Commodities as an Asset Class
Sept 18, 2006
Stephen S. Roach (New York)
In a low-return world, high-yielding commodities have become the siren song of the asset-liability mismatch. Well supported by seemingly powerful fundamentals on both the demand (i.e., globalization) and the supply sides (i.e., capacity shortages) of the macro equation, investors have stampeded into commodity-related assets in recent years. Once a pure play as a physical asset, commodities have now increasingly taken on the trappings of financial assets. That leaves them just as prone to excesses as stocks, bonds, and currencies. This is one of those times.
Previously, I argued that Chinese and US demand were both likely to surprise on the downside -- outcomes that would challenge the optimistic fundamentals still embedded in commodity markets (see my 15 September dispatch, “Whither Commodities?”). I also hinted that the asset play could well reinforce this development -- largely because commodities have now come of age as a legitimate asset class in world financial markets. This companion note develops the asset-driven adjustments that could well lie ahead in commodity markets. The sociological context is key to this dimension of the issue: Virtually every major institutional investor I visit around the world -- from pension funds and insurance companies to mutual fund complexes and hedge funds — has a large and growing commodity department. The same is true of foreign exchange reserve managers and corporate treasury departments of multinational corporations. One major Wall Street firm is now run by a former commodity executive, and another has turned over management of its global bond division to the architect of its thriving commodity business.
Like all such trends, the expansion of the commodity culture is rooted in performance. It’s not just the physical commodities themselves -- most commodity-related assets in cash and futures markets have also delivered outstanding relative returns. For several years, the so-called commodity currencies of Australia and Canada have been on a tear, and big commodity producers like Russia and Brazil have led the recent charge in high-flying emerging markets. Within the global equity universe, the materials sector has been the number-one ranked performer over the past year -- up 14%, or double the 7% returns of second-ranked financials. And, of course, there is the growing profusion of commodity-related ETFs. Meanwhile, Commodity Trading Advisors (CTAs) now collectively manage over $70 billion in assets -- more than three times the total three years ago -- and the IMF reports inflows of approximately $35 billion into commodity futures last year alone.” (See the IMF’s September 2006 Global Financial Stability Report).
Significantly, the consultants are now urging institutional investors to implement a major increase in their asset allocation weightings to commodities. A recent Ibbotson Associates study recommends that commodity weightings in a multi-asset balanced portfolio could be increased, under conservative return and risk-appetite assumptions, to a high of nearly 30%. That would be more than three times current weightings and greater than seven times the estimated $2 trillion value of current annual commodity production (see T.M. Idzorek, “Strategic Asset Allocation and Commodities,” March 2006, available on www.ibottson.com). The Ibbotson analysis praises commodities for their consistent outperformance and negative correlations with other major asset classes -- going so far as to praise commodities for actually providing the protection of “portfolio insurance.” It concludes by stressing “…there is little risk that commodities will dramatically underperform the other asset classes on a risk-adjusted basis over any reasonably long time period.” Laboring under the constant pressure of the asset-liability mismatch, yield-starved investors can hardly afford to ignore this enthusiastic advice. As a result, with multi-asset portfolios likely to have ever-greater representation from commodities, the financial-market dimensions of the commodity trade are likely to become increasingly important.
This transformation from a physical to a financial asset alters the character of commodity investments. Among other things, it subjects the asset to the same cycles of fear and greed that have long been a part of financial market history. From tulips to dot-com and now probably US residential property as well, the boom all too often begets the bust. Yale Professor Robert Shiller puts it best, arguing that asset bubbles arise when perfectly plausible fundamental stories are exaggerated by powerful “amplification mechanisms” (see Shiller’s, Irrational Exuberance, second edition, 2005). That appears to have been the case in commodities. In this instance, the amplification is largely an outgrowth of the China mania that is now sweeping the world -- the belief that commodity-intensive Chinese hyper-growth is here to stay. That’s why I blew the whistle on this one: Not only do I believe that the Chinese authorities will make good on their efforts to cool off an over-heated economy, but I also suspect they will succeed in engineering a well-publicized shift toward more efficient usage of energy and other commodities (see my 2 June essay, “A Commodity-Lite China”). The potential for post-housing bubble adjustments of the American consumer could well be the icing on this cake -- not only lowering US commodity demand through reductions in residential construction activity but also by reducing end-market demand in China’s biggest export market. The recent data flow hints that such adjustments are now just getting under way -- underscored by reports of a meaningful slowing of Chinese investment and industrial output growth in August and a continuing stream of bad news from the US housing market.
Meanwhile, the performance of commodity-based financial assets is starting to fray around the edges. That’s true of energy funds as well as those asset pools with more balanced portfolios of energy, metals, and other industrial materials. While most of these investment vehicles have outstanding 3- and 5-year performance records, the one-year return comparisons are now solidly in negative territory for many of the biggest commodity funds. And this is occurring at the same time that the MSCI All-Country World index has delivered a 14% return for global equities over the past year. Underperformance for a few months is hardly cause for concern, but for both relative- and absolute-return investors, negative comparisons over a 12-month period are raising more than the proverbial eyebrow. As usual, the “hot money” has been the first to head for the exits, but more patient investors may not be too far behind. Shiller-like amplification mechanisms could well compound the problem. Just as they led to near parabolic increases of many commodity prices in March and April, there could be cumulative selling pressure on the downside -- taking commodity prices down much more sharply than fundamentals might otherwise suggest.
For my money, there is far too much talk about the globalization-led commodity super-cycle. It gives the false impression of a one-way market, where every dip is buying opportunity. Yet commodities as a financial asset are as bubble-prone as any other investment. As is always the case in every bubble I have lived through, denial is deepest when asset values go to excess. That’s very much the case today. After three years of extraordinary outperformance, denial over the possibility of a sustained downside adjustment in commodity prices is very much in evidence -- underscoring the time-honored sociology of an asset class that has gone to excess. Meanwhile, China and US-housing-related fundamentals are going the other way -- setting up increasingly tender commodity markets for unpleasant downside surprises on the demand side of the global economy. The herding instincts of institutional investors could well magnify the price declines -- when, and if, they emerge. All this suggests there is still plenty of life left in the time-honored commodity cycle.
