It would also be quite easy to establish – although this is not brought out through additional data here – that there is no relationship between the fiscal stance and inflation rates. Thus, inflation has declined even though the government's fiscal balance remains at approximately the same level as a proportion of GDP.
 
Instead of monetary factors, which are clearly irrelevant, what appears to have been more important is a combination of domestic and external forces in the real economy, which are increasingly intertwined now with the greater integration of India with the global economy. The opening up of the Indian economy coincided in the latter half of the decade of the 1990s, with a period of slowdown and recession in international markets.
 
Since 1996, world trade prices and values of major commodity groups has slumped and even declined in some periods. Indeed, deflation is now the order of the day in the most important large economies of the world, including Japan for some time past and even, at present, the United States. This international slowdown has been accompanied by much greater competitive pressure and attempts at explicit and implicit dumping, as producers across the world seek to establish a foothold in what may become a major future market. Thus unit values of imports have tended to fall, as evident in Chart 10. It is also clear that unit values of imports and import volumes are strongly negatively correlated, and that lower import prices have been associated with strong inflows of imports in volume terms.

Chart 10 >> Click to Enlarge
 
This international tendency has been coterminous with the increasing liberalisation of external trade, which has affected the domestic price of imported goods and their substitutes. The removal of quantitative restrictions and the gradual lowering of tariff barriers have meant that the price of imported goods has fallen much more sharply within the domestic economy than is reflected by simply the unit values of c.i.f. imports. Obviously, this implies a significant downward pressure on domestic prices, which helps to explain why prices of most manufactured goods have remained low or fallen relative to other prices, despite increases in costs.
 
Import penetration, along with the lack of a positive stimulus coming from public investment, shifts in income distribution and a number of other factors, have all been associated with domestic recession. In fact, some degree of de-industrialisation is also evident, especially among small scale producers who have been unable to meet the threat of competition from abroad. Not only does such import competition tend to have much greater advertising and marketing power and established brand images, but it is increasingly coming in at lower per unit prices, as explained above. So the sheer possibility of import penetration itself, would have contributed to the control of prices directly through greater import volumes at lower prices, and indirectly its effect on domestic recession.
 
The recession has indeed been probably the most significant factor behind the current slowdown in prices. While there are many indicators of this current recession (including stagnation in industrial output growth, appalling rates of employment generation, falling per capita consumption in many rural areas, etc.) one useful indicator is the strength of capital formation. Chart 11 shows that real changes in gross and net domestic capital formation have been quite volatile over this period, but there is definite evidence of slowdown in the latter half.

Chart 11 >> Click to Enlarge
 
This becomes much more clear from Chart 12, where the average rates of increase are provided over the two sub-periods. The rate of change of net capital formation in real terms has fallen (in terms of annual averages) very sharply from nearly 10 per cent in the first sub-period, to just above 5 per cent in the second.

Chart 12 >> Click to Enlarge

All these indicators therefore suggest that the dominant cause of the decline in inflation rates has been the slowdown in the real economy, combined with the effect of cheaper imports at a time when internationally as well, prices are stagnant or falling. This is a situation as perilously close to deflation as it is possible to get.
 
Of course deflation has been largely unknown in India over its post-Independence history, and so there is little experience which can be sifted to provide instruction about how to deal with such a potential situation. What is clear, however, is that the current very low rate of inflation is not therefore a cause for celebration, but much more a source of concern. In addition, it is likely that this reflects shifts in income distribution which are more inequalising as well.
 
What is required in this context is much more active intervention by the government, in terms of increased productive spending, to lift the economy out of recession. A small increase in the price level as a result of this could even be welcome it is associated with more growth and employment generation in the system.