How competition reform can check inflation

Business Standard, September 22, 2011

By Pradeep S Mehta

Once again the Reserve Bank of India (RBI) has raised the interest rates, with several questioning the wisdom of the decision. Inflation has become the bugbear of our growth story, and in the recent past some of our econocrats have also suggested for lowering the growth rate to curb it. This may be true for an advanced industrialised country like the US where growth and inflation have been generally low. It is certainly not the right prescription to deal with the ills that our economy is facing, nor can we raise interest rates, again and again, as the prescription for curbing inflation. What seems to be sadly missing in this debate is how competition reforms can help growth, improve governance and check unnatural inflation as well, at least in the medium term.
Market power inflation occurs when businesses exploit monopolistic situations or when they collude explicitly or implicitly with other traders to make abnormal profits by raising prices. We saw this happen in the case of onions about a year ago, where implicit cartels exploited the shortage.

In resource-intensive or utility sectors, it is difficult by their very nature of operations to follow a pricing policy based on normal returns. What they do, is to add a markup over and above their average cost of production. In India, there is no set policy to assess such markups that result in unnaturally high profit margins.

Unnatural inflation mostly occurs when there are supply-side constraints, which the RBI has flagged stating that these need to be tackled to curb inflation. These constraints are due to various reasons, including entry barriers. Some of these entry barriers are also artificial and created by the incumbents to thwart competition. It is here that governance deficit matters. There are many recent examples of how vested interests use their “power” to persuade governments to impose regulations or create favourable conditions that generate monopolistic rents.

Let me elucidate two examples here. Late last year, the government imposed definitive anti-dumping duty for a period of five years on polypropylene imports from Oman, Saudi Arabia and Singapore at the request of oligopolists in the market such as Reliance Industries Ltd (RIL) and Haldia Petrochemical Corporation Ltd (HPCL). Unless there was a cartel among the suppliers from the range of countries, it does not make sense that they would all be dumping, i.e. selling below cost. Evidently the domestic manufacturers were faced with price competition that they could not counter and filed anti-dumping complaints.

Policies with anti-competitive outcomes have been undertaken by state governments also. In October, 2010, the Tamil Nadu government declared that farmers would be given motor pump-sets with four-star energy saving rating for irrigation, free of cost, provided they had registered for supply of free power. However, the rider was that the pump-sets had to be bought only from two nominated companies at double the prices than the cost of such pump sets in the market, which was Rs 6,000-Rs 8,000.

While these anecdotal stories reflect part of the problem, recent experience of inflation in India has exhibited a well-established trend — it is higher in those sectors in which demand is growing without commensurate increase in supply. Inflation forecasting is a tricky business as explained by Kaushik Basu, chief economic adviser in the finance ministry, demand-supply mismatch is not a new thing in India. Many of our econocrats are too busy managing aggregate demand, including tweaking the interest rates, whereas a better response lies in the fact that “supply creates its own demand”.

Empirical evidence has established a negative relation between inflation and growth. Too high an inflation is certainly harmful for a country’s growth. Therefore, without controlling unnaturally high inflation if we adopt growth-reducing policies it will be bad for our economy, with a higher impact on the poor. In fact, sustained low growth can lead to a deflationary situation as in the US in 1930s and in Japan in 1990s.

In short, challenges exist on many fronts. We cannot afford to lower our growth ambitions since that will cut revenues for the government and concomitant negative impact on social spending, which is so important for addressing non-income aspects of poverty. We cannot have a long period of very high inflation since it is eroding the purchasing power, particularly that of the poor. As our prime minister had once said, “curbing inflation is one of the best anti-poverty programmes.”

Our policy honchos are taking several measures to control inflation. Every other day we hear that the present bout of high commodity price is a temporary phenomenon and it will be controlled within a few months. Alas, the situation is getting from bad to worse.

Some of these short-term measures are necessary. But are they sufficient in the long run to make our growth story much more robust with moderate inflation so that the common man can enjoy better purchasing power?

One such long- and medium-term measure is to create a culture of competition in our country. At present, it is largely missing. True, there is a competition agency and it is taking some steps in inculcating competition into our economic landscape but it is not equipped to catalyse large-scale competition reforms.

Competition reforms and the existence of an effective competition regime can help growth and curb inflation. More and effective competition can generate new innovations, which is a major driver of economic growth. Recent research has proven this point and successfully contradicted the conventional thinking that competition is bad for growth because it can curb monopoly rents that was considered as an incentive for successful innovations. A detailed study by the Australian Productivity Commission on the impact of wide competition-policy reforms in Australia carried out in 1995-2005, has estimated that enhanced competition has resulted in a 5.5 per cent more growth in the Australian economy over a period of time.

And there is enough empirical evidence that higher product market competition can reduce inflation over a period of time. Competition can increase supply — more choice for consumers at affordable and fair prices.

Fortunately, the government of India has initiated the adoption of a National Competition Policy that seeks to promote competition reforms across the economy. A draft is under wide consultation. This policy is expected to be adopted within the next six months. Effective implementation of this policy along with our competition law and the necessary coordination between different agencies will usher in a new era of competition reforms in India. Effective competition reforms to enhance growth and curb inflation should be the mantra.

Pradeep S Mehta Secretary General, CUTS International, a research and advocacy group

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