Barton Biggs always used to chide me that “Dr. Copper” was his favorite economist -- possessing an uncanny knack to provide a real-time assessment of the state of the global economy. I suspect that the good doctor has now taken his or her finger off the pulse of the real economy and spends far more time looking at Bloomberg screens. Pity the poor patient -- to say nothing of the doctor!
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The Great Housing Debate
Sept 18, 2006
Richard Berner (in Los Angeles)
US housing activity is in recession and home prices are decelerating sharply, and those trends likely will intensify. The combination could pare as much as 1½ percentage points from US growth in the second half of 2006, and many are thus concluding that the economy is headed for trouble. We continue to think that there are significant offsets to these drags on economic activity, such as stronger global growth and declining energy quotes. As a result, the prognosis for growth could be stronger than either pessimists or market participants expect (see “Is This What A Soft Landing Feels Like?” Global Economic Forum, September 5, 2006).
This debate is central to the economic outlook: The offsets to housing weakness must be balanced against the risks to housing activity, home prices and the ripple effects on the overall economy. There are risks that the collateral damage to the consumer and the economy could be greater than we expect, but there are also chances that we are overestimating the spillover from sinking housing activity and fading housing wealth. Here’s why.
There’s no mistaking the weakness in housing demand and activity. Sales of new and existing homes (including condominiums) were off 21.6% and 11.4% in the year ended in July, declines never before seen except in an overall economic downturn. In response to decade-high inventories of unsold homes, builders have slashed starts of 1-family homes by 16.6% over the same period. Moreover, home prices, as measured by the Office of Federal Housing Enterprise Oversight (OFHEO) price index, decelerated in June to 10.1% from a year ago and just 1.2% in the second quarter, the slowest pace since 1999.
We’re bearish on housing activity and think the deceleration in prices has further to go. We’ve long expected a 25-30% annualized second-half decline in single-family construction, and further, smaller declines over the course of 2007, reflecting lack of pent-up demand, the slide in affordability, and the mismatch between 1-family housing demand and housing starts. Our outlook is in the bottom quintile of the Blue Chip survey. Moreover, we expect that inflation-adjusted housing prices will decelerate from a 6.6% rate in the second quarter to zero over the next 9-12 months. The deceleration will likely be even sharper in nominal terms because we expect that headline inflation will decline as energy product prices continue to fall.
The pessimists argue that the bursting of a putative housing bubble means that prices could decline significantly. There is some risk that prices could decelerate faster or even decline in real terms — after all, investment and speculative activity has picked up in the past five years. But the character of housing demand makes the much-feared decline in prices on a nationwide basis unlikely for two reasons. First, construction activity is small in relation to the housing stock; annual growth is 1½% in a boom year. As a result, it takes a sharp decline in construction activity to affect the stock meaningfully — and it is the demand for that stock of houses that matters for homebuyers. Second, housing demand is relatively sensitive to price changes, although it may take time for them to cumulate to a significant impact. Correspondingly, any plausible change in the stock relative to demand is unlikely to have a large effect on housing prices. Investors thus should not assume that a bust in housing activity would promote more than rusting home prices.
Nonetheless, prices may fall in markets that are affected by a weak economy (e.g., Detroit), by high speculative activity (e.g., some condominium markets) or where there is a preponderance of second homes (e.g., in Florida or the Sunbelt). Ironically, home prices in the Gulf Coast and Florida have fared quite differently in the year following the destructive path of 2005’s hurricanes: The supply shock that reduced the housing stock and caused a scramble for new places to live in the Gulf Coast has led to price hikes of 15-20% in New Orleans-Metairie-Kenner and Baton Rouge, LA and Gulfport-Biloxi, MS. Contrariwise, the sharp escalation in insurance premiums or the difficulty in obtaining homeowners insurance at all has added to downward pressure on Florida home prices. In my view, those disparities underscore the fact that local economic conditions are typically the dominant forces driving home prices.
However, the recession in housing activity is a nationwide development and will significantly depress growth. We estimate that the decline in 1-family housing starts directly will cut 0.9 percentage point from US real growth in the second half of 2006 (single-family construction amounts to about 3.3% of GDP; we expect that apartment construction will improve somewhat after eight years of no growth, which has limited supply and helped rents to firm). The plunge in single-family housing construction will cost both output and jobs. We expect that the loss of jobs in residential construction, real estate brokerage, and mortgage finance could amount to 10,000 monthly. So far, job losses have only shown up in specialty trade contractors, who have shed about 41,000 jobs in the past six months. The losses we expect could take up to $10 billion annualized out of wage and salary income, but that only amounts to 0.2% of the total.
Of course, that’s not all. The decline in housing demand probably will crimp spending on furniture, appliances and other household goods such as carpeting and draperies. A 10% decline in such outlays over a year could knock another 0.3% off overall GDP. Moreover, it would be reasonable to think that the surge in housing wealth and home equity extraction has fueled significant spending gains in these discretionary items, that households can postpone such purchases, and that even a deceleration in housing wealth could promote declines in these big-ticket outlays.
Reasonable, yes, but not entirely accurate. First, housing activity and big-ticket housing-related durables don’t necessarily march in lockstep anymore. That’s partly because household electronics, such as TVs and audio equipment, computers and musical instrument comprise about 40% of such outlays, and innovation and the resulting obsolescence and price declines in such products drive rapid growth. As a result, we expect real growth in such outlays to decelerate sharply but not to contract.
Moreover, and most important, in my view the deceleration in housing wealth will have at most one-fifth the impact on consumer spending that some fear. Some, including former Fed Chairman Greenspan, believe that 50 cents of every additional dollar of home equity extraction has financed consumer outlays. Empirical studies, however, suggest that a $1 decline in real housing wealth would trim spending by at most 11 cents, and some suggest that the effect would be half that magnitude (see “Housing Wealth and Consumer Spending” and “Housing, Mortgages and Consumption: Comparing Australia, the UK and the US,” Global Economic Forum, October 7, 2005 and March 2, 2006, respectively). Of course, that’s not negligible; we estimate that the flattening in real housing wealth in our outlook will pare roughly ½ percentage point from the growth in consumer outlays over the coming year.
The outcome of these debates is critically important for financial markets both at home and abroad. US bonds are vulnerable because they are priced for a more dire growth outcome than I think is likely. While growth in the third quarter now appears to be tracking at a below-trend 2.6%, and longer-term surveyed inflation expectations moderated in early September, we estimate that core inflation ran at a 2.5% pace in August. We also suspect that the plunge in energy quotes — largely the product of lessened supply curbs, not weak demand — will soon lift final demand. Consequently, both real rates and term premiums are likely to rise with positive growth surprises and renewed uncertainty about the path of US monetary policy.
