Inflation Threat

In recent times, inflation is in the news for a number of reasons. First, the latest estimate of current inflation rate has reached whopping 11%, according to Nepal Rastra Bank (NRB). Second, some prominent experts of the subject say the NRB figures underestimate the actual situation.

Another notable fact is that though the inflation figure is already in the double digits, the authorities are not taking any serious step to control it. They are happy to blame it on the international factors and keep a resigned attitude about controlling it. Even more important is the fact that the country’s present economic situation is not at all suitable for realising whatever possible benefits of inflation there may be. The political uncertainty continuing for the last several years has complicated the matter further.

Though it is a quite common text book theory that the burden of the inflation is the heaviest on the lower income and fixed income people (the salaried class, small farmers, petty shopkeepers etc.), the ongoing inflation cycle in Nepal is hurting them higher than in previous cycles. The price index prepared by NRB for measuring the inflation shows that the price hike in food items (that carry 53 percent weight in the average household budget) is 13 percent and in case of cereals, it is nearly double of the average. In case of staple rice (weight 14.16 percent), the price rise is above 25 percent (see table in the page 58).

And the analysts of Nepali inflation so far have concentrated in blaming the international factors - particularly the food and energy crises for increasing inflation. Efforts to find solutions at home and spotting opportunities that this crisis may offer are conspicuously absent.

Prominent among those who think NRB figures underestimate inflation is Dr. Raghab D. Pant, Executive Director of IFDS, a leading research institute on public policy affairs. Though Dr. Pant does not give a separate figure as the actual inflation rate, Sashin Joshi, CEO of NIC Bank, says that inflation in Nepal must be at least one percentage point more than that of India as Nepal is import-dependent and about 70 percent of the imports are from India. (See table in the next page for import dependency with India). “Accordingly, inflation in Nepal is imported from India,” he says. In his estimation, it takes between two to six months for the Indian inflation to be transmitted here.

It is worth noting that the inflation rate reported in India was 11.98 percent in the week ended on July 19, 2008 while it was 7.82 percent in May. It was again at 12.44 percent in the week the ended on August 2.

Also Prithivi Bahadur Pande, the Executive Chairman of Nepal Investment Bank, thinks that inflation in Nepal must be higher than in India. In his reckoning, the inflation rate now in Nepal must be between 12 to 15 percent. “If the Indian inflation is at around 12 percent, the Nepali inflation is certainly more than that,” he argues.

India uses wholesale price index to measure inflation while in Nepal it is based on retail prices. When goods are imported here from India, the importers and retailers add their respective margins, which is naturally higher than one percent. Added to it is the transportation cost. “Thus, when our import from India is so huge, any debate whether the Indian inflation is affecting our inflation here is redundant,” he adds.

CEO of Siddhartha Bank, Surender Bhandari too does not agree with the inflation rate estimated by the NRB. “Present inflation rate must be about 15 percent,” he says. Similar is the view of Kishore Maharjan, CEO of Sunrise Bank, who estimates the actual inflation figure at present to be above 15 percent.

However, Nar Bahadur Thapa, Director at Research Department of NRB, stands by the figures published by NRB and swears by the sanctity of the method of calculation followed by NRB. (See next article for the methodology used by NRB to collect the price data and calculation of inflation rate).

Differences on Causes

The experts differ also on the causes of the ongoing inflation. For example, Thapa of NRB blames significant increase in prices of food, energy and construction material s as the main cause of ongoing inflation. Sashin Joshi agrees to it only partially and says: “These push factors are certainly playing a major role. But we should not forget the role played in inflation by increase in money supply, which is 18 percent according to the latest figures thanks to the increase in government expenditure, as well as inflow of remittances.” Joshi points out that the banks too are contributing to increasing money supply and for this he blames the monetary policy of NRB that has made the environment so conducive for the banks.

As text book theories in economics say, money supply has direct and even proportional contribution to increase inflation if the quantity of real goods and services produced is constant and the money supply consists not only of currency notes issued by the central bank, but also the credit money created by the banks through loan extended in such forms as overdrafts.

