Recession: What to do

Deflation: Managerial Implications for Companies

By Prof. Ramesh Bhat and Sunil Maheshwari

The recent announcement of drop of inflation rate to 0.44% should be a cause of alarm to all of us. We are at the verge of deflation. We all know, deflation is essentially just the opposite of inflation. Like inflation, deflation is also very costly for organizations.

 

Deflation adds complexity to decision making. Let us understand this complexity by using a simple example.  Suppose a company sells 10 units @ Rs. 20 per unit during normal times.  As deflation happens the quantity demand goes down to say 6 units and also there is pressure on prices and prices go down to Rs. 15. This deflation has affected both sides of your revenue – price and demand.  Deflation works on three sides: demand, price and joint impact of demand and price.  These effects can be segregated to examine the implications. 

 

Many times the impacts on input prices side such as raw material and salaries and output price side i.e., prices we charge from customers are not symmetrical.  This can lead to distorted margins and various financial implications.  For example, if during normal time salary was 10% of total revenues (in above example it would be 10% of 200 = 20), the same salary during recession time becomes about 22% significantly affecting the margins.  Therefore actions on many fronts are required to keep things under control and not allow it to worsen further.   

 

In times like this a prolonged recession with deflation is likely to worsen the situation further.  Currently, the government is also likely to face increasing burden of servicing the debts owing to high fiscal deficit (In one of the estimates it is estimated to be 14% of GDP). This may have serious implications for the developmental projects of the Government. This may prolong the deflation.

 

Deflation (or very low inflation) and RBI policy actions (like lowering of interest rates) to stimulate the economy may eventually push interest rates very low. However interest rates in India cannot be reduced beyond a point. This will actually raise the real interest rate in deflationary economy. It will discourage consumption and investment. It will further reduce aggregate demand and the general price level. The downward spiral will continue. Literature describes this situation as a "deflation trap."

During a recession, unemployment is typically high, as the demand for workers is weak. In order to boost employment, nominal wages need to fall. But employees and managers are typically very resistant to accepting wage reductions in nominal terms. Therefore real wages actually rise.

The rise in real wages result the job losses. This may prolong the recession on several counts. It could affect factors like consumer confidence, thereby weakening aggregate demand. It also could discourage firms from increasing employment, given that product prices and profit margins are shrinking.

These developments have some significant implications for companies in sectors that are severely hit by recession. The prices and demand in both these sectors are likely to go further down. These sectors are likely to witness rise in unemployment owing to reasons, explained above. Firms are likely to find it difficult to bear all the expenses. The balance sheet of the firms is likely to remain uncertain. Under these conditions, we suggest the following:

1.  Keep close watch on all discretionary expenses.  All expenses that could be avoided should be avoided or delayed by all means.
2. Find out ways to keep % of various expenses in balance with total revenues.  Renegotiate all contracts.  Ensure all incremental costs are variable in nature.
3. Real wages of people will rise even if nominal wages remain the same. Hence, we should restrain from giving annual raise to employees.
4. Inventories in every firm should be minimised as the prices will fall and the value of inventory will become lower with time.
5. Every customer will be important in deflationary economy. We will have to be extremely customer sensitive.
6.  All investments should be postponed, unless absolutely essential.