Housing demand and activity could decline faster than we expect as buyers pull back and wait for better bargains and builders cut starts aggressively. The demand-supply balance is critical: While a larger demand pullback might result in a faster deceleration in prices than we anticipate, a more rapid adjustment in supply will more quickly align it with demand. We’ll concede that the consumer response to such changes in wealth is uncertain after a long period of price appreciation, but job and income growth remain the dominant forces shaping consumer spending. Despite the appeal of lurid scenarios and the need to be mindful of downside risks, it’s worth noting that even our estimates may overestimate the spillover from fading housing wealth to consumer spending.
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Review and Preview
Sept 18, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
Significant front-end losses caused a significant Treasury curve flattening the past week. After the quiet economic data calendar of the prior week, investors had some significant fundamental news to drive trading — but reacted to it in strange ways, with the market selling off significantly Thursday after a weaker-than-expected retail sales report (based on a meaningful downward revision to July ex auto sales) and then rallying significantly, at least initially before a late collapse Friday, on a slightly worse-than-expected CPI outcome (with the core just barely rounding down to +0.2%). Supply seemed to be at least as much a market focus as the economic reports, with a flood of agency, CMBS and corporate deals dominating investor focus for a good part of the week. Fundamentally, news released the past week provided major vindication for the Fed’s outlook and resulting decision to pause in August, also seeming, at this point, to set the stage clearly for a continued on-hold policy at least through October. In particular, the trade balance, retail sales and business inventories reports led us to cut our 3Q GDP forecast to +2.6% from +3.2% — just the moderately below trend pace the FOMC has been counting on over the medium term to slow and eventually start to reverse ongoing inflation pressures, which we expect will lift core CPI inflation to an 11-year high of +3.0% in September. And the other key flashpoint for Fed policy beyond the growth trajectory also moved in the FOMC’s direction the past week, with longer-term consumer inflation expectations moderating significantly from the decade high hit last month, and market-based measures of longer-term inflation expectations remaining steady. This all sets us up in the coming week for probably the least consequential FOMC meeting in recent memory. Indeed, the FOMC could practically convene for a matter of minutes Tuesday and call it a day if it wanted to, just leaving enough time to decide to leave rates unchanged again and issue a nearly identical statement as in August, as seems the overwhelmingly likely outcome of this meeting.
On the week, 2s-30s flattened 7bp to a three-week low, with the 2-year yield up 7bp to 4.86% and the long bond yield flat at 4.92%.
Flattening along the curve was fairly uniform, with the 3-year yield up 6bp to 4.78%, 5-year up 5bp to 4.755%, and 10-year up 3bp to 4.80%. There really didn’t seem to be much trigger for it in the data — except perhaps investors’ increased attention on the potentially very positive impact on the economy of the ongoing collapse in energy prices — but a significantly less dovish medium-term Fed path was priced into futures market. In the fed funds futures market, the fanciful idea that the FOMC would switch to an easing bias after the October FOMC meeting disappeared and the, in our view, quite unrealistic thinking that the Fed might cut rates in January was significantly scaled back. With the November fed funds contract improving a half bp to 5.28% and the January contract off 2bp to 5.29%, the latter resumed its position as the peak rate contract, while a 4bp sell-off in the February contract to 5.255% cut the odds of a rate cut at the January 30-31 FOMC meeting to only about 15%. Meanwhile, the total amount of easing priced in next year in the eurodollar futures market was significantly reduced, with the Dec 06 to Dec 07 spread up 7.5bp to -37.5bp, as the former lost 2.5bp to 5.395% and the latter 10bp to 5.02%. This was the smallest inversion between these two in a month, and up from the all-time low of -47bp hit two weeks ago.
Coming into the week, we had seen 3Q GDP running at +3.2%, but three reports — trade, retail sales and business inventories — each reduced that estimate by 0.2pp, leaving our estimate now at +2.6%. The trade deficit widened to a significantly larger-than-expected $68.0 billion in July from $64.8 billion in June, as exports fell 1.1% and imports rose 1.0%. The drop in exports was fully explained by a sharp decline in capital goods that was about half accounted for by aircraft and half by various other categories, led by computers. Meanwhile, the bulk of the import gain reflected a price-driven surge in petroleum products to a new record high. Obviously, this will be sharply reversed in coming months, in line with plummeting oil prices. Most of the rest of the upside in imports was attributable to a significant gain in capital goods. The wider overall trade gap pointed to a drag on growth in 3Q from net exports, but the big widening in the capital goods deficit implied significantly stronger investment spending. We now see net exports subtracting about 0.4pp from 3Q instead of adding 0.3pp, but we upped our investment forecast to +15% from +10%. The net of these was slightly negative for our assessment of overall GDP growth.
Retail sales rose 0.2% in August, as motor vehicle dealers’ receipts (+0.4%) posted an odd gain after the drop in unit sales. Ex auto sales also rose 0.2%, but July (+0.6% versus +1.0%) was revised down. In August, sales were restrained by a price-related pullback at gas stations (-1.0%) that should be much larger next month and generally sluggish results from key discretionary categories, in line with the monthly chain store sales results —clothing (-0.3%), general merchandise (+0.4%), electronics and appliances (+0.1%), furniture (-0.3%). On the positive side, the sizable food store component (+0.6%) saw an unusually large gain. With the still strong July start and likely boost from falling gas prices in September, we see 3Q real consumption rising a solid 3.7%, but this was down from our prior estimate of +4.0%.
Finally, retail ex auto inventories rose a lower-than-expected 0.3% in July, pointing to a larger drag from inventories in the third quarter than we had previously estimated. With the upside in investment from the trade report and still relatively strong expected gain in consumption, even with a sharp expected fall in residential construction that we estimate will subtract a full percentage point from growth, we see real final domestic demand in 3Q running at a solid +3.5% pace. But nearly half-point drags from both inventories and trade point to overall GDP growth near +2.6%.
