Thursday, January 27, 2011

Indian Inflation

Economist: Bringing Tears to Indians’ Eyes
Bloomberg: Bank Bonds Off to Worst Start since 2007 as Inflation Rises: India Credit
Economic Times: Indian Long End OIS Rise Tracking Bond Yields

India’s economy is slated to grow at 9% of GDP for the next two years; a great achievement for what is still a developing nation. Nonetheless, the big economic and political problem in India is inflation. India is an anomaly as many nations, especially the rich ones, are concerned about the opposite problem: deflation. Even when India’s 8.4% inflation rate is compared to other developing nations it is still high.

However, India is not a nation plagued by constant high inflation. In fact, wholesale price index (WPI) inflation was negative year-on-year in June and July last year and was below 2% for every month between March and September. Inflation is more volatile in India, but economists do not know why this is.

The increase in inflation is affecting the Indian bond market as Indian banks’ dollar-denominated bonds are heading for their worst January since before the credit crisis. Indian consumers are buying gold and property; two commodities that are inflation resistant. Bonds are unpopular in inflationary environments as inflation can make the real interest− rate returns on the bonds very low or negative in some cases. As market interest rates rise with inflation, the value of existing bonds falls because investors can get higher returns on new issuances. Thus the value of older issuance bonds goes down.

As bonds are less attractive, Indian debt has become more expensive to finance because consumers demand higher interest payments in an inflationary environment. A ten year U.S. Treasury Bill is 482 basis points lower than a ten year Indian bond, up from 463 at the end of December. One basis point equals 0.01%, so if the difference in interest rates is 2.5% between two bonds, financial analysts say the difference is 250 basis points. If investors choose to invest in gold and property instead of bonds, they could cause a liquidity crunch in the banking sector because less money is available.

Although India faces a seriously inflationary threat, there is political and economic tolerance for higher inflation. Real rates of economic growth are high, population growth is slower than ever before, and real incomes are rising quickly enough to compensate for inflation. Indian policymakers fear they will debilitate India’s recovery from the global economic crisis if they increase interest rates to lower inflation by decreasing the money supply. K.K. Chakabarty, deputy governor of the Reserve Bank of India, said that inflation was a difficult but manageable situation.

1. India is a huge market of consumers and producers. What effect would increased inflation have on western investment in India?
2. If India does face a liquidity shortage, then will this shortage spread to other nations, or even the rest of the world?

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