Seeing Inflation and Growth Through a 3D Prism

The specter of inflation is back in South Asia. While core inflation- that excludes certain items, notably food articles and energy- has spiked moderately, headline inflation in most countries is now double digit. This is also happening at a time when many parts of the global economy are fighting deflation!

Generally, supply shocks, or higher demand push prices up. However, a closer look gives us a different picture. The total stock of food grains with the Food Corporation of India and other government agencies, for instance, increased to 58.4 million tonnes in July, 2010. The stock was much above buffer norms. Yet food inflation in India has been double digit for several months. One might argue that this is due to high inflation expectations. Based on available data and the forecast by the Indian Metrological Department, the country will experience a near-normal monsoon. So shortage in agricultural supplies is probably not the reason behind high food inflation.

Similar stories can be traced elsewhere in South Asia. In Bangladesh, for instance, there is a wide gap between international and local prices of imported commodities. Prices of food articles between different locations in Bangladesh are highly divergent.

While monetary policy can be quite useful to contain core inflation, its role as far as headline inflation is concerned has proved to be less potent. Upward adjustment in traditional monetary tools such as policy rates or currency appreciation might not have a profound effect on inflation.

Then there are issues concerning growth. Bangladesh’s gross national savings, for instance, is 35 per cent of its GDP but it invests only 25 per cent. Its incremental capital output ratio (ICOR) is approximately 4. With this ICOR, it should have grown at the rate of 9 per cent. Economic growth rate is the ratio of investment to ICOR. However, it has been growing at approximately 6.0 per cent for the past five years. What explains Bangladesh’s inability to grow at 9.0 per cent? Energy shortages, higher economic distance, inadequate infrastructure, and poor regional connectivity, among others, bar Bangladesh from growing at 8.0 to 9.0 per cent.

It might be more useful to see the aforesaid problems in 3D prisms. 3D is an acronym for Density, Distance, and Division. The concept received much attention following the publication of the World Development Report (WDR) 2009 titled “Reshaping Economic Geography” by the World Bank, although the idea originally comes from Paul Krugman, who received the 2008 Nobel Prize for Economics.

Countries can increase the ‘density’ by concentrating economic activity in a few areas-coastal areas are prime candidates. The ‘distance’ between markets can be shortened through an expansion of transport services. Correct policies should be adopted to reduce barriers to the movement of goods and services, helping to eliminate ‘divisions’.

According to WDR 2009, density is the first of the geographic dimensions of development that underlies the economic mass or output generated on a unit of land. The economic merits of density are profound. Literally no country has developed without the growth of its cities. Examples are abundant – from ancient Rome to modern day’s Seoul or today’s Shenzhen, which did not even exist 30 years ago. Paris generates 28 per cent of France’s GDP using only 2.0 per cent of its land. According to the WDR, denser concentrations of economic activity increase choice and opportunity. They ensure greater market potential for the exchange of goods, services, information, and factors of production.

The next critical factor is distance. Economists measure distance between two places based on economic distance, and not Euclidean one (ordinary distance between two points). The distance between Dhaka and Gazipur (where many apparel industries are located), for instance, is merely 26 kilometres (km). It should take less than an hour to commute between these two places but the travel time is on average two to three hours. From Gazipur a consignment of goods needs half a day, if not a day, to reach Chittagong port, a mere 208 km distance. In China people and goods from Shanghai can travel to Wuhan (a distance of 682 km) in two to three hours. China’s high-speed trains run at speeds between 260 km/hour to 350 km/hour, connecting the coastal areas to inland cities.

Poor infrastructure in Bangladesh and elsewhere in South Asia inhibits products and people from moving freely between cities and the countryside. The cost of high economic distance is enormous. Prices of commodities vary widely between the countryside and cities due to higher economic distances in South Asia, prohibiting prices from converging at least within the country, if not across the region.

Economic borders are narrow elsewhere in the world barring South Asia and Africa. Landlocked Nepal, for example, is just a few kilometres away from the Bangladesh border. But the economic distance between these two neighbours is a few hundred, if not thousand, kilometres. This brings the issue of ‘divisions’ in the picture. There are tariff and non-tariff barriers across the region and beyond the borders. High economic distance and divisions restrict the flow of goods, capital, people, and ideas in South Asia.

Bangladesh shares a 4,098 km border with India. The people of north-east India are closer to Bangladesh than to those in the Indian mainland-irrespective of their geography, history, culture and language. The economic isolation of over 200 million people encourages illicit trade, fuels terrorism and increases tensions along the border. Yet they could have been natural trading partners, exploiting the comparative advantages of their respective regions.

Bangladesh’s economic growth is severely constrained due to energy shortages, while there is surplus hydro-power in Bhutan and north-east India that could be diverted to Bangladesh’s power grid. Energy-starved Bangladesh can invest in Nepal’s underutilised hydropower sector. Bangladesh has two sea ports and it is a connecting point between South Asia and ASEAN countries. Its advantageous geographical location could have been exploited for the benefit of landlocked north-east India and Himalayan countries.

There is a tendency in India and elsewhere in South Asia to seal borders to control the flow of already restricted goods and services if there is inflation or inflation expectations. This deprives poor farmers getting the right price for their produce on one side of the border and the poor on the other side of the border see inflation affecting their incomes. This adversely affects agriculture production-with a lag affect. There are more poor people in India than Sub-Saharan Africa and nearly one-third of Bangladeshis live below the poverty line.

For politicians and bureaucrats it is more convenient to seal borders than address fundamental issues. While many parts of the world are virtually borderless, India is constructing a 4,000-kilometre fence to seal the India-Bangladesh international border.

One might cite recent developments in India-Bangladesh relations as a success so far as South Asia’s regionalism is concerned. This move, if implemented, could reduce the gap between Euclidean and economic distance. However, unless New Delhi allows natural trade between north-east India and Bangladesh, the comparative advantages between these two close neighbours remain unexploited. This limits Bangladesh, north-east India and Nepal to increase the ‘density’ of economic activity by concentrating production in a few border cities geared to exports.

Hence, there is a limitation to what extent fiscal and monetary policy can contain inflation and remove the barriers to growth. In this connection, such issues also need to be viewed through 3D prism. If addressed properly in the light of 3D, individual countries of South Asia as well as the region can solve many fundamental problems concerning inflation and growth.

Originally published at The Financial Express.