Over the last three years inflation in India has stayed stubbornly high and well above the RBI’s comfort level of 5%. Given that such high inflation has persisted through good and bad monsoons, through high and not-so-high oil prices and through economic booms and an economic slump, it is safe to say now that what we see in India is structurally high inflation (as opposed to the cyclical sort which fluctuates with the economic cycle).
Whilst the reasons for us getting into this structural predicament will be the subject of a future column, what is interesting is that the received wisdom in the press seems to be that high inflation is not such a big deal. Why? Because although the price of our weekly shopping basket is rising by 10-15%, so are our salaries; hence net-net inflation is not such a bad thing. Unfortunately, both economic theory and the financials of listed companies suggest that the real impacts of high inflation are significantly worse than what popular perception might suggest.
So what are the negative impacts of inflation? Firstly, inflation transfers wealth from lenders (who have to sit back and watch the real value of the principal they have lent fall) to borrowers (who benefit from the drop in the real value of the principal). Whilst borrowers like me are amongst the beneficiaries, the biggest beneficiary in all this is the biggest borrower in the land – the Government of India – and the losers are the various banks and insurance companies who have lent to the Government.
Secondly, inflation transfers wealth from those on relatively fixed incomes (which in the Indian context are families in the lower socio-economic strata) to people like us (i.e. professionals who have a degree of bargaining power and hence can push our incomes up with rising prices). Apart from the social strife that such a redistribution causes, it also hits companies who are dependent on the lower income groups for their profits. In this context, it is interesting that in this economic recovery sales of consumer non-durables (eg. packaged foods, detergents, personal wash items, etc) have struggled to grow more than 5-6% per annum whilst consumer durables (eg. cars, motorbikes, electrical goods) sales have grown by 30%.
Thirdly, inflation transfers wealth from companies with relatively low pricing power and rising input costs (eg. manufacturers of commoditised items like soaps, biscuits, mid-segment cars, etc) to their suppliers (many of whom in the Indian context are supplying basic inputs such as food grains and various types of minerals). As we saw in the Q1 FY11 results and as we will see in the Q2 results, such a dynamic squeezes EBITDA margins and this could be one of the reasons why capital expenditure by corporates is not rising as quickly as one would expect. In effect, corporates are saying “If we can’t get a fix on our future profit margins, why should we invest big bucks today?”.
Finally, inflation erodes our international competitiveness. Once employees realise that prices are systematically rising by 10-15% every year, we build that into our annual salary negotiations. Our employers in turn factor in their cost bases rising by that amount every year and seek price hikes to that effect from their customers.
Thus the structural dynamic ripples through the economy and becomes an entrenched upward spiral. The RBI then tries to dampen the inflationary flames by hiking interest rates which in turn pushes up value of the rupee and that erodes our competitiveness even further. With most of our goods exports being in highly competitive sectors such as apparel, jewellery and commodities, we are losing ground rapidly to countries like Bangladesh, Sri Lanka and Vietnam. Even more worryingly, our IT Services industry is facing a similar predicament with rapidly rising salaries in that sector in India.
Whilst the popular press might not have latched on to the negative impacts of inflation, the Indian stockmarket has historically been very sensitive to inflation. Over the past decade, the average return from the Sensex has been -1% when inflation has been above 5% versus +13% when inflation has been below 5%. Data on the Sensex companies also shows that corporate earnings expansion has been markedly higher in low inflation environments. In light of this, the latest spurt in the Sensex which comes at a time of rising interest rates, rising salary costs, rising commodity prices and falling EBITDA margins clearly feels liquidity driven as opposed to being fundamentals driven.