How Lower Inflation Lowered Economic Growth with Many Knock-on Effects
The interesting character of the present growth slump is that we did not see it coming. In theory, there are a lot of low-hanging fruits in the Indian economy to sustain demand for a few decades. Even after the financial crisis of 2008, India was growing fast. That fast growth had caused high inflation. 
 
Between 2012 and 2014, India's consumer price inflation (CPI), hovered around 10%. We wanted to bring it under control. The rapid policy action brought it down to 5% by 2015, i.e. within nearly one year. The CPI stayed around this mark till second half of 2017 and, thereafter, dipped even lower. Today it is below 3%. This should have been a cause for celebration. Yet, quite suddenly, growth was just gone. Why? 
 
There were, of course, many reasons. In this article, we will try to understand one that is the least understood—growth-inflation dynamics. 
 
Human Psychology Determines How Inflation and Growth Interact 
 
Take the hypothetical case of a company that is doing reasonably well; its revenues growing at 11%. Out of this, around, say, 8% is contributed by inflation. So, the real growth of the company is about 3%. Now imagine suddenly the inflation turns to 3%. So, the company grow by about 6% instead of 11%. In reality, the real earnings of that company were the same. 
 
When a business that is growing at 11% suddenly grows only at 6%, it will feel like a slowdown. It means that the company defers the purchase of a Rs10-crore machine. These ripple effects temper the economy.  
 
The Knock-on Effects of Low Inflation
 
First, the profits of many companies fall because of lower inflation. Most companies have a credit period of 180 days or more. That means, their costs represent last year’s cost and revenues represent this year's revenue. If inflation falls drastically in that time, the margin between cost and revenue reduces rapidly.
 
If instead of Rs22 crore revenue, a company gets Rs21 crore, it may eliminate all its profits.
 
Second, these companies find it difficult to service debt. High inflation helps the repayment of debt. This is because debt repayment is always fixed in nominal terms. 
 
When you take a loan, say in 2015, the loan instalments are fixed based on the outlook of inflation and interest rates. Ideally, as inflation falls, instalments should also fall, but does it ever happen? Companies that have wafer-thin margins, default.
 
This increases risks to banks. So, banks hold on to the instalments. Naturally, they make other borrowers more vulnerable.
 
Third, when companies see profits decline, they tend to scale back expenses. The scaling is not linear. For example, if your profits reduce by 50%, you cannot buy half a CNC machine; you buy none. Thus, corporate spending reduces. Such companies also cannot give a generous bonus to workmen. To keep afloat, they may have to fire some workers. Or, companies may stop hiring. Thus, this creates an investment slowdown.
 
Similarly, household spending also reduces. Imagine a family whose income is already committed to house rent, food, school fees, etc. When salaries rise 10%-15%, the burden of expenditure becomes easier year after year.
 
But when salaries do not rise or rise merely 5% and they don’t even get any bonus, they must defer their spending. They cannot go for luxurious holidays and have less discretionary spending, etc. All these cutbacks, cause a consumption slowdown.
 
Fourth, as both investments and consumptions slow, economic growth suffers. This causes revenues to decline even more, and economy is pushed into a negative spiral. Tax revenues fall. There are more bad loans. It strains bank balance-sheets even more. India has experienced all of these symptoms since late-2014, when inflation hit 4% level.
 
Low Growth Caused by Lowering Inflation Rapidly
 
The groundwork for inflation targeting was laid in 2008 Financial Sector Reform Committee chaired by Raghuram Rajan. Since Raghuram Rajan took over as the governor of the Reserve Bank of India (RBI) in 2013, RBI focus shifted to inflation targeting. 
 
Bringing inflation down is not a bad idea. The Indian mind is acclimatised to 7% inflation. In 2012, inflation went beyond 10%. If it was brought down to 7%, we would have been fine. 
 
