VAT and inflation spikes
Business Page
This column provides informative commentary on business and financial matters and is written by Patrick van Beek, Managing Proprietor of Caribbean Actuarial & Financial Services.
Stabroek News
April 8, 2007
Introduction
Just under two years ago, while writing for the business page, I focused on the pick-up in the year-on-year rate of inflation (as measured by the Georgetown Urban Consumer Price Index (CPI)) for April 2005 caused by the floods and the dramatic increases in oil prices. I warned that if inflation picked up any more this could lead to a price/wage spiral thereby further enforcing inflationary pressures in the economy. Indeed, in every one of the next 11 months prices increased. In August 2005 alone prices increased by 3.0% - the highest one month increase since my records of monthly data begin (Dec 99). The increases in prices culminated in March 2006 when year-on-year inflation hit 9.65%. Consumer prices cooled off somewhat over the coming months, partly as a result of the oil price easing and partly as a result of a slow-down in economic activity corresponding to the run-up to elections. (FigI)
For the remainder of 2006 inflation remained benign, at under 5%. However the introduction of VAT has once more served to cause a dramatic increase in prices - January saw prices increasing by 6.6% for the month, and the year-on-year rate shot up to 9.29% -a 122% increase over the rate for the previous month. It should be noted that price increases tend to be seasonal, over the last seven years on average the largest price increases have occurred in January, February and March. However even stripping out this effect the seasonally adjusted figures for January and February are 8.91% and 8.09% respectively.
Wage negotiations
An 8% increase in prices will have a dramatic impact on the ability of low income earners to make ends meet. A basket of goods costing G$20,000 one year now costs some G$1,600 more. Considering that the increase in the income tax threshold would result in an increase of take-home pay of $1000, it means that most people will be poorer in real terms.
In the upcoming round of wage negotiations employees and unions bargaining on their behalf will be pushing hard to ensure the standard of living is returned to the point before the implementation of VAT. The headline inflation figure will no doubt be considered the starting point in these negotiations. If increases are granted in line with this rate then this will result in a significant wage bill for the employers. The danger is that these costs are passed on to consumers, further increasing prices thereby fuelling an inflationary price/wage spiral.
Mitigating this risk is the fact that wages generally do not increase much faster than the rate of inflation. In order for real disposable income to increase there needs to be an increase in real terms - that is the pay rise must exceed the rate of inflation. It is interesting to note that despite inflation in Suriname consistently exceeding that in Guyana, its per capita income is much higher than Guyana's. Analysing historical wage increases it is apparent that real wage increases there have been significant.
I suspect this is one of the reasons for the higher rate of inflation. An argument can be made that however desirable price stability is in the long run if incomes are not increased in real terms then it may be doing more harm than good. The corollary to this is that those who are not in employment will suffer unduly due to inflation biting into the purchasing power of their savings.
Savings hit hard
The graph below shows the returns on a small savings account versus inflation and the US$. An investment three and a half years ago growing at the small savings rate would have grown some 12.7% (ignoring tax). However, compared with the increase in prices over the equivalent period (28.3%) the investment in small savings rate has produced a negative rate of return! Putting it another way, an investment at the small rates can buy 12% less today than it could buy when the investment was made three and half years ago. Even the mighty green back has failed to keep pace, largely thanks to general weakness in the Dollar versus the Euro. (Fig 2)
For those wondering why I choose June 2003 as the starting point for this graph it is the date shares first started trading on our local stock exchange operated by GASCI. I originally included the van Beek Index (which tracks the capital returns of local shares trading) as well, however the increase over the period (73.2%) swamped all the other items!
Conclusion
The spike caused by the floods and increasing oil prices turned out to be just that. With the introduction of VAT once again the BoG will be treading a fine line between holding inflation at bay and choking off economic activity.
Unions will not stand by idly and the next round of wage negotiations will see fierce bargaining for increases in wages to counteract the impact of the inflation caused by VAT. All the while, those saving in the banking system are seeing the value of their investments shrinking in real terms.