Trade Dependence with India (Import)
India ’s Share in Import to Nepal since FY 2002/03

1	Country	2002/03	2003/04	2004/05	2005/06	2006/07
2	India	70,924,200	78,739,500	88,675,500	107,143,100	117,740,400
3	Total Import	128,228,134	135,840,335	148,294,229	160,677,924	197,676,512
4	Share of India (in %)	55	53	60	67	60

Source: Trade and Export Promotion Centre

National Urban Consumer Price Index
(1995/96= 100) Mid June 2008

Groups and Categories	Weight (%)	% Change 06/07	% Change 07/08
1. Overall Index	100.00	4.5	11.0
1.1 Food and Beverages	53.20	5.8	13.0
Grains and Cereal Products	18.00	5.0	21.2
Rice & Rice Products	(14.16)	3.2	25.1
Pulses	2.73	8.0	11.1
Vegetables and fruits	7.89	9.6	-3.3
Spices	1.85	21.4	0.3
Meat, Fish and Eggs	5.21	4.3	12.6
Milk and Milk Products	4.05	6.1	10.5
Oil and Ghee	3.07	9.1	29.3
Sugar and Related Products	1.21	-18.0	5.5
Beverages	2.28	2.3	4.2
Restaurant Meals	6.91	4.0	11.2
1.2. NON FOOD AND SERVICES	46.80	3.1	9.0
Cloth, clothing and sewing -Services	8.92	2.5	3.0
Cloths	(2.28)	0.4	1.9
Clothings	(5.75)	2.8	3.2
Footwear	2.20	5.2	5.1
Housing goods and Services	14.87	2.6	16.7
Fuel, light and water	(5.92)	0.4	24.4
Transport and Communication	4.03	0.6	2.5
Medical And Personal Care	8.03	3.1	5.0
Education, Reading and Recreation	7.09	5.9	6.2
Tobacco and related Products	1.66	5.2	10.5
Petroleum Products	2.71	0.1	35.8
Non Petroleum Products	97.29	4.8	9.8
Source: NRB

Core CPI Inflation

(1995/96= 100) Mid June 2008

Groups and Categories % Change 06/ 07 % Change 07/08 1.

1. Overall Index 5.0 8.3

1.1 Food and Beverages 5.8 11.2

1.2 Non Food and Services 4.3 5.5

Source: NR

Kishore Maharjan blames the ongoing inflation not only on oil price rise but more importantly on the frequent strikes or bandhas. “Rising petroleum prices, ongoing scarcity of petroleum and the frequent bandhas together have created a very conducive environment for blackmarketing through creating artificial shortages. This has contributed to the increase the prices of daily necessities,” he says. The situation is persistent as there is a small but powerful group of people which is not worried by the escalating prices as this group gets high salary from their employers and good remittance from abroad bolstering its purchasing power, he points out.

Nabil Bank’s CEO Anil Shah has still different view. According to him, it is neither money supply nor the petroleum price that is causing such high inflation. Rather he blames it on the ongoing political turmoil. “The most effective way to tackle the problem of inflation is to achieve high economic growth for which political stability in the country is a must,” he says, adding, “In the absence of political stability, neither foreign nor domestic investment will be forthcoming. And in the absence of investment growth, you can’t expect economic growth,” is his conclusion.

Thus in Shah’s view, the country has to wait for some more time for the ongoing inflationary phase to end. “During the phase of political transition, political uncertainty is natural. Now we are moving ahead steadily towards the end of the transitional phase, and hopefully the day will come soon when the now volatile situation will stabilise and the investors will increase investment so that the supply of goods will be smooth. In that situation inflation control will be lot easier,” he says.

Inflation & Threat to the Government

Many experts and analysts such as John D. Robertson of Texas A & M University in his paper “Inflation, Unemployment, and Government Collapse” (cps.sagepub.com/cgi/content/abstract/15/4/425) have concluded that there is high probability of collapse of incumbent government when there is high inflation. Though Nepali economists still rule out any such possibility in present day Nepal until it reaches the level of hyper-inflation (as is seen in Zimbabwe), the historical data indicate a close correlation between high inflation and launch of decisive popular movements, start of armed revolt or the like.

Recent international events corroborate this hypothesis. Haiti’s government recently collapsed after a week of food riots that saw Prime Minister Jacques Edouard Alexis’ removal from office.  Enraged by the soaring cost of staples such as rice and beans, Haitians had engaged in a week of rioting in which at least five people lost their lives. Also in India, the ruling Congress party lost in the election to the state assemblies held last year and the defeat was attributed mainly to high inflation.

Nonetheless it is to be accepted that people may not be so aggressive due to inflation if the economic activities are expanding. If the economy is growing, people at least have anticipation for a better change.

Year	Inflation Rate	Political Events
	(Average Price
	Indices)
1990	8.9 %	Jana Andolan I
1996	8.1 %	Maoist War started
2002	2.9 %	King Gyanendra enthroned
2005	4.5 %	Royal Takeover
2006	8 %	Jana Andolan II

Source for the inflation rate: International Monetary Fund

Threats

While inflation may also have a number of positive effects as well (such as encouragement to the producers etc.) when it is moderate, the nature of ongoing inflation in Nepal is such that its effect will be only negative, say the experts.

