Managing inflation: Key to South Asia's economic progress
Sunday, 30 November 2008
Dr. Salehuddin Ahmed
Inflation has become a major concern worldwide including South Asian countries in recent years. A high rate of inflation is detrimental to sustained growth. Moreover, it adversely affects the financial sector development. Another major concern for South Asia, which is the home to the vast majority of the world's poor, is the adverse impact of inflation on the poor and other vulnerable groups in the society. Since the consumption pattern of the poor is different from that of the non-poor and the poor spend a higher share of their budget on food and other essential commodities, inflation especially fuelled by rising prices of food and other necessities hurt the poor more than the non-poor.
The main objective of macroeconomic policies in South Asian countries is to ensure economic stability together with low inflation and sustain high economic growth. As elsewhere in the world, the central banks of South Asian countries are committed to maintaining reasonable price stability. Price stability is desirable because a rising price level (inflation) produces uncertainty hampering smooth economic growth. Although considerable debate exists regarding the nature of growth inflation trade off especially in low income countries, macroeconomic stability is an important prerequisite for harnessing rapid growth and ensuring social equity in South Asia. Inflation can be costly for the poor since their purchasing power is eroded; their assets are devalued more as they hold a larger share of their assets in liquid form compared with the non-poor; and it is difficult for the poor to hedge against inflation due to their limited access to the financial system.
This paper examines present trends of inflation and growth in South Asian countries and suggests policy options for managing inflation at reasonable level. The paper is structured as follows.
Growth and inflation in South Asia: According to recent projections, growth in South Asia is likely to decelerate from 8.6 per cent in 2007 to 7.1 per cent in 2008 and to 6.7 per cent in 2009 (Table 1). On the other hand, inflation is projected to more than double from 5.5 per cent to 11.8 per cent between 2007 and 2008, and recede to 9.2 per cent in 2009. Current account deficits are also projected to widen significantly.
In the context of the present global financial crisis, the growth projections above may be modified downwards for some countries. Even then, the point to be noted here is that some of the countries will achieve growth above the regional and global trends.
In most South Asian countries, overheating from excessive aggregate demand, aggravated by imported cost-push factors, has made inflation a critical issue calling for strengthened macro management and a sober assessment of macroeconomic priorities for designing the reform agenda for the short and medium terms. Overall, the region's growth prospects remain fundamentally strong. One reason for this is that since the end of the Asian crisis, priority in South Asia has been to boost economic growth. In this context, a relatively loose monetary policy fuelled the backward looking inflation expectations that emerged as an important source of South Asian inflation. On the other hand, monetary policy accommodative of food and oil price shocks gave rise to forward looking inflation expectations, somewhat reinforcing the already high backward looking inflation expectations. This unwelcome prospects gave the region's central banks enough reasons to wake up to the importance of subduing inflation before it becomes entrenched and inflicts further damages to their economies. This shows the need for these economies to undergo painful tradeoffs along with much needed corrective policy measures.
In reality, the present growth-inflation trade-off facing South Asian countries appears favourable mainly because the growth prospect of the region remains fundamentally robust. Although the loss of output due to anti-inflationary tightening policies could somewhat dent the region's growth but it is unlikely to push the region into recession. However, it would still take a great deal of political courage to decisively act in controlling inflationary forces.
As with many other developing countries, surging inflation, deteriorating current account balances, worsening fiscal balances, and depreciating local currencies have hit South Asian countries in varying degrees during the current inflation episode. In South Asia, inflation accelerated in 2008 reaching double digits by mid 2008 in most countries (Table 2). In particular, food price inflation emerged as the major concern since food consumption covers a high proportion of consumer spending, especially for the poor. In addition, the countries were adversely affected by adjustments in administrated fuel prices through, for example, higher costs of transportation and for operating farm equipment in the backdrop of rising and volatile oil prices in the world market. The weakening of local currencies against the US dollar especially in India and Pakistan in 2008 also contributed to inflation pressures, exacerbating the rise in global commodity and import prices.
The impact on the current account was, however, partly relieved by strong performance in services exports (India and Maldives) and robust workers' remittances (Bangladesh, Nepal, and Sri Lanka). Slowdown or reversal of capital inflows in the wake of current economic problems in some South Asian countries also emerged as an area of concern. Moreover, elections expected in 2008 and 2009 in several South Asian countries (e.g. Bangladesh and India) might delay in further price adjustments and subsidy cuts leading to worsened fiscal balances. Similarly, tighter credit conditions and higher interest rates in several South Asian countries might dampen investment with slower economic growth.