Meanwhile, on the inflation front, the CPI report came in a bit worse than expected. The overall consumer price index rose 0.2% in August, leading the year-on-year rate to ease to +3.8% from +4.1%, as energy prices (+0.3%) showed a small gain before a likely plunge next month. The core measure rose a high +0.2% (+0.24% unrounded), with the year-on-year rate rising to +2.8% from +2.7%. Apparent seasonal quirks in hotels (-0.4%) and airfares (-1.9%), which have shown a persistent tendency in recent years to decline in August, offset a sharp rebound in clothes prices (+0.9%) after last month’s big drop, restraining core CPI to a +0.2% gain after the prior run of +0.3% readings. The main surprise on the upside was the communications category (0.0%), which did not seem yet to fully pick up the elimination of the federal telephone excise tax. With the recent quirks in apparel, hotels and airfares having passed, core CPI seems likely to resume a +0.3% trend next month, which would lift the year-on-year rate to +3.0%, a high since 1995. Moreover, the composition of the CPI this month (in a reversal of July) suggests that the core PCE price index will probably rise slightly more than core CPI because of the former’s larger weight in apparel and smaller weight for shelter. We estimate a 0.25% gain in the core PCE price index for August, which would lift the annual rate a tenth to +2.5%, which would also be the high since 1995.
While the incoming core inflation data still look worrisome, policymakers can certainly take comfort from the lack of significant feed-through to inflation expectations. Indeed, with gasoline prices in freefall, consumer inflation expectations fell significantly in early September according to the University of Michigan survey, with the 1-year median inflation forecast falling to +3.1% from +3.8% and the 5-year expectation falling to +2.9% from the decade high of +3.2% hit in August. Meanwhile, the Fed’s preferred market-based measure of inflation expectations, the 5-year/5-year forward TIPS inflation breakeven, remained almost completely immobile again even as the simple breakevens continued to break to new lows in line with collapsing oil prices. With the 5-year TIPS yield up 8bp to 2.46% (high in a couple months) and 10-year up 4bp to 2.38%, the benchmark 5-year breakeven inflation rate dipped 2bp to 2.29% and the 10-year 1bp to 2.41%, both lows since January and down from 2.65% and 2.64%, respectively five weeks ago when oil prices were near their highs. With the 5-year move again outpacing the 10-year, though, the 5-year/5-year forward held near 2.55% for a third straight week. Both the consumer and market-based measures are relatively high in absolute terms, but the recent improvement in the former and stability in the latter will no doubt leave the FOMC comfortable in describing inflation expectations as “contained” again on Wednesday.
The economic data calendar is fairly light in the week ahead, with the most notable releases being PPI and housing starts. Early expectations for the September employment and ISM reports will also be influenced by weekly jobless claims, in which initial claims this week will cover the survey period for the employment report, and the Philly Fed survey Thursday. A recent improving trend in claims has suggested that we may see some pick-up in hiring in the next employment report after the recent run of sluggish gains, while the strong Empire State survey Friday, which on an ISM-comparable weighted average basis improved to 55.7 from 55.1, suggested that the factory sector remained in solid shape, notwithstanding the pause in manufacturing output recorded in the August IP report. Of course, Wednesday’s FOMC meeting will be a significant market focus as well, but the outcome seems quite likely to be a non-event. Steady policy seems all but certain, and we see no reason for any substantive changes in the policy statement. The key forward-looking language — “Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” — can be repeated verbatim. The only notable adjustments to the statement will likely be in the normal summary of inter-meeting economic conditions. On this score, there will probably be another reference to signs of moderating growth but perhaps, on the other side, a mention of the recent sharp upward revisions to unit labor costs.
Data releases due out in the coming week include the current account Monday, PPI and housing starts Tuesday, and leading indicators Thursday:
* Based on a modest widening in the trade gap, the current account deficit likely rose slightly in the second quarter in dollar terms to $211 billion. As a share of GDP, however, the deficit appeared to hold steady (at 6.4%) after having peaked at 7.0% in 4Q05.
* We look for the August producer price index to rise 0.4% overall and 0.2% ex food and energy. The core should get a boost in August from a partial bounce-back in motor vehicle prices after the sharp decline posted last month. Meanwhile, we expect the headline reading to be further elevated by a broadly based rebound in food prices and some gasoline-led upside in energy quotes ahead of a likely big decline next month in line with recently plummeting wholesale gasoline prices.
* We expect August housing starts to fall to 1.75 million units annualized. Despite the uptick in hours worked in the construction industry seen in the August employment report, we look for a further gradual deceleration in new home construction in response to the build-up of unsold inventory. Our estimate implies a 2.5% drop versus July.
* The index of leading economic indicators should fall 0.2% in August, its fifth decline in the past seven months, with the biggest negative contributors being consumer confidence, the manufacturing workweek and jobless claims.
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The Anatomy of a VAT Hike
Sept 18, 2006
Elga Bartsch (London)
A key factor shaping the German growth outlook is the three-point VAT hike in January 2007. Earlier hopes that a better-than-expected budget situation would cause the German government to scrap the VAT hike or at least reduce it have been dashed. The 2007 VAT hike is unprecedented on at least three counts: its size, its long lead-time and its being part of a considerable overall fiscal consolidation. In what follows, we look at what we know about the preparation of companies, notably retailers, and what this might imply for the economic effects of the VAT hike. In addition, we outline the other indicators to look out for in the remainder of this year to gauge the size of the consumption retrenchment in early 2007. At this stage, it seems that macroeconomists are much more concerned than company captains.
Looking at the historical pattern of macroeconomic variables around the five VAT hikes Germany has experienced since the mid-1970s reveals a number of stylised facts. As expected, even a one-point VAT hike, which was historically the norm in Germany, caused major gyrations in consumer spending around the time of the tax hike. Typically, these gyrations were big enough to drag overall GDP into the red. The VAT hikes usually also caused consumer price inflation to spike up. But, wisely, the Bundesbank and bond markets looked through these spikes and there wasn’t a systematic reaction in either short rates or bond yields associated with a VAT hike. While business sentiment generally has been unimpressed by the prospect of a VAT hike, consumer confidence has tended to take the tax increase more to heart.
Recall that the impact of a VAT hike on consumer spending essentially stems from two main sources: On the one hand, real purchasing power of households falls as a result of the broad-based price increases. On the other hand, in anticipation of these price increases, consumers aim to bring forward purchases of big-ticket items such as consumer durables. The latter effect tends to cause major swings in consumer spending. But it should not affect the long-term spending dynamics. Looking at consumer spending growth around the five VAT hikes in the past, we find that the average growth rate in the five quarters around a VAT hike has been above the long-term average.
