Sunday, 6 November 2011

Inflation in India

Inflation is a much maligned but sometimes poorly understood phenomenon that has the most significant impact on any personal finance plan.  Particularly in a emerging country like India, inflation can be so rampant as to be the fundamental parameter that influences all investing decisions.  Inflation is usually defined as a rise in the general level of prices of goods and services in an economy over a period of time.  In the words of noted economist Sam Ewing, it is the reason why you pay $15 for the $10 haircut that you used to get for $5 when you had hair. 

First it would be instructive to look at inflation in a mature developed economy like for example the US.  In recent years the US has not experienced significant inflation levels, with the inflation rate hovering around 3-4% for the last decade.  The following is a chart from Wikipedia that shows the US CPI Inflation over the last century.

Over the last couple of decades since 1990 US inflation rates have been relatively stable and low.  Inflation rates of around 3-4% seem very comfortable and makes financial planning over the long range, a tad bit easier.  The interesting thing is that in the 70s inflation was very high averaging in the high single digits, and peaking at 15%.  My key takeaways from this graph are that even in a mature economy inflation if not controlled can go up significantly, and also the variability in the inflation rate cannot be avoided particularly over timeframes that range over decades (like hopefully my retirement days)

Now lets contrast this against the inflation rates seen in India.  I found this historical annual CPI inflation data on the Worldwide Inflation page.
As you can see inflation in India since the mid-70s has averaged around the 10% mark.  The 1999-2005 period in recent memory is almost like a "Golden" period from an inflation perspective, characterized by low levels of inflation, and possibly the resultant bull market.  However, the recent high inflation rates that many of us are complaining about, is just a return to the mean that our parents struggled with through the entire earning careers.  The early-70s seem an aberration due to the events of the time like the India-Pakistan wars, and more importantly the oil-shock of 1973-74.  Before that the mean seems to hover around the 10% mark.  There is not much point looking at inflation data prior to the 50s since the conditions in pre-independence colonial India were very different and lessons learnt from that period are most likely not applicable today.  My key takeaway here is that the India has always worked with a high inflation rate of 10% and I don't see the norm changing in the near future.  Periods of low inflation (in the low single digits) are few and rare, and should be taken advantage of, as and when they occur.  In the meantime, we should be looking back to the age-old methods used by our parents to combat high inflation rates.

Here are some, at first glance non-intuitive, but extremely sane financial decisions that I have seen people make as a result of the prevailing high inflation environment.

We tend to stock up on non-perishables as we know the same product is going to cost more next month.  In these times of rising incomes, people have more purchasing power, and I routinely see them buying large quantities of soaps, cosmetics, house-hold cleaning agents, even grains, biscuits, basically anything that is non-perishable and can be stored for a month or longer.  Every super-market you walk into, you can see sales on bulk non-perishable goods, and people willing to buy these bulk products (for example a pack of 5 soaps, that will probably last a family of 4 for 3-4months) knowing fully well that the same item will cost 5% more in a few months.

Real estate has seen a crazy spiral of inflation driven price increases.  There is a mad rush to acquire property due to the fear that the same house or plot of land will appreciate between 15-20% in a year, pushing it out of your spending capacity.  Builders and property development firms take advantage of this phenomenon by launching huge developments with 100s and nowadays 1000s of flats, with the firm belief that they will be able to find customers to lap up these offerings.  The average joe is in a rush to buy property to "lock-in" today's price, since he/she knows that in as little as 5-7years the same property will cost double the price.

Wages are caught up in an inflation driven spiral as well (economists call this cost-push inflation) as employees clamor for higher wages in order to maintain their lifestyles in a high inflationary environment.  This in turn drives up costs further, and adds to the cycle of inflation.  The new Gen-X and Gen-Y employees have become used to this environment and typically expect wage increases in the double-digit percentages.  This expectation (which has been met in recent years) leads to unhealthy financial decisions that are dependent on future expected wage hikes.  The younger generation is willing to make bigger purchases, most times leveraging on loans, expecting to be able to repay them with future wage increases. 

It makes financial sense in a high inflation environment to accumulate (or hoard) products and assets.  In addition to hoarding what you can afford with your current wealth, most folks begin to leverage by taking loans to accumulate assets beyond their current means.  The thought is that the high inflation environment will continue, and future loan re-payment will be with a de-valued currency that is progressively easier on the borrower. 

Health care costs continue to spiral, making it difficult to estimate insurance premiums and how much insurance cover to purchase.  Insurance firms increase annual health care premiums, and keep releasing products with higher insurance limits, and more innovative schemes like top-up insurance products with high deductibles.  There is also a brisk trade in life insurance policies since the term insurance that you bought 5 years ago for Rs 10 lakhs cover, no longer seems adequate today simply because of the de-valuation of currency due to inflation.

Finally, retirement plans are most impacted, since any form of fixed retirement income (PPF, NSC, FDs etc) is typically not inflation indexed and hence doomed to failure.  Equity and real estate are probably the only forms of inflation indexed investments that can combat the high prevailing inflation rates.  And predicting a retirement corpus to enable early retirement becomes a herculean task to estimate with any reasonable degree of accuracy.  

The positives in this story are that, high inflation environments have existed before in mature economies, and are fairly typical in other emerging economies even today.  We should be looking for strategies for wealth management and growth that have worked in these environments in other countries, and adapt and apply them within the Indian context today.  This would be the right approach since, "The middle class learn from their own mistakes, while the rich learn from others mistakes!"

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