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How best to tackle inflation

Rajesh Kumar, Outlook Money | July 16, 2008

The inflation fire is now an inferno. It singed wallets on its way from 4.7 per cent in July 2007 to 8.86 per cent in May 2008. It did not stop there, but shot up to a 13-year high of 11.42 per cent for the week ended 14 June. Much of this recent rise is being attributed to the pervasive impact of the increase in the state-administered prices of oil products on 5 June. That looked inevitable after international oil prices rose to an all-time high, up to $140 a barrel last fortnight. Worse, this inflation is not expected to go south anytime soon. Says Shuchita Mehta, senior economist, Standard Chartered Bank: "We expect inflation to remain high for some time and to average 8.72 per cent this fiscal year."

Why high inflation is here to stay

Oil aftershock. With little chance of increasing global supplies, higher extraction costs, production cuts and export taxes in some oil producing countries, and speculative investments in oil by large international investors has buttressed price pressures due to continuing high demand for oil.

Rising food prices. A worldwide shortage is driving up food prices. In India, oil seed prices are 20 per cent higher than a year ago. While food supplies are expected to increase over 6-8 months, higher costs of inputs (diesel, fertilisers, and seeds, among others) would likely continue to keep prices high.

High commodity prices. High prices of commodities such as iron and steel and edibles have been responsible for about a fifth of the spike in price rise. With stockmarkets worldwide falling, large international institutional investors are buying commodities, further pushing up their prices and inflation, a trend unlikely to change soon.

Expensive funds. On 24 June, the Reserve Bank of India [Get Quote] hiked the cash-reserve ratio and the repo rate (rate at which it lends to banks) by 50 basis points each to reduce liquidity and weaken inflationary pressures. This has raised banks' cost of funds and, thus, making cost of production higher. With limited policy options, it could do so again.

Weaker rupee. With a rapid price rise you need more rupees for the same amount of imports, making imported products or those with high import content such as edible oils, costlier. Expect more of the same.

Money shock

The immediate impact of high inflation will be pressure on household budgets, and lower savings, both for now and the future. Higher interest rates are pushing up EMIs. Inflation-adjusted returns from fixed income options, be it fixed deposits or pensions, have gone negative.

Five-year term deposits paying 8.5 per cent when inflation is 11.5 per cent are giving real returns of -2.69 per cent. So, the value of what you get back is lower than what you put in. The future's not rosy either. Higher costs due to high inflation is likely to dent corporate profitability, putting downward pressure on stock prices.

Some sectors, such as aviation, could see layoffs, while fewer people will be hired by IT, BPO, and banking and financial services companies. A recent services employment report for April-June 2008 by staffing company TeamLease said ITeS lost the most (-24 points) on its index of increasing employment.

Your action plan

As always, to tackle the situation, you will have to keep existing outflows down, skip new large expenses, bump up your savings, and invest in higher return options at, perhaps, marginally higher risk.

Enhance emergency funds, life and health covers. The 3-6 months' worth of expenses that you keep aside in liquid assets such as fixed deposits for emergencies will need to be increased. Life and health covers may need to be augmented. Bridge the gap with low-cost term plans and family floaters.

Avoid large savings account balances. Drain your bank account into short-term debt funds such as fixed maturity plans.  Sanjay Prakash, CEO, HSBC Asset Management, says: "At 9-10 per cent returns, the real rate of return for FMPs may be negative in the short term. But, we expect inflation to lower by the last quarter of 2008 after which returns will turn positive."

Prepay your home loan. As home finance rates are set to climb higher, prepay your floating rate loans. No investment option will currently give assured returns to match the higher interest outgo.

Opt for capital gains and dividend instead of interest. Interest income is taxed at your income tax rate while capital gains taxes are lower or zero. Also, short-term capital gains are taxed at higher rates than long-term gains, which can even be zero. Dividends in your hands, whether from stocks, equity or debt mutual funds, is tax free.

Continue with equity investments. "The only way to beat inflation is to keep investing in equity," says Rajen Shah, chief investment officer, Angel Broking. Carry on with your existing systematic investment plans in equity funds. For fresh investments, seek larger cap funds from OLM 50 - they are likely to rebound first, along with the blue-chips they primarily invest in.

If you want to pick up stocks, invest in stages and go for value buys. History is on your side. If you had invested in the Sensex after the markets recovered from the tech bust in 2004, you would be sitting on gains of about 150 per cent even now. Avoid interest rate-sensitive stocks such as real estate and auto. Go for large-cap pharma and FMCG stocks, which are more stable.

Diversify in international funds and gold. Over the last six months, while the Indian market was falling by over 30 per cent, international funds fell by a little over 13 per cent. As before, we will yet again recommend that you invest 5-10 per cent of your portfolio in gold exchange-traded funds and gold mutual funds as periods of high inflation witness a surge in gold prices.

This will shore up the minimum long-term growth of your overall investments.

High inflation has terrible repercussions on the future of our money. Luckily, we have enough weapons in our arsenal to fight and win the war against it. Time's come to pull out all stops. 