We offer three potential explanations for this surprising result that consumer spending was stronger around a VAT hike than on the long-term average.
- First, governments only considered VAT hikes in periods of economic strength. However, this hypothesis is not supported by the overall GDP pattern.
- Second, consumers find it easier to raise spending ahead of the VAT hike than to reduce it afterwards. This ratchet-effect is well known in consumer behaviour.
- Third, everyone loves a bargain. The illusion of seizing a special opportunity causes many of us to buy items on holidays, which on closer inspection have no place in our lives. A VAT hike might create a similar atmosphere of a special opportunity.
Yet, historical norms are only a limited guide. This VAT hike is very different from its predecessors. The sheer size of the VAT increase suggests non-linear effects in consumers’ and retailers’ reactions. In addition, the hike has been known long in advance.
However, other countries, which have seen large increases in sales or value added taxes, do not have particularly fond memories. The UK saw the VAT rate raised by 2.5 percentage points in 1991 and Japan experienced a two-percentage point hike in the sales tax in 1997. Both countries subsequently hit a rough patch. The UK, which was in recession at the time, eventually found its currency being catapulted out of the ERM in autumn 1992. Japan, where the sales tax increase was part of a major fiscal consolidation programme, was later that year hit by the Asian crisis and big bank failures. Barring any negative external surprises, the impact of the German VAT hike should be more limited. The German economy is stronger than the UK in the early 1990s. The fiscal tightening in Germany, even though ambitious, is not as large as the one in Japan. Finally, with the ECB overseeing a multi-country currency union, the risk of monetary policy reaction should be more limited. But the examples of the UK and Japan show that with a VAT hike this size, there is no scope for other negative surprises.
To gauge the impact of the VAT hike, we will watch a number of indicators closely. Top of our list are indicators of retail price developments. The most comprehensive one is the CPI report, which at least on a regional basis is available on a timely basis and includes a detailed breakdown. The Statistics Office recently launched a price barometer for goods bought frequently (http://www.destatis.de/preismonitor). So far, there are very limited indications of price increases ahead of the VAT hike. However, surveys show that retailers intend to raise their prices. We would note though that retailers’ price expectations don’t have a close correlation with consumer price inflation.
More than ever, we will be avid readers of company news. One large mail-order retailer, for instance, has indicated that instead of passing the VAT hike onto customers, it intends to roll it back to suppliers. If these suppliers happen to be foreign exporters, other countries will have to shoulder part of the German VAT burden. Another big discounter has already promised not to pass on the VAT hike and has launched an advertising campaign to this effect. This discounter gained considerable market share after the euro was launched. It simply rounded prices down while others rounded prices up rather generously. At the time, perceived inflation spiked up and consumer spending tanked. This largely self-inflicted damage should cause retailers and service companies alike to tread more cautiously this time round, we think.
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Debating the Commodity Bubble
Sept 18, 2006
Andy Xie (from Singapore)
*The commodity market is experiencing a bubble: While commodity demand is strong due to China’s investment boom and a robust global economy, investment demand has risen at a much faster pace, which is a result of low interest rates. Financial demand will likely be withdrawn from the market when inflation forces the Fed to raise interest rates again, probably in 2008.
*China may exaggerate the commodity cycle: China’s demand may raise average commodity prices over time but not necessarily cushion the downturn. As China’s investment is very cyclical, the bottom for commodity prices may be as low as in previous cycles.
*China and Africa are natural partners: The best story for commodities, in my view, is the emerging partnership between Africa and China. Africa sells natural resources at high prices to China but buys consumer products at low prices from China. China can also build up infrastructure in Africa cheaply. This relationship vastly improves Africa’s terms of trade.
Summary and conclusions
I participated in a debate on the nature of the commodity boom at a panel that the Lee Kwan Yew School of Public Policy organized ahead of the IMF/World Bank annual meeting in Singapore last week. The purpose of the debate was to offer insights into how developing countries manage funds that they have accrued through good fortune. As the commodity price surge is generally agreed to be a bubble, developing countries are already setting aside the bulk of their extra earnings for rainy days.
The commodity market is experiencing a bubble like dotcom businesses were five years ago, I believe. The current downturn in prices is probably not the end of the boom. Either a global recession or rising interest rates will likely cause the bubble to burst. Bond yields around the world are low enough to sustain slower but still robust demand growth in 2007, i.e., the conditions for the bursting of the commodity bubble do not seem to be there yet.
Low bond yields are not compatible with rising inflationary pressure. The Fed is using its inflation-fighting credibility to convince the bond market otherwise. A global downturn and bursting of the commodity bubble may occur when the bond market stops believing the Fed. A potential bond sell-off in 2H07 could precede a global recession and the end of the commodity bubble in 2008, in my view.
To secure the supply of raw materials, China is going deep into Africa. This is benefiting both economies. China is buying raw materials from African countries at high prices and selling consumer goods to these markets at low prices. This is exactly the opposite of the relationship Africa had with the West. In addition, Chinese firms are building infrastructure in Africa at low prices. The enormous improvement in the terms of trade for Africa has produced an economic boom for the region.
The commodity downturn may just be a correction
The commodity markets are currently experiencing an optical illusion. As the price for Brent crude has fallen from US$78/bbl in early August to US$62/bbl currently, the discussions in the market are about an oil price collapse. But the current price is still higher than the average of US$54.6/bbl in 2005 and three times the average price in the 1990s.
The talk of a collapse in metal prices is even more absurd, in my view. The copper price has declined from the high of US$8,788/ton in May to US$7,400/ton currently. The current price is still twice as high as the average price last year and 3.7 times the average price in the 1990s. Similarly, nickel’s current price is twice as high as the average in 2005 and four times the average in the 1990s.
If the bubble were bursting, prices would fall below historical averages, i.e., metal prices could drop by 75% from current levels. Some argue that Chinese demand could keep the bottom substantially higher than in the past. But Chinese demand is highly cyclical and coincides with the global cycle because of its export dependency. While Chinese demand may, therefore, keep average prices higher through a cycle, it may not be able to cushion the downturn.
Bubble or boom?
The common argument for rising commodity prices is Chinese demand. Changes in demand from India or other countries are just not big enough at the margin to have a dramatic effect on prices. Chinese imports do show a dramatic increase in recent years. China’s crude imports have risen by 19% and refined products by 13% per annum over the past five years. China’s copper imports have quadrupled in ten years.