But the lowering inflation beyond 7% rapidly, affects public psychology. The general public was not prepared for lower salary growth. Companies were not prepared to slow revenue growth. Banks were not prepared with strong balance sheets. These preparations should have been done BEFORE setting in motion the inflation constriction of the economy.
 
Without these preparations, the economy faltered. While revenues were being constricted, banks were being forced to recognise bad loans under prudential norms. This is akin to performing heart surgery and brain surgery at the same time.
 
To allow the public perception to adjust, we needed both, a mass education campaign to move to lower inflation paradigm AND a gradual reduction in inflation. Absent both, the impact of sharp constriction in demand and supply, to tame inflation, resulted in a slowdown, which superficially seems to be without any reason.
 
What Can We Do Now?
 
The first step is a explain this to the people. Ministers, experts, economists should explain the new paradigm of low inflation. There are many examples of low inflation economies in the developed world. Using their examples, we can explain how the low-inflation economy implies lower salary growth even when real growth is high. It means the interest rate on savings will SEEM low.
 
A concurrent effort is required to bring the large and small corporates to this new low-inflation paradigm. Corporates should expect lower revenue growth. It implies we cannot set sales targets at 20% revenue growth. The margin transmission across the supply chain may happen smoother if everyone is aware of the paradigm shift in inflation.
 
The education efforts must be targeted to banks too. As inflation expectations change, the strategies for managing bank balance sheets also change. The way interest rate transmission is done. None of this was done. It should start immediately because it seems lo inflation is here to stay.
 
(Rahul Prakash Deodhar is a private investor and Advocate, Bombay High Court. He can be reached at [email protected], on twitter at @rahuldeodhar or at his website www.rahuldeodhar.com.)
 
Comments
Kushal Kumar
2 years ago
According to news reports on 30 August , 2019 , RBI Annual Report has suggested that bank frauds saw a whopping 74% jump in value in 2018-19 as compared to the previous year. In terms of number of cases , it was up by 15%. Besides , GDP for Q1 of 2019-20 covering April -June in 2019 reportedly grew at 5% , lowest in over six years past. In the context of these major worrisome concerns in financial and economic sector in India , it is apt to refer readers to this Vedic astrology writer’s predictive alerts in article - “ The year 2019 astrologically for India” - published last year 2018 on 7 October at theindiapost.com. The predictive alert for more care and appropriate strategy reads like this in the article :-
“ February –March onward in 2019……………….Some sort of crisis or worrisome concerns in financial and economic sector look to be there.
July to September in 2019. These three months may also call for more care and appropriate strategy against floods , landslides , etc. Over reaction may not drag us to war or wastage. Distribution of central finances may be disputed by a State or States. Liabilities or restrictive complexion of the past policies may weigh heavily on the success or completion of the ongoing ambitious projects , particularly those related to energy generation.” These themes were also dealt with in predictive alerts in another article - “ World trends in April to August 2019” - brought to public domain widely in March and subsequently on 5 April 2019. The alert had said that a period of four and a half months from mid- April to August , particularly June around , in present year 2019 looked to be having major worrisome concerns in - “ financial and economic sector in India as well” calling for more care and appropriate strategy. A review of planetary impacts around May had suggested that such trends could reach out as far as mid-October , particularly about 7 August to 9 October , in 2019.
Note :- This writers significant predictive work about the US most relevant to the ongoing times in 2019 and 2020 can be visited at wisdom-magazine.com/Article.aspx/4897/ and wisdom-magazine.com/Article.aspx/5060/.

Rahul Deodhar
2 years ago
Thank you, everyone, for the comments. Articles are a means of discussion so that we arrive at a plan that makes India grow faster.

Just to clarify my position and some explanation.

1)
This inflation-initiated slowdown is only ONE of the many reasons for the slowdown. There are other issues too, hope to cover them in future articles.
So @Ramesh Poapt is right - there are many issues. But not enough attention is focussed on this.

2)
There are many fundamental reforms we need to undertake instead of the cosmetic band-aid job.

