India’s Golden Problem


The Year Ahead 2018


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A country’s current account is the sum of its balance of trade – in other words, net revenue on exports minus payments for imports. India imports vast quantities of gold to cater to its local demand and, at a time when the global economy is still sluggish, Indian firms are unable to export as much as they used to. The net result is the spiraling deficit, which is chiefly responsible for the drag on the exchange rate of the Indian rupee.

Since the government cannot do much about boosting exports in a slow global market, the focus is on cutting imports. But as India’s Chief Economic Advisor, Raghuram Rajan, has pointed out, there is not much that the government can do about the country’s vast imports of oil or coal – both of which are essential for supplying the country’s energy needs and ensuring the smooth functioning of the economy. Gold imports, on the other hand, are unproductive investments.

When gold prices softened by over 20% earlier this year, as a result of a lowered appetite for the metal as a safe haven investment, many were hopeful that India would spend less on imports. This would then narrow the current account deficit and strengthening the currency. However, the lower prices sparked a massive buying spree. According to a report by Biman Mukherji in The Wall Street Journal, it is estimated that gold imports saw an extraordinary 130% year-on-year increase in April, at a time when prices were down 10% year-on-year. The staggering rise in volumes has further widened the deficit and brought it to a dangerous high.

The only solution will be trying to curb India’s insatiable appetite for the metal, and the Finance Ministry has been trying every trick in the book. Over the last eighteen months, the import tax on gold has been raised from 2% to 6% and the rupee has depreciated as well, both of which drive up the cost to the consumer. As a further measure, the Reserve Bank announced last week that only jewelry exporters would be allowed to use credit for gold imports.

But even as further measures are expected, the program has not had a strong impact – demand refuses to slow. Moreover, many argue that tightened restrictions and higher import costs for gold will have adverse consequences. If demand for gold savings continues to persist, these measures will give a fillip to a dormant smuggling industry that will seek to profit. As many a Bollywood film’s plot from the mid-1970s would suggest, the black market for gold will thrive when there are impediments that keep an Indian family from the yellow metal. But why is this?

The Indian proclivity for accumulating gold is born out of a desire to hedge against rapidly rising costs but also because of a serious distrust in other major financial instruments – such as equities or real estate. The government’s measures may well see a short-term impact but addressing the issue at its root will have to involve offering Indian households a wider, more viable, set of investment alternatives.

Firstly, along with focusing on curbing runaway retail inflation, the government must focus on offering a more robust suite of inflation-indexed financial instruments. This will attract those who are looking to hedge against costs. However, there are also more sophisticated options at the government’s disposal, which will involve strengthening the financial infrastructure around gold-linked securities such as ETFs. In the current system, units of gold ETFs are backed by physical gold, which is bought and held by the mutual fund companies with their clients’ funds.

One idea would be to create a regulatory system that would allow mutual funds to lend this gold out, instead of just holding on to it. By lending it within the system, the mutual funds will benefit from earning an additional return on their asset and jewelers can use this supply to cut down on international imports, which are becoming more expensive as a result of government regulation. This approach would ensure that the gold ETF market functions more productively, but still does not find a more productive use for the thousands of tons of gold that lie idle in homes and vaults.

Addressing that issue might be possible with a slightly bolder option – allowing the Reserve Bank to issue gold bonds. This system would allow households to take their physical gold and exchange it for certificates – not only will these be redeemable at any point but they will also be transferable, allowing holders to buy and sell these certificates at prevailing market rates. It will also be cheaper for households, eliminating their explicit (vaults, bank lockers) and implicit (risk of fire, theft) holding costs. The Reserve Bank can then put these assets to work by lending it out to jewelers and earning a return while simultaneously curbing gold imports.

This latter system can be further strengthened to ensure participation by offering a carrot – gold bond buyers will receive a 3% value premium over the amount of physical gold they turn in and, crucially, there will no questions asked on the origin of the gold. This, in effect, will allow a vast amount of black money that is held as gold to enter the legal financial system. Such a system is likely to not only generate a significant current account surplus, but also to dramatically strengthen the Indian rupee versus the dollar.

However, these options are not without their own set of concerns. Making gold-linked instruments more sophisticated and lucrative for everyone involved may usher in more, and larger, investors who would otherwise have not entered the asset class. Would this drive up prices and volatility further? It’s a good question that merits study but I’d wager that it is also a risk that the government will have to take for longer-term stability.;