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Tuesday, Apr 25, 2006

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Connecting the 3 Cs

Manasi Phadke

The emerging equation is the rising commodity prices, mainly due to China on a buying spree as it invests in urban development and infrastructure, and the impact of all this on currency; in the current Indian context convertibility.

It is exciting times on the global commodities market. After all, in a world characterised by a consumption boom, commodities can only be winners.

The prices of commodities, and their futures — be it crude oil, gold, copper, steel, sugar or orange juice — are all on a new high. For most capital goods, demand typically gets generated in China. For instance, steel: China's investment in ports, urban development and infrastructure has increased prices of steel globally. It is the world's second biggest oil guzzler. Thus, funds investing in commodity futures are basically seeing that as indirectly investing in the China growth story.

Even as China consumes, the resource rich economies benefit. The copper miners of Peru, the oil producers of Venezuela and Saudi Arabia, steel-makers in India are all witnessing better prices in a supply-sluggish environment. This has typically led to huge hot money flows into these economies. With the commodities markets unable to absorb the money, there is now a huge increase in futures and stock prices in India and resource-rich Latin American economies, making these the most attractive "emerging markets" for portfolio investments.

Will this trend continue? Yes, as long as China continues to consume and invest in creating infrastructure. In the medium term at least, it seems that FII inflows into these economies will continue to be strong and stocks and commodities markets will continue to boom. However, there are worries. One of those is that faced by any globalising economy. As the FII inflows become stronger, they increase the interest in the currencies, thereby fuelling appreciation and hurting domestic exports. There is also the problem of inflationary pressure. This necessitates sterilisation intervention by central banks, thereby disturbing the balance in the gilts market. However, these are only minor costs and not real reasons for nightmares. The more important cost of these inflows lies in their potential for crises. The Latin American crisis of the 1990s well demonstrated how commodities cycles can lead to high market volatility and to busts with adverse consequences for the economy.

The movements in the commodity prices are uncomfortably similar to that during the 1990s crisis. There are two issues that need serious attention in this context. One, if indeed commodity supply sluggishness is driving the current boom, then prices will continue to rise in the short run, and this is a clear call for investing more in those resources in the longer run. The countries experiencing huge capital inflows now need to invest wisely, in basic infrastructure, resource replenishments and R&D for this boom to be sustained. And, two and pertinently in the Indian context, more clarity is needed on global real and monetary linkages before drawing the road map to full capital account convertibility.

Real growth fuels interests in different assets, creating opportunities to make money through bets on their valuations. As long as there is real global growth, there will be opportunities and capital will continue to flow into India. The real problem could arise were China to apply fiscal brakes for example. Thus, while drawing a road map to CAC, we will have to factor in all real events that could lead to capital flight with a lag. Thus, we will have now to focus on new and "real' leading indicators of potential crises episodes.

In a global economy dangerously skewed to the East (read China), the leading indicators of potential crises for India may lie in the US, China, or elsewhere in Asia. So long as New Delhi understands how real shocks affect capital flows and with what time lag, the vulnerability of the Indian economy to external shocks will remain limited even with full CAC.

(The author is Economic Advisor to the Mahratta Chamber of Commerce, Industries and Agriculture, Pune.)

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