Worsening supply bottlenecks are likely to eat up half the savings from the oil and gold price correction

Yesterday?s column (?Uncomfortable truth about CAD?, FE, April 24, http://goo.gl/l1u5g) pointed out how the sharp correction in gold and oil prices has set the proverbial cat among the pigeons. With these two commodities compromising 40% of all India?s imports, there is an increasing expectation in some quarters that?as long as prices persist at current levels?our current account worries are over and, with it, concerns about macroeconomic stability.

To be sure, from a stability perspective, things are looking far less ominous than six months ago. The government seems determined to pursue fiscal consolidation, non-food inflation pressures are finally moderating (helped by falling commodity prices) and there will be some relief on the current account from lower commodity prices.

Yet growth prospects remain weak despite 100 bps of rate cuts and a 20% depreciation of the exchange rate over the last 18 months. Why? Because in world economy still characterised by sub-trend growth, exports are unlikely to surge. The trigger will have to come from the much-awaited rebound in corporate investment. And, as is now widely acknowledged, the constraints to corporate investment are execution bottlenecks on the ground?land acquisition, coal linkages, raw material availability, and environmental and policy clearances at each level of government.

While the role of these factors is well-understood on dampening investment and growth prospects, their role in exacerbating external imbalances is less appreciated. As we pointed out in yesterday?s piece, 50% of the CAD deterioration over the last two years has nothing to do with weak exports or high commodity prices, but a widening of the trade and CAD on account of policy and execution bottlenecks at home. Worryingly, things are likely to get worse before they get better, offsetting a big chunk of the savings from oil and gold imports. So, let?s not proclaim victory on the CAD just as yet.

The direct impact: coal, iron ore, fertiliser

Rising coal imports are perhaps the most obvious manifestation of supply constraints at home that have accentuated external imbalances. As electricity generation capacity has ramped up, the demand-supply mismatch of coal has been exacerbated. Currently, coal import volumes are on course to doubling from just two years ago. In value terms, coal imports were less than $10 billion in FY11 and jumped to almost $18 billion the next year. The moderation of coal prices over the last 10 months is the only reason that coal imports did not surge further in FY13, even as import volumes increased another 30%.

The increase in the import bill?on coal alone?has been about $8-9 billion over the last two years. Given the expected demand for coal next year?even without price pooling?and given Coal India?s expected production increase, we expect coal imports to increase by another $3-4 billion. However, if the government goes through with a coal price-pooling policy (which is desirable but seems unlikely given recent developments) coal imports are likely to increase by another 20-25 million tonnes, causing coal imports to rise another $3-4 billion.

Exacerbating the situation are the mining bans in Karnataka and Goa that have caused iron ore extraction to reduce dramatically and exports to collapse. The Karnataka ban meant that iron ore export volumes more than halved to about 45 million tonnes from 100 the year before. Then came the Goa ban which has driven export volumes down all the way to 15 million tonnes, and are likely to be close to zero next year. As such, iron ore exports that used to amount to $6 billion three years ago have collapsed to $1.5 billion this year and will be virtually zero next year. The recent Supreme Court ruling will not change these dynamics because increased production limits are meant to serve domestic demand, and exports are only permitted once domestic demand is satiated. Given the domestic demand-supply mismatch at the moment, this is a very unlikely occurrence.

But that?s not all. With iron ore extraction moderating sharply, the economy has been forced to import much larger quantities of scrap metal, which have almost doubled from $7 billion in FY10 to $13 billion in FY13. None of this is meant to pass judgement on the merits of the mining bans. But simply to document the impact it has had on exacerbating the external imbalances.

As if all this is not enough, fertiliser imports have increased 30% in volume and value terms over the last two years, as consumption, demand and imports of urea have increased and gas production at home has faltered.

The indirect impact: FDI profit repatriation surges While supply bottlenecks are now well-documented, what?s been missed is the alarming pace with which foreign investors have been repatriating profits/dividends/royalties from FDI investments in India.

Much is made about Indian corporates investing overseas. But did we know that gross profit repatriation from inward FDI has almost doubled from $12 billion to $20 billion in two years and net profit repatriation (adjusted for reinvested earnings) has tripled from $4 billion to $12 billion during that period? More broadly, India?s ever-worsening net international investment position has meant net investment income outflows have risen by 1% of GDP over the last 5 years. This phenomenon is not unique to India. Indonesia experienced something similar few years ago. FDI surged into the country to bolster the capital account. However, as that investment began to earn returns, profit repatriation increased sharply by about 0.5% of GDP between 2009 and 2011 before stabilising at that more elevated level.

So, there is a structural worsening that?s bound to happen over time. But the sharp and non-linear manner in which it has accelerated during the very years in which the investment climate has weakened, macroeconomic uncertainty has risen, and concerns about currency depreciation have renewed, suggests that it is related to the policy and investment climate in India.

Things could get worse before they get better

All told, the increase in coal, scrap metals and fertiliser imports, reduction in iron ore exports, and increased FDI profit repatriation have resulted in the current account worsening by $25 billion since FY11. This accounts for almost exactly 50% of the deterioration over the last two years.

What?s more, things could get worse before they get better. Even without price-pooling, coal imports are likely to rise by another $3-4 billion. Iron ore exports are likely to be negligible next year, with a continuing increase in scrap metal imports. With no urea price rationalisation on the cards, fertiliser imports are likely to keep increasing, and the latest quarterly data shows that FDI profit repatriation is showing no let-up.

In sum, all of the aforementioned phenomena are expected to widen the CAD by another $13-14 billion?which will offset more than half the savings on the current account even assuming gold and oil prices remain at these depreciated levels.

Our destiny lies in our own hands

Make no mistake, the sharp correction in commodity prices is clearly good news for India. But relying on commodity price corrections to solve our CAD problems is living on a wing and a prayer. Instead, tackling our supply bottlenecks is not just critical for growth but also alleviating our external imbalances. Alas, the answers lie within.

Sajjid Chinoy is Senior South Asia Economist at JP Morgan

(Concluded)