India: uncomfortable and unspoken truths about CAD ; JPMorgan

India: uncomfortable and
unspoken truths about CAD
 The recent sharp decline in oil and gold prices is being
seen as a panacea to India’s macro challenges
 To be sure, the import savings from lower oil and gold
prices is potentially significant
 But half of the deterioration of India’s CAD is unrelated
to high commodity prices or weak exports
 Instead, it’s driven by policy and execution bottlenecks
that are likely to offset a significant chink in savings
from falling commodity prices over the next year
The sharp decline in gold and oil prices over the last two
weeks is seen, in some quarters, as a panacea to several of
India’s macroeconomic challenges. In particular, with oil and
gold being India’s two largest imports, there are hopes that if
the price decline is sustained, India’s current account
problems may be a thing of the past, with the CAD lapsing
back to the old normal of 2%-3% of GDP.
But markets and analysts are getting ahead of themselves. To
be sure, the recent fall in gold and oil prices can make a
significant dent in India’s import bill, and we quantify the
impact under various scenarios. But what markets have not
internalized is that 50% of the current account deterioration
over the last two years has nothing to do with global
commodity prices or weak exports. Rather, it is policy and
regulatory bottlenecks at home that have caused coal,
fertilizer, and scrap metal imports to surge, and iron ore
exports to collapse. Moreover, macroeconomic uncertainty
has precipitated a sharp repatriation of FDI profits that is also
weighing on the CAD.
These phenomena are likely to get worse before they get
better, and potentially offset more than half the gains that will
accrue from falling oil and gold prices. So while falling
commodity prices is clearly a good thing in the Indian
context, we think it’s much too early to claim victory just yet.
Gold and oil are all the rage for now
The sharp decline in oil and gold prices over the last two
weeks has set the proverbial cat among the pigeons. With oil
and gold being India’s two largest imports (accounting for
nearly 40% of the total import bill), India is rightly seen as
one of the biggest beneficiaries of the fall. Consequently, the
atmosphere is pregnant with hope that if the decline does not
reverse, India’s current account problems—deemed to be the
country’s biggest macro risk—may be a thing of the past. But
is this really the beginning of the end of India’s current
account deficit problems?
Can gold be a game changer?
The point of this Note is not to opine on whether the fall in
commodity prices will be sustained, but simply to ask, if
prices remain at current levels, will the beneficial impact on
gold imports be sufficiently significant to narrow the CAD?
We think the short answer is yes, but based on certain
behavioral assumptions.
First, however, a little history: India’s gold imports surged to
US$56 billion in 2011-12 as 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 US$51 billion i

�� -->
2012-13. However, this would still constitute a 10% reduction
in gold imports, largely due to moderating volumes—
presumably a reaction to the duty hikes.
So how large could the potential impact on gold imports be
from the latest price decline? Understanding the static price
impact is straightforward. Since the plunge in gold prices at
the end of last week, gold prices have averaged around
US$1,400/ounce, a 15% reduction from average prices last
fiscal year. Consequently, if the price remains at the current
level, the value of gold imports would decline about
US$8 billion compared to 2012-13 on account of the price
decline alone.
But the more interesting question to us is, what will the
impact on volumes be from a much lower gold price? To what
extent will speculative demand unwind and how quickly will
it unwind? Will gold consumption rise in the near term in
response to falling prices? Answers to these questions warrant
a separate Note. For the purpose of this Note, however, we
limit ourselves to a sensitivity analysis to illustrate the
potential magnitude of the impact under various scenarios.
Recall, India’s gold demand (in volume terms) was rather
stable in the years leading up to the failure of Lehman
Brothers in 2008, 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% over the 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 table demonstrates the reduction in the value of gold
imports based on different combinations of global prices and
reduction in incremental demand. As it reveals, the potential
reduction can be meaningful. If prices stay at current levels
and incremental demand falls by a third, imports will fall by
nearly US$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 don’t forget oil
Measuring the impact of falling oil prices on the CAD is
somewhat more straightforward: India’s consumption growth
of petroleum products has been largely invariant to the
economic cycle and generally averaged 4%. Within this group
the demand for diesel has been rising at almost 9% a year
However, things have changed over the last few months. The
sharp diesel price increase last September followed by
sustained increases this year and the move to market prices
for bulk purchasers have all contributed to slowing diesel
demand growth to less than 5%.
