Dharmakirti Joshi & Gunjan Gulati: Global integration, local barriers

Greater integration with the world has lowered India's inflation, but inter-state barriers have meant this benefit has not percolated evenly across all states.

In the last three years, India has not only recorded the highest growth historically, but also emerged as one of the fastest growing economies in the world. What is notable is that high growth has not been accompanied by high inflation. On the contrary, the overall inflation in India has been quite benign. The CPI and WPI inflation stood at 4 and 5.4 per cent respectively between 2003-04 and 2005-06.

Further, in comparison to the decade of the 1990s (1993-94 to 2004-05), the decade of the 2000s (2000-01 to 2004-05) has witnessed a reduction in inflation and its volatility as measured through the coefficient of variation (CV). All-India inflation measured through the GDP deflator has come down from 8 per cent to 3.8 per cent, and its CV has reduced from 18 per cent to 15 per cent between 1990s and 2000s.

Both the reduction in the level of inflation and its volatility are attributable to improvements in productivity, technological advances and increased global integration. The reduced volatility of inflation is also consistent with the hypothesis that openness reduces inflation volatility. A recent research by Christopher and Malik (2006) shows that trade openness reduced inflation volatility and the impact is more pronounced in developing than in developed economies. Reduced tariff barriers and rising shares of trade in GDP are indicators of increasing openness of India and lower and less volatile inflation is a manifestation of that.

The next question that comes to mind is whether the reduction in inflation has benefited all the states uniformly or some states more than others. The uneven regional growth pattern for India has been well documented. Is the same true for inflation? To examine this we look at the pattern of inflation across Indian states.

At the state level, two measures of inflation are available "" State Domestic Product (SDP) deflator and Consumer Price Index (CPI). While the former is the most comprehensive measure of inflation, the latter measures the standard/cost of living. We rely on the former in our analysis as, apart from being comprehensive, it allows us to examine the sectoral sources of inflation. The table documents the growth performance vis-à-vis inflation (measured through SDP deflator) for 20 major Indian states. The states have been grouped according to their performance vis-à-vis the all India average.

This highlights the uneven spread of inflation across states. Many states with high growth were the ones that witnessed low inflation. Included in this category are eight states: Delhi, Gujarat, West Bengal, Andhra Pradesh, Kerala, Karnataka, Uttaranchal and a bit surprisingly Bihar. The states in this group grew at an average rate of 7.4 per cent and witnessed an average inflation of 3.0 per cent during 2001-02 to 2004-05. Further most of these states, with the exception of Bihar and West Bengal, have high per capita income levels. Thus, clearly the states with better initial conditions have generally been the beneficiaries of high growth and low inflation. These states also benefited from relatively low inflation in agriculture, industry and services. Thus, the supply side shocks from agriculture did not contribute to inflation except in the case of Kerala which witnessed an average growth of ""3.3 per cent in the sector.

In contrast are the states that witnessed low growth and above-average inflation (Quadrant III). These states on the average grew at 3.8 per cent per annum and witnessed 4.1 per cent inflation during the first five years of this decade. While the growth is significantly below the average, inflation is only marginally above the "all India" average. This group includes high per capita income states like Maharashtra and Tamil Nadu and the poorest states in India like Orissa and Madhya Pradesh. The sectoral pattern of inflation shows that agricultural inflation has been high in Orissa, Madhya Pradesh and Tamil Nadu but industrial inflation has stayed below the "all-India" average. Services sector inflation was also above average for these states. Thus, agriculture and services sectors have been the contributors to above-average inflation in these states. With agriculture growing at -1.9 and -1.1 respectively in Maharashtra and Tamil Nadu, a negative supply shock from agriculture gave push to agricultural inflation. Amongst these states, service sector inflation was the highest in Madhya Pradesh.

Clearly the benefit from lower inflation has not been uniform across all the states. The differences in inflation rates are to some extent explainable through idiosyncratic shocks from agriculture. But clearly the mix of growth and inflation seems to have shifted in favour of higher growth and low inflation across many Indian states with high growth states benefiting the most.

Also, while inflation-volatility at the all-India level has fallen, it has remained high and stable across states. The CV of inflation across states has remained high at close to 42 per cent through 1990s and 2000s.

While India has got more integrated with the rest of the world, Indian states have not integrated much with each other. A number of inter-state trade barriers like permits, checkpoints, fiscal barriers exist. These increase the transaction costs for commerce between states. Thus the integration with rest of the world affects different states differently. Moving towards a common market by removing these barriers is likely not only to promote growth but also help in reducing inflation differentials and its volatility across states.

The authors are Principal Economist and Economist at CRISIL Ltd