The Federal Reserve may continue with its easy money policy in the United States for much of this year until a full recovery is in sight. Bernanke has kept interest rates at near zero in recent times in his anxiety to revive the economy and reduce unemployment. In the process, the massive liquidity pumped up in the US has found its way into commodities like oil, copper, aluminium, nickel, etc.
According to one estimate, in 2009 alone, an additional $50 billion of cheap money got invested in purely commodity funds. This is three times the average amount that got invested in commodities during any of the boom years from 2004 to 2007.
The question to ask is: on what basis are speculators driving up commodity prices even as the global economy as a whole still remains quite weak? Speculation in commodities continues unabated this year. In spite of the weak recovery signs in the US and Euro region, oil prices are estimated to touch $90 a barrel by this year end.
The link between global oil prices and Pranab Mukherjee's Budget assumptions is very clear and direct. If crude prices average at around $85 a barrel during 2010-11 the government's oil subsidy bill could bloat to about Rs 1,50,000 crore, assuming there is no revision of domestic oil prices upward.
An expenditure slippage of that order could increase the fiscal deficit by 3 per cent, from the budgeted 5.5 per cent of GDP. There goes the fiscal consolidation programme. This is the worst case scenario.
A slightly better scenario could be this: in the face of political opposition, the government may gather courage to raise oil prices marginally. After doing that, the fiscal deficit may still slip by about 1.5 per cent and end up at 7 per cent of GDP by March 2011.
The larger point being made is the rising global commodity prices led by oil will negatively impact India's growth assumption in the 2010 Budget. India's so-called domestically driven growth story will get greatly hamstrung if global commodity prices do not return to normal levels as would be dictated by the current fundamentals of the global economy.
For instance, it is totally inexplicable that the prices of oil, copper, aluminium, etc today should be as much as they were during the peak of the global economic boom in 2007. Those fundamental boom conditions do not exist today with the developed economies still showing a lot of inherent weakness. Then why are commodity prices as high as they were three years ago?
This is happening largely because of a phenomenon called carry trade. Carry trade is a simple mechanism by which speculators borrow dollars for short periods at near-zero interest rate and speculate in commodities and stocks. The promoter of a leading shipping company in India told me how huge numbers of fully loaded oil tankers are simply floating on the high seas for the last several months without any destination.
This is how it happens. If you are a big commodity trader on Wall Street, all you have to do is raise a cheap dollar loan, buy a hundred thousand barrels of oil in the spot market at the prevailing price.
To fully hedge the bet, the same oil is sold in the futures market at the prevailing premium. So you have physically bought oil at $75 and sold it at $83 in the futures market. The premium earned ($7 per barrel) covers the cost of the short-term loan, freight charges for hiring the oil tanker and yet gives you a profit. Indeed, it is astonishing that the speculative market allows such a foolproof bet with little or no risk.
This is happening largely because of the near-zero interest rate policy being followed in the developed economies. Speculation is very safe when money becomes so cheap. After a point, unending supplies of money create higher price points for the speculators to feel totally secure.
Of course, the big danger lies in how such cumulative price bubbles eventually unwind. However, from a purely Indian standpoint, the rising global commodity prices will create serious disruptions in India's political economy. The much touted domestic growth story will get seriously impaired if the price of key commodities, oil, food and metals, move up to much higher levels.
Political opposition is already growing on the back of rising food and oil prices. Further global speculation in commodities can make things worse for India's political economy in the months ahead. The opposition parties are bound to raise the tempo of protest as commodity prices rise further.
As the political protest gathers momentum, the government might lose the will to do productivity enhancing reforms - such as setting right the agriculture supply chain - which are precisely meant to combat domestic inflationary pressures. The rising global commodity prices can therefore cause enough political scare to scupper domestic reforms initiatives. This is a trap the government must avoid at all costs, going forward.
Western economies are using massive liquidity injection to suit their needs. This liquidity is causing premature inflationary pressures in emerging economies like India. India must combat this inflationary pressure by doing enough productivity enhancing reforms on the supply side so that inflation does not corrode output growth. There is a risk of that happening if sustained anti-inflation reforms on the supply side are not put in place.
MK Venu (mk.venu@expressindia.com)
The writer is Managing Editor, 'The Financial Express'
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