The commodity correction is welcome but half the CAD worsening is on account of policy & regulatory distortions

They say fortune favours the brave. For all the criticism that policymakers has copped over the last few years, one has to admit they?ve been brave over the last six months. Who would have thought diesel prices would have been hiked by seven rupees and still rising in a pre-election year? Who would have thought the government would have had the gumption to slash spending to reduce the fiscal deficit to almost 5%? Who would have thought it would risk its political survival over of FDI in multi-brand retail?

And, as so often happens, bravery begets fortune. Oil and gold prices have plunged in recent weeks. Gold prices have corrected 12% in just three weeks, while crude prices are down 10% since March. Not only will this help inflation and oil subsidies but?because oil and gold account for 40% of all imports?has the potential to make a big dent in India?s most significant macroeconomic challenge, the current account deficit.

But the sharp correction in commodity prices is being (wrongly) construed in some quarters as a panacea to all our current problems. There are whispers of how?if prices stay at this level?CAD will lapse back to the old normal of 2-3% of GDP. And rates markets have begun to price in a 50 bps rate cut at the May review, presuming that the commodity price correction is a game changer.

But markets are getting ahead of themselves. To be sure, the recent fall in gold and oil prices is undoubtedly a big positive for India. But, equally, half the current account deterioration over the last two years has nothing to do with global commodities or weak exports. Instead, it?s on account of policy and regulatory bottlenecks at home, that have caused coal, fertiliser and scrap metal imports to surge, iron ore exports to collapse, and precipitated a sharp outflow of FDI profits.

In the first part of a two-part series we quantify the potential savings from lower oil and gold savings under different scenarios, but show that almost half the widening of CAD over the last two years has nothing to do with commodities or exports. In tomorrow?s second part, we assess the future prospects of policy-induced imports and come to the sobering conclusion that some of these phenomena are likely to get worse before they get better, thereby offsetting more than half the gains from falling oil and gold prices. So while falling commodity prices is clearly a good thing for India, we are not out of the woods just as yet.

Can gold be a game changer?

Forecasting commodity prices is a mug?s game. The point of this piece is therefore not to opine on the direction of commodity prices but to document how large the beneficial impact could be for India if prices remain at these levels. That said, commodity prices tend to be seasonally lower in the second quarter as demand tends to soften in the transition between winter and summer. For instance, average gold prices in 3Q have been higher than the 2Q low in 18 of the last 19 years, with an average price increase of 6.4%.

But, back to India. Recall, gold imports surged to $56 billion in FY12 as both rising prices and volumes combined to create a double-whammy. The government responded with multiple duty hikes but, to its dismay, gold imports are still expected to print a hefty $51 billion in 2012-13. This would, however, still constitute a 10% reduction in gold volumes?presumably a reaction to duty hikes.

So how large could the potential impact on gold imports be from the current price correction? If prices remains around current levels ($1,400/ounce), gold imports would decline about $8 billion vis-?-vis last year on account of the price decline alone.

The more interesting question is what the impact on volumes will be from a much lower gold price? To what extent will speculative demand unwind? Will gold consumption rise in the near term in response to falling prices? Answers to these questions warrant a separate note in itself. For now, we limit ourselves to a sensitivity analysis under various scenarios. Recall, India?s gold demand (in volume terms) was rather stable in the years leading up to Lehman, averaging about 710 tonnes per year. We assume this to be India?s stable demand for gold. Volumes rose by 30%, on average, post-Lehman, before tapering off 10% last year. We take the latest year?s volumes over the pre-Lehman volumes to be the ?incremental demand? which is believed to be a combination of speculative demand, inflation-hedging, rural penetration, and perception of gold as an asset class.

The accompanying table demonstrates the saving from various combinations of price and reduction in incremental demand. As is evident, the potential reduction in can be meaningful. If prices stay at current levels, and incremental demand falls by a third, imports will reduce almost $11 billion. Furthermore, this only takes into account the ?flow? impact. If one assumes that the stock of speculative gold holdings?accumulated over the last few years?also unwinds at these prices, then incremental demand falls far more sharply.

And let?s not forget savings from oil. If Brent crude prices average $100 over the next fiscal, India?s net oil import bill will decline by $12 billion from last year. If crude falls to $90 billion, the savings will rise to $22 billion.

One can now understand why markets are getting excited. If crude and oil prices stay at current levels, the imports savings could be close to $25 billion?more than one fourth of the FY13 CAD.

Uncomfortable truths: It?s not just oil and gold

Yet this is only half the story. While markets obsess about oil and gold, what seems to have been missed is that half CAD widening over the last two years has got nothing to do with global commodity prices or the export slowdown!

Instead, it owes its genesis to policy, regulatory and execution challenges at home. As a consequence, coal imports have doubled in the last two years, fertiliser imports have increased 30%, iron ore exports have ground to a halt and thereby also resulted in a 50% increase rise in metal scrap imports. All of these phenomena are a direct consequence of policy action or inaction. In addition, macroeconomic uncertainty, investment slowdown and execution bottlenecks have meant that the repatriation of profits from FDI in India has tripled over the last three years. So even as we obsess about Indian corporates investing overseas, what?s slipped through the cracks is that $12 billion dollars of FDI profits that could potentially be reinvested in India is being repatriated ever year.

Why is this important? Because over the last two years these phenomena have contributed a whopping $25 billion to CAD?and are responsible for half the deterioration since 2010-11. And, unlike global commodities, these are very much under the purview of policymakers, and can be mitigated or reversed by policy intervention.

In tomorrow?s follow-up we will look at these policy and regulatory distortions in more detail. Unfortunately, things are likely to get worse on these fronts before they get better. And, in the process, could wipe out a chunk of the savings from falling commodity prices. India has got lucky in recent weeks from falling oil and gold prices. And perhaps that luck was deserved. But, as we discuss tomorrow, we will need more than luck to solve our current account problems.

Sajjid Chinoy is Senior South Asia Economist at JP Morgan

(To be concluded)