Researchers at the Delhi-based think tank India Development Foundation (IDF) have an interesting take on the possible drivers of consumer price inflation. Looking at a cross-section of states and their consumer price indices for agricultural workers (CPI-AL), they find a direct correlation with the quantum of funds allocated to the states under the National Rural Employment Guarantee Act (NREGA).
Kerala, for instance, is pretty much at the bottom of the table of NREG allocations; it has also seen one of the lowest rates of consumer price inflation. Andhra Pradesh, on the other hand, tops the tables of both inflation and NREG funds. A possible conclusion: NREG funds appear to have a hand in pushing up inflation.
The correlation is useful from a policy perspective but perhaps not difficult to explain. Most of the NREGA money goes into public works programmes like creating water-harvesting facilities or making roads and bunds.
These are known to be extremely wage-intensive and translate into very quick multipliers on consumer demand. The spurt in demand driven by NREGA projects has unfortunately come at a time when there have been marked supply shortages in the farm economy, resulting in a spurt in food prices. If one assumes that the increase in demand varies directly with the amount of funds allocated, then the variation across states seems intuitive.
However, this article is not intended to be a critique or appraisal of the NREGA. What I am more concerned with is infrastructure spending in general and the problems of "absorbing" the massive infusion of funds that is planned for these sectors over the next few years. Let me elaborate a little more on this.
The Planning Commission, in its approach paper to the eleventh Five-Year Plan, commencing in 2007-08, has estimated that about $300 bn of new investments will go into infrastructure to achieve the target rate of growth of 9 per cent, on average. The government seems reasonably sanguine that the funds will be available. It seems to bank heavily on the sharp rise in the domestic savings rate in the last couple of years.
This, it believes, should make more funds available. The arithmetic, at a broad level, does make sense. If the current rates of savings of 33-34 per cent of GDP sustain and a current account deficit of 2 per cent of GDP can be funded, that adds up to an investment rate of about 36 per cent. If about a fifth of that can be invested in infrastructure, the target can easily be met. Remember nominal GDP is over $900 bn and growing every year.
Government officials admit that for the savings to translate into investment, some institutional changes are needed. For instance, there is a crying need for a robust domestic debt market, particularly for long-term funds, to help infrastructure companies fund their liabilities.
Better concession agreements need to be drawn up for build-operate-transfer projects. However, they seem reasonably certain that these problems can be sorted out in the near term and the targeted amount of funds will, indeed, materialise.
The question that bothers me at this stage is not whether enough funds will materialise. From my perspective, the more important question is: What if they do? Is the supply side of the economy robust enough to absorb the demand that stems from it?
Remember that a number of projects will be similar to the NREGA--highly labour- and wage-intensive. If, as is likely, the supply of wage-goods--particularly food and other agricultural products--continues to be fragile and susceptible to random shocks and there is an increase in employment and incomes, we might see periodic bouts of high inflation such as the current one. In fact, we might see sustained upward pressure on prices for a period, which will push the trend rate of inflation up.
We might see price spirals not just for agricultural goods but for manufactured products as well. Take the case of cement, which is used quite a bit in infrastructure projects.
The balance between the demand and supply of cement looks pretty delicate all the way up to 2009 or 2010. I suspect analysts who are forecasting this have not accounted for the kind of infrastructure spending that is being envisaged. Thus, it is likely that if spending does ramp up, the upward pressure on prices could be intense.
What does the government do about these bouts of inflation if, as it hopes, infrastructure spending ramps up? Are we likely to see monetary policy remaining tight for the years to come to try and stifle price pressures? Are we likely to see more "offline" arrangements such as the one with cement manufacturers?
My sense is that the government will have to accept somewhat higher rates of inflation if it is indeed serious about tackling the infrastructure problem. As the investments actually pay off in terms of enhanced capacity, inflation will come down. Until then higher inflation might just be the necessary cost that we need to bear in making a transition to a higher growth trajectory.
There is a critical missing link in this analysis--wages. The direction of wage movement, particularly for the poorest segments such as agricultural workers, is particularly critical and should be brought centre stage in the debate on inflation.
If, indeed, higher prices for low end wage-goods like food are the consequence of rising wages, it might not necessarily be that bad. As long as the rate of wage increase outstrips the increase in prices--that is, real wages rise--the impact of high inflation need not be that devastating. The IDF paper incidentally finds that in the July to September quarter of 2006, average real wages increased for farm hands. If real wages tend to decline, the solution perhaps lies in providing additional income transfers rather in trying to bring inflation down at any cost.
The author is chief economist, ABN Amro. The views here are personal.