Until three years ago, Chinese demand was probably the driver of commodity prices. But the flood of financial investment in the commodity market in late 2003 changed the dynamic. The total amount of financial investment in the commodity market could be four times China’s total annual imports. The financial factor has overshadowed the China factor. China has become an excuse for money to flow into the market.
Strong demand from China and surging financial investment in the commodity market are due to the same factor — loose monetary conditions. China’s exports have been exceptionally strong, averaging 28% growth a year over the past five years, twice as fast as during the previous 20 years. In addition to China’s rising competitiveness, the demand stimulus from loose global monetary conditions is a key factor. China’s investment boom is funded with the income from its export boom; hence, China’s strong demand for commodities is due to the same factors that underpin strong US consumption.
In addition to sparking strong demand, the loose monetary conditions in the past five years have caused financial speculation to proliferate, in particular into unconventional asset classes like commodities. Exchange-traded funds, commodity funds and even pension funds are buying commodities. Pension funds are buying copper to be kept in warehouses in anticipation of China paying higher prices. I think they may look back at such follies with horror in a few years.
Commodity price decouples from demand
The IEA has just lowered the 2006 global oil demand estimate by 100 kb/d to 84.7 mb/d. This is the third downward revision this year by the IEA. However, despite the recent downward correction, the oil price remains above the 2005 average and the level at the beginning of the year.
In the first eight months of 2006, China’s copper imports dropped by 24% to an annual rate of 1.93 million tons, copper waste and scrap fell by 7% to an annual rate of 4.46 million tons, and copper ore declined by 4% to an annual rate of 3.87 million tons. Even though China is the dominant driver of copper demand, the copper price has increased by 62% this year.
Weak demand for oil is due to very weak OECD demand. The IEA expects a 6.5% increase in China’s oil demand in line with historical trends. China had a severe electricity shortage in 2004 and factories had to use diesel generators. As electricity generation picked up in 2005, oil consumption slumped.
The global economy is still growing at a 5% clip. But commodity demand is showing significant weakness. This is primarily due to the demand response to high prices, I believe. Commodity prices, on the other hand, are being supported by financial demand. The funds flow into commodity markets has not reversed yet.
In the past five years, the funds flow into commodities was possibly equal to three or four times China’s total annual demand for commodities. Financial demand has simply overwhelmed real demand in price determination.
When will the bubble burst?
The number of financial professionals in the commodity sector may have increased by 10 times in the past five years. As long as these numbers remain, commodity prices will remain high because they will have to talk up prices to keep their businesses functioning.
For example, pension funds are buying commodities. They are essentially buying items like copper to be warehoused for future sales to China at higher prices. It is surprising to see that the investment case for retirement funds can be based on price inflation alone.
But it will take time for such apparent follies to be reversed. As specialists are hired to assess commodities, their jobs are closely tied to the bull case for commodities, which contributes to the resilience of the commodity bubble.
There are three common triggers for a bubble to burst: (1) panic, (2) rising interest rates, or (3) recession. The trigger for the Asian Financial Crisis in 1997 was panic. A few savvy investors put pressure on the Thai baht. Many insiders in Southeast Asia knew that the boom was a bubble and were waiting for a signal to sell. Their rush for the exit led to the crisis.
The rise in interest rates in 1989 was probably the trigger that burst the Japan bubble. This bubble was very large. The excess value of asset paper was probably four to five times GDP. It was top heavy and vulnerable to any shock. Even though the discount rate rose to a still low level of 3.25% from 2.5%, the bubble burst.
Recession was frequently the trigger for commodity bursts in the nineteenth century. The boom-burst investment cycles of this period offered speculative opportunities in a cyclical upturn. When overcapacity triggered the demand downturn, the bubble burst.
The current cycle resembles the boom-burst cycles of the nineteenth century. The difference now is that the financial system is very sophisticated in taking risks. Asset prices, therefore, keep rising to pump up demand, especially consumption demand in the US and investment demand in China. The chances are that inflation rather than overcapacity will bring down this cycle.
When inflation accelerates, the Fed will be forced to raise rates again. The Fed has not pushed interest rates up high enough to restrict demand in this cycle; hence, inflationary pressure keeps building. In particular, Asia’s land price has increased sharply and I expect this to feed the global inflation pipeline for years to come.
Despite the high and rising inflation trend, the Fed and other central banks have convinced the bond market that inflation will come down. The low bond yields are supporting demand and speculation — and keeping the commodity bubble alive.
By the middle of 2007, the bond market may change its view on inflation. I expect the global inflation rate to rise to 4% next year from 3% now, while GDP growth should decelerate to 4% from 5% currently. The lingering stagflation could trigger the bond market to price in higher inflation by mid-2007. Surging bond yields would likely cause the commodity bubble to burst thereafter.
China goes to Africa
China sank its roots in Africa during the days of Chairman Mao, who wanted China to compete with the then Soviet Union for influence in Africa. Although there was not sufficient food in China at that time, massive aid was still sent to Africa.
The relationship now has a strong economic foundation. China has had limited success in securing the supply of raw materials. Several acquisition attempts were rebuffed by western governments. China has to go to Africa to develop new sources of production.
Several pleasant surprises have emerged in this relationship. The supply of cheap Chinese consumer products has had a major impact on the life of low-income people in Africa. The region used to buy consumer products from the West or Japan. Low income levels meant that most people could not afford such products.
On the other hand, the commodity price has doubled on average in the past four years. African countries are earning much more than previously. The rise in commodity prices and switch to cheap Chinese consumer products have allowed Africa’s terms of trade to improve significantly. This is the driver for the economic boom in Africa now.
The bilateral trade has blossomed to an estimated US$56 billion in 2006 from US$10.8 billion in 2001. Africa could run a trade surplus of US$6 billion this year. If bilateral trade triples over the next decade — a target that is not ambitious in light of recent developments — it may push Africa’s growth rate to double-digit levels.
In addition, Chinese contractors are building infrastructure at lower prices compared to what the West previously offered. Over the next decade or two, Africa could eliminate its infrastructure bottleneck, laying the foundation for a potential double-digit growth rate.
