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Tuesday, April 03, 2007

Squeezing the Middle Class Without Impacting Growth?

RBI has raised rates again in less then two months making the dream of home ownership to most middle class harder. The benchmark rate for floating rate is 12.75% adding eight more years to a 20 lakh loan making renting much cheaper than owning a house .[Bloomberg]

RBI is aiming to remove Rs 40,000 crores from the economy. But, as Gudem alerted earlier, its also pumping back some of the liquidity, to keep rupee weak, reducing the impact of its own action.

Meanwhile homeowners suffer. It'll probably reduce demand for home and other goods - expensive and not so expensive - by most middle class. But as it's already clear, the inflation issue the RBI is trying to tackle is coming from raising food prices. No amount of suffocation of middle class consumption will likely to lower the demand for food and so will have little impact on food commodities prices.

Andy Mukherjee, of Bloomberg, seems to think that because most large companies have access to cheap overseas capital, they are likely to keep growing and keep the economy growing at high rates as it has for the past three years:

Domestic tight-money conditions may not dissuade investments by large Indian companies, which have easy recourse to cheaper overseas borrowings.

As a result, the Indian economy may grow about 9 percent for a third straight year, almost ruling out interest-rate cuts in 2007. [Bloomberg]

I'm not so sure. Some companies with strong export lead growth may expand, but if local demand growth dries up, most companies will probably go slow on expanding capacity. RBI's narrow focus on reducing inflation may slow the economy down significantly by suffocating consumer consumption while hitting the breaks on industrial expansion. (There are other methods available that may be more helpful in reducing inflation caused by commodities, such as opening up the sector for free trade, as discussed in the comments section of this post.) It took years to get consumption back on track and to get industry to invest in expansion again, after a similar RBI induced recession of mid-90s. But this time may be a bit different.

If we follow this path for very long, we may have continued inflation, from food commodities, and an economy in recession, creating a much dreaded stagflation type situation - a very difficult muddle to get out off.

Cross-posted on INI-Signal.