Sunday, May 25, 2008

Oil Prices, Inflation, Dollar Exchange Rates

Oil prices touch $135. Inflationary pressure is highest today across the world. Food prices are shooting up. India is seeing the highest inflation in the whole of Asia; about 7.5%. All my macro-economic lessons from my B-school classes are flashing before my eyes. I belong to the school of thought which believes in free markets with minimum government intervention in the form of subsidies or price-caps.
India has been the prime example of the OPPOSITE of a free market for the longest of times. This period was long known as the lisence raj! Ofcourse, once India decided to throw open its market to foreign investors, there has always been this tension of what to throw open to the free market, and what to subsidize/apply price caps. Today, for example, medicines and health care products are heavily price capped. Fuel is heavily subsidized. If the government let prices of both these important sectors float, a major portion of the population which lies under the poverty line will be seriously affected in the short term, before the free market kicks in and responds. Ofcourse, if you were the ruling party, you'd never want to make this move 'cause this is sure to get you overthrown the next term. Most of the masses, which are directly affected by the initial surge in prices of the free market, do not understand the broader macro-economics behind such a policy change. They would hold the government accountable for the high prices they are paying (in the short term) and this would cause government instability which in term would put the price caps/subsidies right back in place. So, in effect, the price caps and subsidies are here to stay for a while atleast.
However, today, the fuel subsidy is the one that is due to change very quickly. Due to the subsidy/price-cap policies in many countries in Asia, demands for fuel haven't come down in the last couple of years. It has only gone up! This should not be the case 'cause there is primarily an increas in demand, when the supply has remained constant. There HAS to be a price change according to basic economics. The rest of the world (Europe and US) have seen negative growth in demand for fuel becauses the prices have almost doubled now! It was $2.10 per gallon when I left the US in 2006 March. Today in May 2008, i think the fuel prices are hitting almost $4 per gallon. In India on the other hand, the price has gone up from Rs. 42 per liter to Rs. 48 I think. This can't go one forever??
We are already seeing signs of change across Asia (which is where most of the fuel price caps/subsidies from governemnts exist) . Indonesia has raised reduced fuel subsidy and hiked its fuel price. So have Sri Lanka and a few other Asian countries. India & China will soon follow suit. On the contrary to what a lot of people think of this being a bad thing.. I love this move! This would give the most populated portion of the world a little chance to feel the heat of the increasing price. This will temper down the demand for fuel from this side of the world. Fuel suddenly will become more expensive to everyone, and they will try to cut down on the usage of fuel. This will suddenly make alternate sources of energy more viable. More solar energy and bio-fuel energy will be consumed as compared to fossil fuels! This will force more money to be pumped into innovating in solar energy and other alternate sources. Great! All the better for our planet!

On a somewhat similar note, the other big deal is the gigantic inflation world over on food prices. Food prices are soaring. America is blaming India and china for increased food consumption. India rubbished US's claims by showing that US has suddenly increased it's bio-fuel consumption (which means more and more food like corn is being used to make bio-fuel), hence driving demand of food through the roof! But, then, I have asked myself why such high fluctuations in food prices suddenly. Shouldn't it have been a little more gradual? So gradual, that we shouldn't be noticing it. An article I read on the Business Standard a couple of days ago made me understand things a little better. The buying power of India and China have gone up. Hence, a Rs. 1 or Rs. 2 increase in food prices isn't noticed as much as it would've been noticed 10 years back (demand for food has become lot more. Which means, according to the free market theory, there has to be a drastic change in price to even affect the demand.

The future kind of gives me the creepies. Let's see where all this is headed!



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