So I hope Mr. Aiyer, please do bear with me. In coming articles I hope to deal with some of the issues you highlighted in your detailed comment.

I am pro-liberalisation and you can read my last article on manufacturing slowdown.
https://www.moneylife.in/article/why-the-indian-manufacturing-sector-does-not-take-off-and-how-to-fix-it/57989.html


3)
I may have confused @Som about inflation. Maybe I wasn't able to explain my position properly.

Low inflation IS good. My problem is with (a) speed of correcting inflation and (b) reducing inflation below what people intuitively think it is WITHOUT explaining and communicating it properly.

@gcmbinty - absolutely true! it will be assimilated but without education about the low-inflation regime, it will take longer.

4)
On twitter, I was asked how it matters since (according to the person) inflation will take off as RBI keeps lowering interest rates and we may have overheating economy. So my response (elaborated more) was the following:

(a) Since we are in Inflation Targeting Regime, it means as inflation heads higher than 4% RBI will start to bring it down.

(b) In doing so, RBI will kill demand-side unless supply catches up. Now India is a supply-constrained economy, so this is a problem.

(c) Supply will remain tempered unless investors/entrepreneurs understand that nominal growth will be lower than between 2003-2009 phase (just because inflation is lower). That education hasn't happened.

(d) the correct response is to undertake fundamental reform. Agree with Mr. Aiyer on that.


FINALLY,
The issue of growth is complicated, not just for India but globally. Let us discuss various ways. I am planning to write some more articles on this issue. Please do read and through comments and discussion create a template for growth.

Readers may also find my webpage and presentation on India Growth interesting
www.rahuldeodhar.com/IndiaGrowth

SuchindranathAiyerS
2 years ago
A lower inflation rate is an indicator of a healthy economy. When the focus is on appearances rather than substance and war is waged on the inflation rate rather than the fundamentals which contribute to it a la Jet Lee and the BJP, then you have chaos.
gcmbinty
2 years ago
The inflation rate of 3% to 3.5% is the most stable, assimilating and not affecting the fall of the rupee value. This is not a low inflation but the one that is easy get assimilated in the economy. This is my faith as a consumer.
Ramesh Poapt
2 years ago
the above and below is very negative conclusion. Global factors are
totally neglected. Further lot of positive developments have successfully
taken up, which is totally ignored. Agreed that lot of has to be done yet.
Structural changes are being made. Its impact will be visible for sure.
I m not pro or anti Govt. But criticizing Govt all the way is too unfair.
Low inflation/growth/default/investment maths above is faulty.
SURAJIT SOM
Replied to Ramesh Poapt comment 2 years ago
What hapenned to "make in India" ? It became "Make in France (Rafale), Russia( S-400 Missile), China( almost everything including idols !!!) .....
SuchindranathAiyerS
2 years ago
I saw it coming. I have been warning of this right since 2014. The cause of this mess is NOT low inflation rate (which is good) but enormous instability in all other areas of policy. Not only did I see it coming but so did better known people than I such as Yashwant Sinha and Arun Shourie. The Mahdi Sarkar has pursued all the failed policies of "Nehruvian Socialism" with far greater technology assisted rigour adding to the last seventy years of momentum with a discernible downward kink in 2014 on an already downward trajectory. Yashwant has even written a book describing some counter productive decisions. "India undone".

The core problem remains Government’s self indulgent profligacy and its non productive control of a lion’s share of capital and over paid, incompetent human resources from Public Sector Undertakings to Courts to Government Offices. This puts an enormous burden on the productive (private sector) in terms of taxes (by many names) regulations, harassment, shifting policies such as retrospective laws, inflation and extortion (made lawful by the Modi Government). The Monkey Bath Mahdi’s Bharathiya Jhumla Party is certainly not going to reverse its policies or make amends. It will be politically impossible for it to let go of 50% om State Payroll, cut 50% of salaries of those remaining on State pay roll, all regulations that place the State above individual and enterprise to generate this redundancy and afford the productive the tax relief and regulation relief to get on with being productive.

