Sunday, February 10, 2013

I recently came across an article in Firstpost that drew my interest. The article talked about an asset that is also responsible for inflation in our country. Interestingly the same asset is also responsible for the widening current account deficit problem. The asset is none other than land. As per the article, land is responsible for higher inflation to a significant extent. And the reason it does so is because of its limited supply.

It all starts with people investing in land in order to earn rates higher than the rate of inflation. But things go awry when speculation sets in. Since the supply of land is limited, speculators enter the market and pay higher prices to hold on to the land. Their idea being that if they hold the land long enough, they would be able to find another speculator or interested party willing to pay a higher price. As this cycle of speculation sets in, the same piece of land keeps getting priced higher and higher. Two things come off it. First the persons from whom the land is being bought get richer and have more money at their disposal. Second, the feeling that they have become wealthy leads them to splurge even more not just on essential goods and services but also discretionary ones.

As demand of these goods and services rise and supply shrinks, there is inflation which leads to higher prices of goods in the country. The increase in prices attracts foreign goods and services without commensurate rise in exports. When this cycle sets in, there is an adverse impact on the country's current account deficit. As the cycle of speculation deepens inflation rates and current account deficit increases.

When this cycle continues for a long time then asset bubbles start to build. This seems to be exactly what is happening in India. Land prices have been spiraling upwards thanks to speculators. Though this is not the only contributing factor for inflation, but still it has supported continued higher prices in the country. The government needs to reform the laws to prevent and control this kind of speculation. The consequences are severe. We can already feel its repercussions with slowing growth and dampened economic conditions simply because the high inflation is not letting Reserve Bank of India (RBI) cut rates and encourage investment towards production of more go ods and services. If the bubble continues to build then things are just going to get worse. And when it bursts, the shockwaves will hurt the economy even more.