentives for financial savings as against real assets.

But markets will not wait forever for the government and central bank to manage this, inflation will consequently conquer itself - through demand destruction but albeit over a longer period than would have been through appropriate course correction. Consumer demand and job growth is already impacted in urban India which will percolate to rural economy. For industry, international demand will again become a key driver of growth.

Only one aspects as I see it can result in a different outcome - substantial decline in global energy prices..maybe that is what Reserve Bank and Government have been punting on since 2009? Our old men have over-spent in a casino on a losing trade...

Social Contract

Social contract is the unsaid agreement which establishes the legitimacy of the state over its population. As the state dilutes this contract through inability to keep its promises, corruption or brutality in enforcing its might, the allegiance of its population  frays.

The same aspects can be seen in the organizations which are at much lower levels of complexity. A family's bonding is based on emotional attachment and provision of material well-being of its members by the earners. A commercial enterprise is based on creating wealth and delivering progress to its employees and shareholders.

Nation states while much larger are manifestations of the same basic human tenets. Each nation state in the context of its geopolitical history and its political leadership determines its social contract.

The Soviet Union contracted global leadership and asked its populace to submit to this pursuit. While it underestimated the human desire for independence and openness, it also overestimated its economic and military ability. Economic success and promised destiny of global leadership at the cost of political freedom is the contract in China and and the belief that this view will be uniform in Xinjiang, Tibet or the core Han populace. As growth slows and the economy is forced to re-balance, contradictions will play out over the next decade. The Americans have contracted freedom and economic success. The politics of low interest rates, financial bubbles (housing, stocks), bail-out and the various social programs lie with the failure of the state to deliver the second part in the last 2 decades - good quality job creation.

What has the Indian state contracted? Over the last millennium, the Indian state has been defined differently in different parts of the country. For example, the Mughal state encompassed primarily northern and central India and then during the British times it extended from borders of Afghanistan to Burma to Sri Lanka. Even during these times they outsourced governance to states which owed them allegiance.

India has a very heterogeneous population with different religions, languages, castes etc. In my view there are these following four aspirations but the manifest in different order of priority for different parts of the country:

• Stability & Security - The northern part of the country which borne the brunt of invasions over the centuries, stability and security is a key driving factor. For example, Sikhs are estimated to be 10-15% of the army.
• Economic success - The western part of the country, predominantly, Gujarat has a long history of sea-faring commerce. 
• Overall progress - South India which has seen greater stability over the ages and ease of capital accumulation pursues wider aspects like education and literture. Three of the key IT hubs of India (Bengaluru, Chennai and Hyderabad) are in the Southern part.
• Low inflation and social order - In the eastern states of UP, Bihar, and West Bengal where large part of the Indian population lives on the fertile Gangetic plain this is a key priority. Pressure on land and overall resources have made this the driving factor. This is stability of a different form than the first one enumerated above.

The Muslim population in these areas would have the same aspirations but over the years their views have been polarized. 

In the ultimate analysis, it the leadership than has emerged from the eastern heartland of India has defined the politics of the country (Nehru, Indira or Rajiv led Congress Party or Vajpayee led BJP). Rest of the leadership existed from other geographies more in terms of compromise (Gowda, Narasimha Rao) where the stability still resides with the Eastern leadership. This core will continue to strive to ensure that no leadership emerges from the economically progressive states of Western & Southern India. For the such leadership to emerge it will need to build a bridge with the populace of the East, something no leader has tried, even Sharad Pawar for all his abilities could never build a franchise in the heartland states.

For example, for Narendra Modi to become the Prime Minister, the following conditions will have to be satisfied:

• Current social contract frays - high inflation, corruption, lack of employment, law & order has caused serious concern in the population. The impact is sought to be reduced through a food security bill (at least in perception)
• Building aspiration - Substantial part of the current voting population is in its early youth (<30 years). Higher aspirations built by a wider view to the world (through media proliferation) is itself adding a new dimension to the social contract with the Eastern states. He needs to show the path to achieving these aspirations
• Developing a local franchise - He needs to create a significant franchise for the party in the states of UP & Bihar where people can associate with his world view

In the end, which party such a person belongs does not matter. No one asks today which party did Lincoln or Roosevelt belong, they re-defined the US. We can see how the discourse in national politics has already changed. Economic progress and efficiency will define the tenure. It will change the status quo that has settled in the Centre. In the end, as the East came with its historical baggage, so will the West.

Simply Economics

India, post independence, has been a capital importing economy (current account deficit). While the intent at most times has been to use this to create productive assets, there has been a significant shift to import for consumption. The spend by the government in social schemes has further increased this trend.

The global environment prior to the 2008 crises was very conducive in the form of easy monetary policies and high consumption in developed economies (encouraging imports). But the vulnerabilities have exacerbated since.

The Indian government and the central bank reacted to the crises with expansionary policies - reducing excise duties, lower interest rates, flexible restructuring terms for bad loans, while the global central banks created ultra loose policies. This combination supported the sharp cyclical upturn of 2010 and 2011.

These measures made no change to the productive capacity of the economy in the long-run. The private sector had not recovered from the the jolt of 2008 when the governance issues played out in full. Mega-corruption scandals and activism of Supreme Court / CAG created a stand-still in the government.

The social schemes and rural sector transfers (higher procurement, higher minimum support prices for grains) continued as the government fought to remain in favor resulting in high fiscal deficits. These measures kept the consumption engine in the economy firing while more capital was directed towards real estate and gold by households to protect from inflation (implication of negative interest rates).

Fast forward to today, we have the following issues:

• a profligate and corrupt government unable to act;
• consumption slowing down as employment generation contracts;
• corporate India facing a slowing revenue and profit growth;
• massive non-performing loans (we have a fully levered banking sector running at 75% + loan-deposit ratio);
• very high current account deficit, resulting in the rupee problem.

International monetary regime will no longer be supportive to allow for such failings in the economy. 

Before I come to the implications, in economics savings (domestic plus imported) is equal to investments. Domestic savings rate which was 37% in 2008 is expected to dip below 30% this fiscal. International imports of savings has been in the form of FII flows to debt and equity, which has seen significant outflows in the last 2 months. If savings decline, so will investments and this is the primary determinant of the level of GDP growth in India.

The rise in international rates primarily dollar rates will put significant pressure on capital flows. We have seen a brief trailer in the last few weeks. This has happened when the dollar index has barely moved. 

The dollar is likely to see its 3rd significant rally since Bretton Woods (when it came off the gold standard in 1968) as the Fed increases interest rates and shale gas creates greater productivity in the economy. The first rally in the early 1980s driven by Volcker interest rate regime caused the Latam crises, the second was in the mid-1990s when the Asian Financial Crises played out. These crises were caused by over-dependence on foreign capital.

The implication of above changes are already playing out and these trends will deepen. Banks, real estate, consumption related and import dependent businesses and the rupee will suffer. External demand sectors like pharma, IT and MNC linked export businesses will gain. Metal related business will continue to feel the heat of the Chinese slowdown. As the above pressures correct the saving imbalance in the economy in the next 3-4 years capex linked sectors will recover.