For example, as Dr. Pant points out, the ongoing inflation has been hurting the low income-group people the most. To clarify his point, Dr. Pant notes that the price hike in cereals as reported by NRB is 21.2 percent and within this category the price rise in rice and rice products is 25.1 percent. “Since the share of these products in the overall household expenditure of the low income people is the highest, the ongoing inflation has already made the life of these people miserable,” he says. Thus he points out that if the ongoing inflation continues for long, social unrest is most likely to erupt.

Maharjan’s prediction is that with this inflation, the disparity between the haves and haves-not will widen. The haves will be able to continue their existing lifestyle as their income is likely to go higher, he thinks, indicating to the likely increase in the salary of the government employees in the coming budget. As this will leave a large section of the society high and dry, the social harmony is very much likely to worsen leading to all types of problems, he fears.

Bhandari and Shah agree. “People may lose hope when they find that however hard they toil, they don’t earn enough to survive. In such situation, they may resort to any action which may be dangerous,” says Shah.

But NRB’s Thapa says there is no need for panic right now. According to him, the present rate of inflation is not unbearable as yet. “How can one argue that the present rate of inflation which is just above 11 percent is devastating when Sri Lanka and Pakistan have 26.5 percent and 19 percent and India’s is one percentage point above what we have?” he questions.

In fact, the hazards of inflation aren’t limited to the low income people only. There is high correlation between inflation and change in government – either by election or popular uprising (see box on next page).

Responsibility

The trickiest question to answer in the inflation debate is related with its solution. In the international practice, controlling inflation is the primary responsibility of the central bank. As Y.V. Reddy, the Governor of Reserve Bank of India recently said in an interview that RBI will do whatever it takes to bring inflation into manageable limits; the NRB too must do something to control inflation in Nepal.

Agrees Joshi, who thinks it is the fiscal policy rather than monetary policy that can be effective in controlling the ongoing inflation of Nepal. For this he offers two reasons. First, the potency of monetary policy tools is nullified by the open border, currency convertibility and trade dependence. Second, the ongoing inflation is caused more by supply constraints than by sudden increase in demand.

One of the monetary policy measures to control inflation is tightening Cash Reserve Ratio (CRR) for the banks just as India did recently. However, Pande fears that if such a step is taken in Nepal it would be counter-productive as it would discourage investment.

“What Nepal needs at the moment is more investment and no pretext can be justified to control it even if such a step may contain inflation,” he says.

But the fiscal policy solution is not easy either. One fiscal policy step in this connection is to reduce the general expenditure as reducing development expenditure is not desirable. The major expense headings in general expenditure of the government are the loan services and salary to the government employees. These cannot be reduced in the short-term. Added to this are the new expenses related to peacekeeping.

Therefore, Shah thinks it may be better to forget about inflation and focus on other pressing issues. “The ongoing inflation is not in our control as it is caused by international factors. Therefore, we better focus on things that are under our control,” he says suggesting that the government should rather try to ease the supply situation and invest in development activities.

Maharjan suggests letting the petroleum price adjust to the international level and controlling bandhs. These two steps would ensure easy availability of fuel and smooth operation of transport so that the supply of essential goods will be smooth.

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What is Price Index and Inflation?

A price index is a weighted average of all prices taken together. Prices for a given section of goods or services in a given region, during a given interval of time are collected to estimate price index. It is a gauge designed to help to compare how these prices, taken as a whole, differ between time periods or geographical locations. The current inflation rate is derived through comparing such changes.

Inflation means increase in the general level of prices of goods and services. It brings decline in the value of money. For example, if the price of 1 liter of refined cooking oil alters from Rs 95 to Rs 100, quality remaining the same, then this increase in price level symbolizes inflation. This change must be pervasive to be called inflation. In other words, the price change in only one commodity does not qualify to be inflation. Moreover, the price change should be continuous over an extensive time-frame. The rate of change in price indices is the rate of inflation.

Formula Used By NRB for Estimating Price Index

In Nepal, the NRB uses Consumer Price Index (CPI), also known as Retail Price Index, to measure inflation.. Though there are many ways of calculating Consumer Price Index, NRB uses the Laspeyres formula. Laspeyres suggested this index formula in 1871.