In other words, this is a “For Government, By Government, To Government, Government” which believes that the Private Sector is some sort of mythical heavenly cow that can keep giving it infinite wealth and money , on demand, under conditions of absolute Government and NIL Governance.

The Government has assumed the presence of a competent set of employees with integrity and effective structures and systems in the non productive (State) sector. Nothing could be farther from the truth. The Government has assumed that the productive (private and individual citizen) sector is some sort of magical, heavenly cow that can bear the brunt of arbitrary, whimsical policies wielded by corrupt, incompetent Bureaucrats, Police, and Judges and keep on producing wealth and money to maintain the Non Productive State is self indulgent and obscene luxury. Nothing could be farther than the truth.

I have been saying this since the Modi Government took office in 2014, as its very first actions and legislations predicated a Totalitarian Congress Government with even greater, technology assisted, self absorbed and self serving ruthlessness. It has continued implementing and enforcing all the failed policies that sank India since 1947 with greater viciousness thereafter to give us a command economy redolent of Nehru and Indira Gandhi but with technology supported ruthlessness and untrammeled, bureaucratic viciousness.

India is a command economy. It applies enormous overheads through taxes, regulations, corruption, extortion by government employees wielding laws and regulations made to purpose from the productive (i.e. non Government) sectors of the economy to fund the profligacy, pomp, pelf, perversions and perpetuation of India’s SC, ST, BC, OBC, Moslem, Christian, Bureaucrat, Politician, Police, Judge Kleptocracy. This renders Indian goods and services into poor value for too much money and internationally inferior quality for excessive price.

By the way, the 1.75 Lakh Crore transfer from the RBI will do nothing at all to revive the economy. It is just throwing good money after bad. Like a huge “revival loan package” to a dying Industry with Neta-Babu connections OR a public sector “enterprise” like Air India.
Like Nirmala Seetharaman’s 13% hike in outlay for a non productive, if not down right counter productive, Education sector, this will be just like rain showers on the shifting sands of the desert.

India has done nothing to promote productivity, accountability, integrity, competence and excellence. It is the same old Nehruvian Socialist State in which the Modi Sarkar has tightened and applied all the failed policies since 1947 with greater, technology assisted rigour. India is now more of a “Command Economy” than it was under Nehru or Indira Gandhi.

The lion’s share of capital and human resources of India remain unaccountable, non productive, incompetent, unfit for purpose and corrupt under Government (including Courts, Armed Forces and Public Sector) and feeds on the diminishing productive resources of the country to support the State’s profligacy, self indulgence and mismanagement.

The economic disaster that has been unfolding in India since 2014 is primarily the architecture of an arrogant and self indulgent lawyer who was easily beguiled by Babus to do what is good for them and bad for the country.. Modi Bhakths are treating him as Khangress would a Gandhi.
SURAJIT SOM
2 years ago
We were told that low inflation is good , high inflation is bad. Now Rahulji suggests otherwise !!!! The fact is manufaturing is stagnating -hence no new jobs- and agriculture is also stagnating. It is only services sector - IT etc- which is somehow chugging along. Manufacturing is where most jobs ought to be created but that can not happen when industry is in recession-almost. Lack of job is now hurting other sectors such as housing , car , tourism etc. In fact lakhs of people are simply paying EMI while the developers are simply busy siphoning off the money !!!! Now Supreme Court has to intervene to deliver houses !!!! We are told there are some 1,40,000 incomplete houses !!!! How there can be growth under such circumstances ? Sick manufacturing and poor agriculture sectors are a terrible recipe for economic growth, employment etc. Most power companies are virtually bankrupt . That indicates the condition of manufacturing . We are spending tens of billions of dollars for importing fighter aircrafts , missiles ,smartphones .....Our money is creating jobs but in France, Russia, China ......not in India !!!!!

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