Of This & That...

Many Shades of Inflation

The author believes that Indian inflation may lead to a redistribution of pricing power, and here’s why

Let’s define the problem first. The current ‘global’ inflation problem can be said to have come from a sharp spurt in the supply of money over the last decade, which first caused asset price inflation (stocks, bonds, real estate, etc) and is now moving into product price inflation (commodities, energy, food, etc). The first was celebrated by the masses, and the latter is now being cried over.

None of this was unpredictable. It is in the natural course of things, part of the many cycles in life. This one is part of the Monetary Cycle, which started with Greenspan's policies in the US, post the IT- bubble and got concentrated in the subsequent housing and bond bubbles.

As these policies gained momentum, they ended with deflationary pressures and bubble collapses, principally in housing and now bonds. But the inflationary deer-in-the-python is now passing through into product markets, principally the major commodities, which include energy and food, but will soon be seen in other manufactured goods. Finally, it will end with wage inflation; wages will rise and assets will fall till the old ‘purchasing power parity’ ratios are corrected once again.

This is the theoretical model. In actual practice, these are never universal truths. Let us take each of the above aphorisms one by one.

The excess of Dollars did not stay in the US, but has ended up in emerging market economies, which in turn, has created an excess of local currencies in their respective markets. In the US, this started as an excess of debt (which created its own sub-prime, SIV and other disasters), but in the emerging markets, it turned up in the form of portfolio equity, export profits and 'investible surpluses' like Private Equity. These funds have therefore finally ended up in Gross Fixed Asset formation, capacity creation and have shown up as Investment Demand. So, even as the money looks like equity investment from the Indian investee's point of view, it is actually, debt-funded (or funded by short-term investments) in the US and prone to liquidity pulls. This will create deflationary pressures in asset markets here in India, which is what we are seeing in our equity and bond markets.

In India, these flows have shown up as Forex debt and some (equity) portfolio flows, both short-term and long-term. In China, these flows have shown up as 'export surplus’, but the net effect has been the same: Investment Demand, whether in Working Capital or Fixed Assets, more the latter than the former.

Both the investing economies/ currencies, US and Japan have different funding sources. The US, being savings deficit, has funded these flows from the bond markets, while Japan, being savings surplus, has been the source of carry trades, while the assets have ended up in India, etc. China, of course, has been both saver and investor, which might make it the biggest sufferer of this coming crisis.

So the universal truth of 'global inflation’ is actually just an average, while the actual realities may be extremely divergent, depending on where you are, what you are suffering from and where you can go. Your policy responses would mostly depend on your answers to the above questions.

The US is seeing an asset-price implosion, the short-term implication of which is a desperate need for cash to maintain bank portfolios, or to fund Margin Calls for 'prime brokers'. Like in any stock market, if you don’t fund margin calls, your positions are cut and you go into bankruptcy. So, depending on where you are, Bear Sterns or JP Morgan, it is a zero-sum game within the country, which will correct itself over a period of time. Under-leveraged players like Berkshire Hathaway will gain in value what the likes of Bear Sterns will lose.

The knee-jerk policy response to this is the infusion of cash, which will eventually flow into product markets, causing the kind of inflationary expectations that we are seeing just now. Which is why even as the Libor is falling, lending spreads are hardening, allocating cash away from the trouble spots in the economy. But the liquidity-driven inflation that we are seeing in the US is structurally very different from what we will see in other parts of the world.

China, for example, is seeing red-hot inflation pressures from its investment boom. That is why I said that it is a toss-up who will be worse affected, the US or China. While in the US, the major damage is to the financial sector, whose 'working capital' is seeing a compression, China will see a similar compression in Fixed Asset formation.

They might (apparently) be able to carry the dead inventory of half-finished projects, simply because it is equity-funded, but that does not reduce the damage they will suffer. Normally, if the lessons of history are well-learned, deflationary (and therefore Depression) pressures are heavier when you carry dead Fixed Assets rather than Working Capital. Look at Japan's lost decade, or the impact of the investment boom in the US pre-1929.

India too could face its own set of problems, mainly depending on the extent of leverage deployed in its recent Fixed Asset investment boom. Thank our stars that we have a high domestic savings rate, and Forex funding is not a big part of our project finance, thanks to the bans on ECB, etc. Very sensibly the RBI is keeping its eye on these ratios, which will help India ride out this global funds crunch.

To Indian inflation, then. This is demand-led, probably the only country in the world which has this 'good' inflation, that redistributes pricing power to those sectors which need an additional dose of profitability, so as to drive investment into those sectors. Like everybody, we will suffer our own local deflation (in real estate, stocks and bonds to projects which have not started producing as yet, i.e. long-gestation projects). Not surprising, then, that we suffer the highest (relative) real interest rates in the world, if you factor in stable currency values, inflation at 6 per cent and interest rates at 12-14 per cent.

Our inflation is happening in consumption areas, like food and energy. Pricing power will shift to those (producer) sectors, which will fare better than those who are positioned in the sectors mentioned in the earlier para. From the outside, it seems to me that for an Indian company going global, the challenge is to find long-term liquidity (from profits/ long-term debt) and use it to invest in those areas of the economy that are suffering deflation. Further, it could exploit its strategic positioning in various sectors, say, the energy and food sectors, to extract whatever additional pricing power it can find. Essentially, ‘milk’ the food and energy sectors and put my money into the deflated sectors of the Indian economy.

Indian corporates need to worry why their major liability is still in a currency with the world's highest real interest rate, and they are investing in assets abroad, all denominated in currencies with low interest rates. There is an obvious arbitrage just now, to borrow in currencies with low real interest rates, low appreciation probability against the Rupee; and to invest in the areas pointed out above. Much of Indian industry seems to be doing the opposite, all in the name of globalisation.

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