Prices on fire

Why inflation rose to a record high...
Rising oil prices. At an all-time high of $140 per barrel, oil prices have more than doubled from $64 a barrel in April 2007, fuelling inflation.

Rising food prices. A global shortage of foodgrains, such as wheat and rice, has made the food prices index shoot up by about 10 per cent, pushing up inflation.

High commodity prices. High prices of commodities such as steel and cement due to their less-than-adequate supply has made industrial production, housing, roads, airports and other crucial infrastructure more expensive.

High cost of funds. To combat inflation, the central bank is sucking out excess money from the economy by increasing cash-reserve ratio and increasing repo rates so that less money chases the limited supply of goods and services. This, however, is also driving up the cost of existing funds, that is interest rates, adding to inflation.

Rupee's eroding purchasing power. Rising prices are eroding the value of what the rupee can buy vis-a-vis other currencies such as the dollar. The rupee's fall of around 8 per cent in the last six months has made major imports like petroleum and edible oil costlier, fuelling inflation.

...and why it will continue to remain high

New era of high oil prices. With little prospect of increase in international oil supplies, production declines in some oil producing countries, increasing oil production costs, taxes on oil exports by producing countries and speculative investments in oil by large international investors, besides continuing high oil demand, oil prices are expected to remain high.

No respite from high food prices. While the situation of shortfall in supply is likely to improve in the next 6-8 months, higher input costs in the form of costlier diesel, seeds, fertilisers and the like will neutralise the impact of enhanced food supply.

Uninterrupted rise of commodity prices. As most stockmarkets across the world test lower levels, investments by institutional investors pouring into commodities is expected to keep commodity prices high. Also, with no sign of demand for commodities from high-growth countries like China tapering off, no relief seems to be in sight.

High interest rates to continue. As long as high prices remain, with limited fiscal policy options, the Reserve Bank of India will either make attempts to suck out money or ensure status quo. This will mean continuing high interest rates and inflation.

continued pressure on the rupee. Various domestic and international macroeconomic factors are expected to keep up the pressure on the rupee, which will make imports more expensive.

How high inflation will affect you

Higher Budgets. Get ready to pay more for vegetables, groceries, especially soaps, detergents, packaged food, personal and public transport, as well as for services such as couriers.

Costlier loans. You can expect costlier loans, especially car and personal loans. New home loan rates are likely to go up even as the tenure or EMIs of existing home loan rates go up.

More expensive recreation. Higher airfares along with lower purchasing power will make international travel more expensive even as domestic leisure becomes costlier.

Dent on returns. Fixed income options such as bank fixed deposits and monthly income options will give negative returns after adjusting for inflation, impacting senior citizens, single parents and risk-averse investors such as those with many dependents. Impact on corporate profitability via higher costs will bring down stock prices.

Higher taxes. To raise more money to cushion vulnerable parts of the population the government might impose higher taxes, cesses and surcharges on goods and services.

Lower infrastructure growth. Upcoming road, airport, power and port projects will witness cost escalations and might see slow downs.

Some layoffs and lower pay hikes. Hard hit sectors such as aviation could see some layoffs while most sectors are likely to witness lower pay hikes. This may be especially true in the IT and the BPO sectors.

More austere workplace. Expect fewer office parties and conferences, reduction in amenities, office travel and allowances as employers try to cut corners to save costs.

How you can fight back

Review your emergency fund requirement. Keep six months' expenses as emergency funds, mostly in short-term debt funds such as inflation- and tax-efficient FMPs.

Examine your health and life cover. With costs going up, you need to bump up your life and health covers. Go for low-cost, high-cover term plans and floating health covers to bridge the gap. avoid large idle savings and bank balances. Invest in short-term debt funds like FMPs.

Defer large loan-based purchases. Avoid large EMIs that will stretch your finances more. Go for your first home if you can afford the down payment and EMI.

Prepay high-cost loans. Start with your floating rate home loan. Remember, no investment option will provide guaranteed returns that equal the higher interest payout.

Seek capital gains and dividend instead of interest. Interest income gets taxed at your income tax rate. Long-term capital gains and dividends from equity and equity MFs are tax-free, but taxed at 10 per cent without indexation and 20 per cent with indexation if coming from debt funds. Dividends from debt funds are tax-free post dividend distribution tax.

Continue staggered investments in equity and equity MFs. Carry on with your systematic investment plans (SIPs) in equity funds. For fresh investments, seek large-cap funds from OLM 50 that are likely to benefit from a rebound along with blue chips they predominantly invest in.

Diversify into international funds and gold. Gain from the upsides in well-performing equity markets in other countries by investing in international funds. Investing in gold (up to 5-10 per cent of your corpus) will give your portfolio a stable growth.

Avoid interest rate-sensitive stocks. This includes sectors such as real estate and auto. The best bets would be large-cap pharma and FMCG stocks currently available at attractive valuations.

Invest windfalls.

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