The West is monitoring this development and its criticism is that (1) China does not tie its investment with governance improvement; and (2) Chinese contractors do not hire local workers. Both criticisms are wide of the mark, in my view. China’s effectiveness is due to its low cost. African income is so low that any strategy that depends on the help of high-wage western employees is unlikely to be successful. Chinese wages are similar to those in Africa. With rising income from natural resource exports, Africa could afford China’s expertise to build on a scale not possible previously.
In terms of hiring local people, it is good if it is cost-effective. If Chinese construction workers are cheap and more productive, why not use them? This would bring down the investment cost, which ultimately benefits local people.
I wrote five years ago that China could transform Africa. I am more convinced now. Regardless of criticisms, I think the relationship between Africa and China will expand because it is based on solid mutual economic interests.
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August NODX Dips to 2.6%
Sept 18, 2006
Deyi Tan (Singapore)
August trade momentum continued to subside, in line with what is implied by the US ISM leading indicator. Exports rose a lesser 10.5% YoY (versus +13.6% in July). Imports also moderated to 14.9% YoY (versus +18.5% YoY in July). The trade surplus rose to S$3.9 billion from S$2.9 billion in July.
Electronic and non-electronic weakness in sync. Non-oil domestic exports rose a subdued 2.6% YoY (versus +8.4% in July). While both the electronic and non-electronic segments were performing strongly earlier in the year, the moderation in both segments is now evident. Electronic NODX rose 3.9% YoY (versus +4.9% YoY in July). The secular decline in disk drives continues at -21.1%, reducing its share in electronic NODX from a peak of 32% in 2001 to the current 13%. Slowdown in integrated circuits (+11.1% in August versus +16.8% in July) and PCs parts (+1.6% versus +3.9% in July) drove the bulk of the electronic deceleration. Telecoms remains the strongest performing electronic segment at 51.6% YoY.
Non-electronic NODX also registered a weak 1.4% (versus +11.7% in July). In particular, after registering strong growth for the past quarters, pharmaceuticals exports contracted 26.0% in July. Petrochemicals exports, however, held steady at 16.3% YoY.
US export market still healthy. Despite fears of a recession, non-oil domestic exports to US continued to forge ahead at 16.1% YoY (versus +23.3% YoY in July). In contrast, NODX exports to economies that are on the rebound such as the EU and Japan registered consecutive declines (-23.7% YoY and -7.5% YoY, respectively). Exports to China were relatively subdued at 4.3%.
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A Guide to Analyzing Macro Sensitivity to Oil Prices
Sept 18, 2006
Chetan Ahya (Mumbai)
How dependent is India on oil for its energy needs? Oil meets about 30% of India’s commercial energy requirements. The share of oil in overall energy consumption for India is lower than that for most emerging markets. Coal is the predominant source of energy (55% of total) due to abundant availability.
Domestic oil pricing — regulated deregulation? Since April 2002, the government has implicitly reinstated oil pricing regulation. Currently, the government controls about 64% of petroleum products sales on a volume basis and 80% on a value basis. The weighted average crude oil realization implied in domestic oil prices is about US$48/bbl (WTI), compared with the current international market price of US$63/bbl.
How sensitive is India’s macro balance sheet to oil price movement? Unlike in past cycles, India’s macro balance sheet is better positioned to absorb the oil price shock in the current cycle. The near-term adverse macro impact has also been cushioned by the government by keeping domestic oil products’ price increases significantly lower, incurring a subsidy of 1.6% of GDP in F2007 (our estimate).
What if oil prices decline to US$50/bbl? We believe that the government is unlikely to cut domestic prices significantly until global crude oil prices reach US$50/bbl (WTI). Hence, the fall in oil prices up to US$50/bbl is likely have a less than proportionate positive effect on inflation, private consumption and growth.
Falling oil prices have again brought the discussion on India’s macro sensitivity to oil prices into focus. In this note, we seek to present a broad analysis on India’s dependence on oil as a source of energy, the evolution of the government’s domestic pricing policy for petroleum products and the sensitivity of India’s macro economy to oil price movement.
I. India’s dependence on oil as a source of energy
Share of oil in energy consumption is relatively low…
The share of oil in overall energy consumption for India is lower than for most emerging markets. Oil meets about 30% of India’s commercial energy requirements. Coal is the predominant source of energy (55% of total) due to abundant availability. According to the Planning Commission of India, coal reserves are expected to last for over 50 years at current levels of production and hence coal will continue to remain a key source of energy for India. The balance is accounted for by natural gas (8.5%) and nuclear & hydro power (6.6%).
….but share in world oil consumption is high
Despite oil having a low share in overall energy consumption, India is one of the leading consumers of oil in the emerging world, owing to the relatively larger size of the economy. India’s oil consumption has increased to 2.5 million barrels per day (3% share in global oil consumption) in 2005 from 1.6 million barrels per day (2.3% share) in 1995. Over the past ten years, India’s oil consumption has grown at an average of 4.6% per annum as compared to 7.5% for China and 1.3% for other major emerging markets. India’s efficiency of oil usage, as measured by oil intensity (primary oil consumption per unit of GDP), is higher than the world average and marginally higher than that for top emerging countries.
Dependence on imported oil is high
India’s proven reserves of oil and oil production have remained largely stagnant over the past decade. As a result, increasing oil consumption has meant greater reliance on crude oil imports for India. Currently, India imports about 77% of its crude oil requirement as compared with 44% in 1995. Crude oil accounted for about 26% of India’s total imports in 2005 (4.4% of GDP). Most of India’s crude oil imports are from Southeast Asia and Nigeria. India’s overall oil balance (crude oil and petroleum product imports less exports) is one of the worst in the region. India can potentially use its natural gas reserves as an alternative energy source to some extent. However, our Utilities team believes that the supplies for the same are likely to come through only in 2011-2012. As a result, India is likely to remain dependent on other sources at least up to 2012.
II. Evolution of government’s policy on oil
Domestic prices of oil products (other than industrial products such as naphtha and aviation turbine fuel) have always been directly or indirectly controlled by the government. For a brief period between April 2002 and April 2004 (when crude oil prices were US$24-35/bbl) oil companies could independently determine the price of diesel and gasoline. Currently, although the public sector oil companies are supposed to collectively fix prices of crude oil and petroleum products based on so-called import parity pricing, in practice all price changes are decided by the government. Hence, the sector is devoid of any real competition among the public sector oil companies. The entry of private oil companies such as Reliance Industries, Essar Oil and Shell in the marketing of petroleum products in a small way has not changed this reality since the bulk of output from private refineries is still marketed by the government-owned companies. Currently, controlled petroleum product sales account for approximately 64% total sales on a volume basis and 80% on a value basis.
