Saturday, June 6, 2009

aam admi and WPI

Stubbornly upward bound retail prices along with bottomed-out WPI tend to take the common man by surprise and make the inflation numbers being
carried by the media (calculated as per WPI) suspect. Should he be happy about the low inflation numbers or should he worry about untamed prices of common commodities at the nearest kirana shop?

The simple fact that the a stubborn CPI and falling WPI had been existing together for the previous eight months leaves one wondering what the media-flashed low numbers mean. Here is an effort to compare and distinguish the underlying currents in the WPI and its relevance to the aam aadmi.

Fundamentally, WPI remains an attempt to index the prices of about 435 commodities collected at the wholesale level and compiled by the office of the economic advisor, ministry of commerce and industry and to calculate the extent of price movement on a year-over-year (Y-o-Y) basis. To filter out the seasonal effects that the fundamentals of the different commodities in the WPI basket might have, Y-o-Y calculation has been done to measure inflation or the price change. Hence one has to remember that the inflation number calculated based on WPI is only a relative number based on the price level a year ago and any lower inflation does not mean that prices have reversed but that the rate of price increase had declined.

Further, of the 435 commodities represented in the computation of the WPI index only about 77, i.e., 18% refers to commodities that can be associated with immediate consumption by the common man. And this has a combined weight of 21.54%.

Tracking the movement of WPI, it is natural that the price increase, which the common man sees in many of the commodities of common consumption, is likely to remain higher by 6.03% at the wholesale level. Though the appropriateness of the commodities and their weights remain debatable, to preempt the same, authorities should consider conducting expenditure surveys on a frequent basis (as is the case in the United States) or at least expanding the scope of the NSSO annual surveys to include WPI related commodities as well, to make it reflect ground realities more frequently. It would ensure that policies taken to contain inflation yield intended results.

The rest of the commodities in the WPI basket undergo some amount of industrial processing/value addition before being consumed by consumers directly or indirectly (services/manufactured goods) and can be grouped into three, depending on their consumption availability over a short/ medium/ long period in time. Among them, the first group of commodities gets value added and is available for direct/indirect consumption of our common man in a short time. This group would have an immediate impact on the price levels for the common man if not at the same interval as that of the earlier discussed group of commodities.

As per the existing WPI basket, it would approximately account for only about 26% of the total. With a 2.62% increase in WPI and given its weightage of 31.48%, the change in the WPI number would take a short period in time to get reflected in the prices of the ‘commodities or services’ that our common man would consume. The second class of industrial commodities (7% with 6.48% weight in WPI) would take a slightly longer time (six to 12 months) to impact the overall price levels or somewhat indirectly reach the common man.

The last group of commodities which represents about 49% of the WPI basket had undergone a price change of 1% (with its WPI weightage at 40.79%)
but would take more than a year’s time to get reflected in the price of goods and services that the aam aadmi witnesses in his neighbourhood. Overall, what trend he sees in WPI will not be what he would get to see on the grocery shop and will always be different due to reasons below.

Firstly, WPI is a reflection of prices that exist at the wholesale markets and there exists a long value chain mired in opaque markets which add to its margins often to mark up themselves to what our common man sees as inflation. Reforms in the value chain connecting producers with consumers and increasing market transparency would help in transferring the benefit of lower increase in WPI into CPI in all groups of commodities, more so in the case of the first group of commodities which are closer to the common man.

Secondly, given the current high volatility in forex rates (11%), equities (46%), interest rates (24%), and commodities (26%), value addition becomes a costlier process due to the high cost of risk management, which gets passed on to the consumers and reflected in increased prices of processed/value-added products. It essentially leads into a price-wage loop as it happened in the previous boom, breaking of which would need demand shrinkage that has the potential to lead to an unemployment spiral.

The existence of derivative markets in the above asset classes with public and private participation bringing in heterogeneity would not only help corporates to manage their risks effectively but also act as the conduit for the masses and public institutions to express their price expectations for natural or policy enabled smoother adjustment in demand and supply.

Thirdly, the existence of an effective competition policy and strict monitoring would help avoid collusion among the few industries within a given sector, thus preventing higher mark-ups in value-added commodities. Though the laundry list of inefficiencies in markets, manufacturers and service providers is unending, the first three here are obvious.

It will be a combination of policy, institutional and regulatory reforms that would help shrink the spread between the WPI and CPI. Till then for our common man, it will be not what he sees on the media as inflation or somewhere closer to it that he would get in his neighbourhood. After all, there is a reason for the public lending rate of the commercial banks (12.25%) to remain higher than the RBI’s lending rate to the commercial banks (reverse repo rate – 3.5 %).

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