Consequently, if the price of Brent crude stays at $100 over
the next fiscal year—in the vicinity of where it is now—
India’s net import bill will be around US$95 billion, a
reduction of US$12 billion from the levels in FY13. If crude
falls further to US$90, the savings will rise closer to
US$22 billion.
One can now begin to see why markets are getting excited. If
crude oil prices stay at current levels, with relatively conservative
assumptions on volumes and behavioral changes,
the imports savings could be close to US$25 billion—more
than one-fourth of this year’s CAD.
Unspoken truths: it’s not just oil and gold
But we think this is only half the story. Because while
markets obsess about oil and gold prices, what’s missed is
that a large chunk of the CAD widening over the last two
years has had nothing to do with global commodity prices or
the export slowdown. Rather, it has owed its genesis to
policy, regulatory, and execution challenges at home. As a
consequence, coal imports have almost doubled in the last two
years, fertilizer imports have increased 30%, iron ore exports
have ground to a halt and resulted in a 50% increase in metal
scrap imports. Each of these phenomena is a direct
consequence of policy action or inaction. In addition,
macroeconomic uncertainty, the investment slowdown, and
execution bottlenecks have meant that the repatriation of
profits from FDI in India has seen an alarmingly rise over the
last two years. Why is this important? Because over the last
two years, these phenomena together have contributed a
whopping US$25 billion to the CAD—and are responsible for
half the CAD deterioration since 2010-11 (see table). More
important, unlike global commodity prices, these are very
much under the purview of policymakers and can be
mitigated/reversed/eliminated by policy intervention.
More worrisome, things could get worse before they get
better. So unless these issues are tackled, a significant fraction
of the savings from falling commodity prices is likely to be
offset by deterioration on these fronts. And this is something
that markets seem completely oblivious to.
Coal imports almost double in two years
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 double from just two years ago. In value terms, coal
imports were less than US$10 billion in FY11 and jumped to
almost US$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 US$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 US$3-
4 billion. If, however, 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 or US$3-4 billion.
And iron ore exports grind to a halt…
Exacerbating the situation are the mining bans in Karnataka
and Goa that have caused iron ore extraction to be reduced
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 likely will push them to close to zero
next year. As such, iron ore exports that used to amount to
US$6 billion three years ago have collapsed to US$1.5 billion
this year and will be virtually zero next year. We think the
recent Supreme Court ruling will not change these dynamics
because increased production limits are meant to satisfy
domestic demand, and exports are only permitted once
domestic demand is satisfied. Given the domestic demandsupply
mismatch at the moment, this is a very unlikely
occurrence we believe.
But that’s not all. With iron ore extraction falling sharply, the
economy has been forced to import much larger quantities of
scrap metal, which have almost doubled from US$7 billion in
FY10 to US$13 billion in FY13.
And fertilizer 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, less
attention has been given to the alarming pace at which foreign
investors have been repatriating profits/dividends/royalties
from FDI investment in India.
Much is made about Indian corporates investing overseas. But
less well known is that gross profit repatriation from inward
FDI has almost doubled from US$12 billion to US$20 billion
in two years, and net profit repatriation (adjusted for
reinvested earnings) has tripled from US$4 billion to
US$12 billion during that period. More broadly, India’s everworsening
net international investment position has meant
investment income outflows have risen by 1% of GDP in five
years.
This phenomenon is not unique to India. Indonesia
experienced a similar phenomenon a 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 stabilizing at that more elevated level.
This leads to a structural worsening in the CAD over time.
But the sharp and non-linear manner in which this 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 investment climate in India.
Things could worsen before getting better
All told, the increase in coal, scrap metal, and fertilizer
imports, reduction in iron ore exports, and increased FDI
profit repatriation have resulted in the current account
widening by US$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 US$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 rationalization in the works,
fertilizer imports are likely to keep increasing, and the latest
quarterly data show that the FDI profit repatriation is showing
no let-up. In sum, all of the aforementioned phenomena are
expected to widen the CAD by another US$13-14 billion over
the next year, which will offset more than half the savings on
the current account even assuming gold and oil prices remain
at these depreciated levels.
Make no mistake, the sharp fall in commodity prices is clearly
good news for India. But relying on commodity price declines
to solve the country’s CAD problems is like living on a wing
and prayer. Instead, tackling India’s supply bottlenecks is not
just critical for growth but also for alleviating its external
imbalances. Alas, we think the answers lie within.