Reliance on oil for taxes has been very high
Traditionally, the government has used oil products as a major source for raising taxes. Oil-related indirect taxes accounted for about 23% of the combined central and state government taxes (33% of total indirect taxes) in F2005. In our view, this ratio is unlikely to have changed much since then. This high level of taxes results in retail prices of gasoline and diesel being higher than most other emerging markets even though the government has not increased retail prices significantly over the last three years. The government levies seven different types of taxes on oil products:
Excise duty or domestic production tax: Excise duties on gasoline and diesel are levied using a combination of ad valorem and specific rates. Gasoline production is charged an ad valorem duty of 8% and a specific levy of US$0.9/gallon while diesel production is charged an ad valorem duty of 8% and a specific levy of US$0.1/gallon.
Road cess: A specific rate of US$0.17/gallon is levied on gasoline and diesel production. These collections are earmarked for funding road infrastructure development.
Import tariff: A 5% import tariff is levied on the import of crude oil. In addition, a 7.5% import tariff is levied on gasoline and diesel imports.
Education cess: An additional tax of 2% is levied as education cess on customs and excise duty levies on petrol and diesel. These collections are earmarked for funding government expenditure on education.
Sales tax (State-level value added tax): A sales tax (state level value added tax) is levied on sales of petroleum product at a varied rate across different states (for gasoline ranging between 20-35% and for diesel ranging between 8-34%).
Octroi/entry tax: Certain states/cities also levy an entry tax in the range of 1-10% on crude oil/petroleum products when they enter the limits of that territory.
Royalties: The central and state governments receive royalty payments in the range of 5-12.5% on oil & gas produced from offshore and onshore oil fields.
Large gap between required market determined price and actual price
Oil products can grouped in three baskets: (a) industrial products, where prices are largely market-determined and tend to move in line with import parity prices, (b) oil products used for cooking by lower and middle income population including LPG (liquefied petroleum gas) and kerosene, and (c) products where the government partially passes the burden of higher international prices onto the consumers. This is essentially the case for gasoline and diesel. Traditionally, the government has been using these products for cross-subsidizing kerosene and LPG. The government also levies high level of taxes on these products. Politically, the government is more sensitive to increases in the diesel price as it is used by truck operators for transport of mass items of consumption. Hence, domestic diesel prices tend to be lower than gasoline prices.
Our estimates indicate that current weighted average realization of oil products in the domestic market implies an average crude oil price of US$48/bbl (WTI), as compared with the current international market price of US$63/bbl (and fiscal year to date average of US$71.5/bbl). This gap between the required fully marked-to-market price of petroleum products and the current domestic prices of these products is covered by (a) passing the burden onto oil companies (largely government-owned) both upstream and downstream; (b) increasing the fiscal burden by way of reduction in indirect taxes on petroleum products; and (c) issuing bonds to oil companies to compensate for the under-recovery (which the government treats as an off-budget liability, i.e., this part of the subsidy burden is not taken into account for presenting annual budget deficit estimates). In our view, if crude prices (WTI) average about US$70/bbl in F2007 and the government does not resort to any further price increases, then the overall oil subsidy burden will rise to 1.6% of GDP, with 44% being borne by the government in the form of direct subsidy and issuance of oil bonds. The balance of 56% will be borne by the oil companies.
III. Sensitivity of India’s macro to oil prices
The typical macro impact of oil price movement
The government’s interference in domestic oil pricing means that movements in oil prices can have a less-than or more-than-proportionate impact on key macro indicators such as inflation, consumption and growth. If the government were to allow the domestic oil prices to be completely market-determined, the typical macro impact would be as follows:
(a) Inflation, private consumption and growth: If crude prices move down or up by 10% (for the full year), it results in a direct impact on wholesale price inflation rising by 0.6-0.7% points if the government passes the full decrease/increase to the consumers (a cascading effect of a similar amount would also be felt). Our estimates show that a US$5/bbl increase in average crude oil prices results in increasing/lowering GDP growth by 0.20% points, if the full benefit/cost is passed to the consumers. As we mention earlier, the government has clearly not been passing the full burden on to consumers. Hence, if consumer prices continue to be left unchanged, the government (including public sector oil companies) burden will decline/rise by approximately US$2.5 billion (0.3% of GDP) for a US$5/bbl change in crude oil prices.
(b) External balance and liquidity: About a US$5/bbl decline/increase in crude oil prices results in India’s import bill and current account deficit reducing/rising by about US$2.8 billion per annum (or 0.3% of GDP).
Oil price sensitivity in the current cycle
Unlike past cycles, the macro balance sheet is relatively well positioned to absorb the oil shock in the current cycle. For instance, in 2001-2, as the oil prices shot up, the balance of payments situation worsened, adversely impacting the exchange rate. As a result, the central bank was forced to hike interest rates to defend the exchange rate. This, coupled with higher prices hurting consumers, caused a sharp contraction in domestic demand. However, in the current cycle, higher oil prices have not resulted in a similar macro pressure. Firstly, the balance of payments surplus has been relatively healthy in the current cycle, as higher oil price payments have been offset by higher exports and capital inflows. Secondly, the government has also interfered in the domestic pricing more than the previous cycles, cushioning domestic demand.
What if oil prices decline to US$50/bbl?
With current weighted average crude price realization implied in the current domestic market prices at about US$48/bbl, we believe that, as the global crude oil prices decline, the government is unlikely to cut domestic prices proportionately. Hence, the fall in oil prices up to about US$50/bbl will have a less than proportionate positive effect on inflation, private consumption and growth. The most important area where the benefit will flow is the government balance sheet. If oil prices decline to US$50/bbl and the government leaves domestic product prices unchanged, the subsidy burden will be completely wiped out. However, the benefit from subsidy reduction would be partially offset by a fall in tax revenues since oil-related indirect taxes account for about 23% of the combined central and state government taxes. The impact on the balance of payments is also likely to be moderately positive. However, we believe that to the extent that the current decline in oil prices would be a reflection of weaker global growth, the decline in oil imports could be offset by weaker export growth and the ebbing of capital inflows.
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