CIRCUIT BREAKER. There’s a nasty side to falling inflation

After grappling with runaway price rise for the last six years, most Indians have come to regard inflation as an evil in itself. Market experts often exhort the Reserve Bank of India to ‘slay the inflation monster’, visualising it as a sort of marauding Godzilla that stamps out the common man. They should now be happy.

Declines in global commodity prices, taken with the recent free fall in crude oil have combined to subdue the monster pretty effectively in the last six months. Domestic consumer price inflation (industrial workers) averaged 6.6 per cent in the first eleven months of 2014, after staying put at 8 to 12 per cent between 2008 and 2013. The wholesale price index reading in November actually fell to zero.

But despite our problems with price rise, this may not be cause for celebration. For a growing and aspirational economy like India, the adverse consequences of low inflation can be pretty hard to digest too.

It isn’t sinking in yet, but the most direct consequence of falling inflation rates is a fall in income growth for the salaried.

A tug-of-war is currently on between the employee unions of public sector banks and their managements. The unions are threatening to strike work unless the banks grant them a 19.5 per cent salary hike, but banks are only willing to offer a 12.5 per cent hike. The reality is that, if inflation continues to languish at current levels, a 12.5 per cent salary increase may begin to look like a luxury a couple of years hence.

This is not just true for government employees whose pay carries a dearness allowance component, but also for private sector employees. In the last four years, despite sluggish sales and profits, corporate India has seen its wage bill increase by 13-14 per cent every year. The primary reason for this was high and sticky inflation rates.

High inflation creates an obligation for employers to periodically enhance compensation to protect the purchasing power of their employees. But if inflation is in single digits, what bargaining power will employees have to negotiate wage hikes?

Apart from curbing annual increments, low inflation can also impact job prospects by restricting fresh hiring by firms. As most employers tend to be wary of reducing prevailing compensation packages to their employees, they may choose instead to make do with a smaller workforce. This would mean fewer jobs created and higher unemployment rates in the economy. This is indeed why Japan’s decade-long deflation or the Euro Zone’s falling inflation numbers are causing so much consternation among economists.

For an aspirational economy like India, where two-thirds of the population is of the working age group, slow job creation and low income growth can be particularly debilitating. Ultra-low inflation that persists for long can put paid to the ‘demographic dividend’ that everyone is banking on, to power growth.

If low inflation is bad news for the salaried, it isn’t reason to party for corporate India either. In the high inflation regime of the last six years, most consumer-facing sectors in India have come to take their pricing power for granted. So if steel prices rose, carmakers complained vociferously about it and immediately put up their selling prices. If cement prices soared, real estate developers jacked up the price tags on their already expensive apartments. When inputs prices fell for brief periods, though, producers were content not to tinker with their price-lines and quietly enjoyed higher profit margins. Old habits die hard and the Centre’s recent decision to revoke excise duty concessions on vehicles and appliances from January has seen passenger car and durables companies announce a 4 to 6 per cent increase in prices this month. This is despite the fact that global prices of key industrial inputs have declined in the last year.

But in a low inflation regime, slower income growth may prompt consumers to actively resist such price hikes. If inputs prices fall, such companies may be forced to tighten their belts and pass on the declines to their buyers, to stimulate demand.

‘Indian companies will deliver a 15-20 per cent earnings growth over the next five years.’ You must have heard this pronouncement quite often from market gurus keen to make a case for equities and justify the Indian market’s stiff-ish valuations of 20 times or so.

These earnings projections are based, not on tea leaves or tarot cards, but on a ballpark computation that goes something like this. Market gurus usually assume that India’s real GDP will grow at a rate of 6 or 7 per cent over the next five years, same as the last five years. To this real GDP (which captures the actual output) an 8 per cent inflation rate is added to get to a nominal growth of 14-15 per cent.

Based on the (wishful) belief that the best and brightest of corporate India will grow at a multiplier to the GDP (say 1.5X), they then get to the impressive 21-22 per cent profit growth ‘projection’ for the next five years.

The truth is that corporate India’s profits seldom grow in such a well-behaved and orderly fashion over any five-year block. But besides this, such projections can be seriously compromised by lower inflation rates. If the inflation assumption in the above equation is trimmed from 8 to say, 5 per cent, corporate profit growth sinks to 16 to 18 per cent. Will this not merit a lower valuation for equities?

Falling inflation, by hitting at the sales and pricing power of companies, can act as a speed-breaker to earnings expansion. So if low inflation drags on, you may have to lower your return expectations from your stock market investments too.

If there’s one section of people who have really benefited from high inflation rates in recent years, it is Indian borrowers — whether of the retail or institutional variety.

It is thanks to high inflation that India’s real estate boom has flourished over the last six years. As interest rates on home loans (after factoring in tax breaks) were typically much lower than inflation rates, anyone who borrowed to buy property created significant wealth. For one, double-digit inflation rates (with matching salary increases) made sure that their equated monthly instalments (EMIs) became more manageable over time. Two, inflation also propelled the value of their homes and the rental incomes upwards, even as their EMIs stayed put.

It is not just retail home buyers, but also the Centre which has reaped rich rewards from high inflation. The Centre’s total debt to GDP ratio, which was at over 65 per cent 10 years ago has dropped to 49 per cent now. Though the Centre’s loan expanded threefold in this period, galloping nominal GDP inflated away that debt.

Therefore, inflation is in reality good for salary earners, India Inc, investors and the government. So next time the inflation monster makes a comeback, maybe we should give it due respect?