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Gold plunge won’t cure India’s CAD travail
More than 20 per cent plunge in international gold prices has warmed the hearts of Indian policy makers.
THEY ARE FERVENTLY hoping that continued weakness in gold prices could significantly reduce India’s current account deficit (CAD) this fiscal.

Will their hopes be realised?

One is not very sure if the long-term trends in international gold prices (in US dollars), the foreign exchange value of the US dollar and the Indian rupee are any indication. International gold and the dollar’s external value have a strong negative relationship. This means that weakness in gold could be neutralised by a stronger US dollar (weaker rupee). And if physical gold demand in India does not moderate significantly, India could end up spending the same or even higher amounts of foreign exchange for buying gold. That would preclude any big relief on the CAD front.  

Over the past two centuries, major movements in the gold price have been associated with several recurring themes – inflation, changes in the exchange rate of the US dollar and heightened political and economic uncertainty.

The past 15 years represents a microcosm of the price patterns observed in gold in the past 2 centuries. Gold, in this period, has swayed to rising inflation concern and has also been significantly affected by the change in the external value of the US dollar. Also notably, the yellow metal has attracted sustained demand during periods of global political and economic uncertainty.

As the chart shows, the upward move in gold prices appears to have gained strong momentum after 2000. This has broadly coincided with the period when the US dollar’s overall external value against a basket of currencies  fell steeply.

In fact, this inverse relationship between the foreign exchange value of the dollar and the dollar price of the internationally traded commodities has been a significant aspect of international commodities price movements in recent times. Most commodities experienced strong upward price moves as the dollar declined in the early part of the last decade.

US dollar and commodities – negative relationship

To be sure, this strength in commodities in the recent past cannot be ascribed to the weakness of the dollar alone. The broader fundamentals relating to each commodity too has had a significant influence on the price.

Still, statistical analysis shows that this negative relationship between the US dollar and commodities (particularly gold) is quite significant. Nearly 65 per cent of the moves in one variable have historically been responded to by moves in the opposite direction by the other variable.

Therefore, as gold backs off from its recent historical highs, it may be reasonable to expect that the US dollar’s international value could well be on a medium-term uptrend. If that were the case, it may also be reasonable to assume that the Indian rupee could remain weak in the ensuing period.

Physical demand for gold in India may not abate significantly in such an environment of rupee weakness.
If that were the case, where will be the relief for India’s gaping current account deficit?  

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