Assuming that for individual item i, price at the base period is p i 0 , at the observation period p i t , and quantity at the base period is q i 0 , “Laspeyres formula”, is as presented below

Here, the denominator and numerator are total expenditures for all items at the base and the observation period respectively. This formula assumes that the consumers purchase the same amount of commodities both at the base period and the observation period. In other words, the quantities are fixed at the base period. 

For practical use, eq.(1) is transformed as follows;

This is weighted average of price ratios of each item - weighted by expenditures at the base period.

Data Collection Method

A slight error in the data collected may affect the usefulness of the price index. Therfore, the accuracy of the data is very important. Many critics who doubt the accuracy of the inflation rate announced officially doubt at the accuracy of the data used in the price index.

To select the items to be included in the price index and to give the wightage to each item, NRB bases its decision on the latest Urban Household Budget Survey. Such survey was first conducted in the year 1973-75 and the latest was conducted in the year 1995/96. One such survey was conducted just recently and its final report is about to be published, accoring to NRB sources.

Till now with 1995/96 as the base year and the quantiry and prices of that year as the base year quantity and base year prices, NRB compares them with the current year prices. To collect the current year prices, NRB sends its staffs to meet the businessmen in different market centres in periodic basis.

Price monitoring unit in the Research Department of NRB is resonsible for collecting these data. Prices of commodities from Kathmandu, Lalitpur, Bhaktapur, Thimi and Banepa market centers are collected by the department itself while for the collection of data from markets outside Kathmandu valley the staff of respective offices of NRB are mobilised. NRB has been collecting retail prices of 301 food and non-food items from 21 urban centres (267 items for Terai, 284 for Hills and 301 for the Valley). Some prices are collected on a weekly basis while others are collected on fortnightly, monthly, quarterly, half-yearly and yearly basis. (See table for the routine of collecting prices in Kathmandu valley and around).

These details and data go through the formula of Laspeyres to determine the National and Regional indices which are disseminated through various media. This report provides the percentage change in the price index of the current month over the same month of the previous year which is called the year-on-year (YOY) change. Moreover, it provides the YOY change in the price index for each of the previous 12 months. A simple average of these twelve month data gives the current average inflation rate.

Some Notable Price Indices are as follows:

Consumer price index (CPIs) measure the price of a selection of goods and services purchased by a “typical consumer.”

Producer price index (PPI a.k.a Wholesale Price Index) which measure the prices received by manufacturers. This differs from the CPI. The price subsidy, profits and taxes may cause the amount received by the producer to differ from what the consumer paid. PPI has certain influences on the CPI as through wholesale and retail margins. This margin is passed on to consumer affecting CPI. Thus any consequent increase in CPI is due to PPI/WPI. India uses wholesale price index to measure inflation.

The GDP Deflator is another measure of inflation but it differs from the inflation data reported by NRB. GDP deflator is the measure of the prices of all the goods and services included in Gross Domestic Product (GDP). The Inflation data reported by NRB differs from GDP deflator because many items included in GDP may not be included in the items for which NRB collects the data for the price index it prepares for measuring consumer price inflation.

Capital goods price Index isn’t applied yet anywhere in the world but several economists have pointed out the need of measuring capital goods inflation separately because most of the inflation in recent times has happened in the capital goods prices. Capital goods include stocks, real estate and other assets.

Core versus Headline inflation

Core inflation is a gauge of inflation that rules out certain items that face unstable price fluctuations, e.g. food products and energy. CPI tends to change more on a short term basis than does “core inflation”. This is because core inflation doesn’t take into consideration the change in prices of food and energy etc. which has temporary price stability. Core inflation is thus intended to be a gauge and forecaster of core long-term inflation. Nevertheless economists argue that this index is no superior to CPI as it ignores the movements in prices of subtle items.

Headline inflation is a measure of the total inflation within a market incorporating the price movements also in food and energy. Such movements occur when a specific segment of the economy experiences an impulsive price increase probably due to external factors. As a result, headline inflation may not present an accurate picture of the current state of the economy. This differs from core inflation which excludes factors such as food and energy costs.

Many of the bankers and experts of the subject believe that the current inflation is undoubtedly due to the prices of oil and food. NRB shows whopping 11% rate of inflation (which is actually the headline inflation) and if assessments are made between the core and the headline inflation (see table on page 58) then we realise that to a certain extent, the current inflation is definitely influenced by prices of oil and food.

This is because the headline inflation rate, as of mid June, 2008, is higher than that of core inflation of the same period. This is because headline inflation incorporates the price movements of all the items including food and oil while the core inflation excludes prices of oil and food which have temporary price stability.

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