The writer is Governor of Bangladesh Bank, the Central Bank of the country
Inflation has become a major concern worldwide including South Asian countries in recent years. A high rate of inflation is detrimental to sustained growth. Moreover, it adversely affects the financial sector development. Another major concern for South Asia, which is the home to the vast majority of the world's poor, is the adverse impact of inflation on the poor and other vulnerable groups in the society. Since the consumption pattern of the poor is different from that of the non-poor and the poor spend a higher share of their budget on food and other essential commodities, inflation especially fuelled by rising prices of food and other necessities hurt the poor more than the non-poor.
The main objective of macroeconomic policies in South Asian countries is to ensure economic stability together with low inflation and sustain high economic growth. As elsewhere in the world, the central banks of South Asian countries are committed to maintaining reasonable price stability. Price stability is desirable because a rising price level (inflation) produces uncertainty hampering smooth economic growth. Although considerable debate exists regarding the nature of growth inflation trade off especially in low income countries, macroeconomic stability is an important prerequisite for harnessing rapid growth and ensuring social equity in South Asia. Inflation can be costly for the poor since their purchasing power is eroded; their assets are devalued more as they hold a larger share of their assets in liquid form compared with the non-poor; and it is difficult for the poor to hedge against inflation due to their limited access to the financial system.
This paper examines present trends of inflation and growth in South Asian countries and suggests policy options for managing inflation at reasonable level. The paper is structured as follows.
Growth and inflation in South Asia: According to recent projections, growth in South Asia is likely to decelerate from 8.6 per cent in 2007 to 7.1 per cent in 2008 and to 6.7 per cent in 2009 (Table 1). On the other hand, inflation is projected to more than double from 5.5 per cent to 11.8 per cent between 2007 and 2008, and recede to 9.2 per cent in 2009. Current account deficits are also projected to widen significantly.
In the context of the present global financial crisis, the growth projections above may be modified downwards for some countries. Even then, the point to be noted here is that some of the countries will achieve growth above the regional and global trends.
In most South Asian countries, overheating from excessive aggregate demand, aggravated by imported cost-push factors, has made inflation a critical issue calling for strengthened macro management and a sober assessment of macroeconomic priorities for designing the reform agenda for the short and medium terms. Overall, the region's growth prospects remain fundamentally strong. One reason for this is that since the end of the Asian crisis, priority in South Asia has been to boost economic growth. In this context, a relatively loose monetary policy fuelled the backward looking inflation expectations that emerged as an important source of South Asian inflation. On the other hand, monetary policy accommodative of food and oil price shocks gave rise to forward looking inflation expectations, somewhat reinforcing the already high backward looking inflation expectations. This unwelcome prospects gave the region's central banks enough reasons to wake up to the importance of subduing inflation before it becomes entrenched and inflicts further damages to their economies. This shows the need for these economies to undergo painful tradeoffs along with much needed corrective policy measures.
In reality, the present growth-inflation trade-off facing South Asian countries appears favourable mainly because the growth prospect of the region remains fundamentally robust. Although the loss of output due to anti-inflationary tightening policies could somewhat dent the region's growth but it is unlikely to push the region into recession. However, it would still take a great deal of political courage to decisively act in controlling inflationary forces.
As with many other developing countries, surging inflation, deteriorating current account balances, worsening fiscal balances, and depreciating local currencies have hit South Asian countries in varying degrees during the current inflation episode. In South Asia, inflation accelerated in 2008 reaching double digits by mid 2008 in most countries (Table 2). In particular, food price inflation emerged as the major concern since food consumption covers a high proportion of consumer spending, especially for the poor. In addition, the countries were adversely affected by adjustments in administrated fuel prices through, for example, higher costs of transportation and for operating farm equipment in the backdrop of rising and volatile oil prices in the world market. The weakening of local currencies against the US dollar especially in India and Pakistan in 2008 also contributed to inflation pressures, exacerbating the rise in global commodity and import prices.
The impact on the current account was, however, partly relieved by strong performance in services exports (India and Maldives) and robust workers' remittances (Bangladesh, Nepal, and Sri Lanka). Slowdown or reversal of capital inflows in the wake of current economic problems in some South Asian countries also emerged as an area of concern. Moreover, elections expected in 2008 and 2009 in several South Asian countries (e.g. Bangladesh and India) might delay in further price adjustments and subsidy cuts leading to worsened fiscal balances. Similarly, tighter credit conditions and higher interest rates in several South Asian countries might dampen investment with slower economic growth.
The writer is Governor of Bangladesh Bank, the Central Bank of the country