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India’s gold fetish


India imported 958 MTs of gold in 2010 and something over 1,000 MTs in 2011. Assuming gold price at $ 1730 per ounce, the value of gold imports in 2011 was $ 57.56 billion. In contrast, considering India’s GDP at $ 1.4 trillion, India’s fiscal deficit for the year 2011 is expected to be around $ 91 billion. In other words, over 60 percent of India’s fiscal deficit goes to stimulate the world economy and only 40 percent results in some enhancement to domestic aggregate demand. Were the fiscal deficit to be pegged at 4 percent instead of the present 6.5 percent, gold imports would completely offset any stimulus to the domestic economy by their deflationary impact. Little wonder then, our GDP growth has been falling since 2008 as gold imports picked up in line with the uptrend in world prices of the metal. In the same period, GDP growth fell from about 10 percent to about 6.9 percent in 2011. Sure, gold imports are not the only factor, but their deflationary impact on the economy can no longer be ignored in policy making. That is but one side of the equation.


India’s total goods exports in 2011 are expected to be $ 250 billion while total imports, of which gold is one part, are expected to be $ 370 billion leaving a trade gap of $ 120 billion. Of the total imports, $ 104 billion is oil followed by $ 57.56 billion of gold. Net export of services, which includes software exports, etc, contributes $ 49 billion, reducing the trade gap to $ 71 billion. This gap is financed from external sources like the FDI, FII inflows and NRI deposits with banks. These together are expected to total about $ 60 billion, leaving an uncovered gap of $ 12 billion to be met by drawdown of reserves.

Going forward to 2012, while imports and exports will remain of the same order of magnitude, repayment obligations in 2012 will shoot up by an estimated $ 20 to $ 30 billion. FII and FDI inflows may actually drop as the economic growth rate continues to slide. Gold imports exceed software services exports. In fact, the value of gold imports now exceeds the total quantum of investment inflows into the economy by way of FDI and FII. Our domestic investors are selling future profits of Indian companies to foreign investors to buy gold. That is a swap that seems certain to lose money for the domestic investors over the long term.

Clearly, considering the deflationary impact of gold imports on the economy, as well as the need to finance them, the import of gold at the current levels is unsustainable. To understand what can be done to reduce the incentives for gold imports one needs to consider why they happen in the first place. While there is little doubt that some of the gold imports are for consumption in the form of jewellery, a bulk of the incremental imports since 2007 — around 600 MTs — are for investment purposes. It is this component of the demand that the Reserve Bank of India (RBI) needs to focus on.
Indian experience with fiat currencies is recent. Prior to the British rule in India circa 1880, there was never any fiat currency worth the name. Gold and silver coins, stamped by a local sovereign to attest purity and weight, served both as currency. More importantly, there were no banks before the British established them in the 1900s. Only moneylenders existed. If you needed to save money, there was only one way to do it — collect gold coins or jewellery. No other alternative existed unless you went into business yourself or bought more property. With property came the political risk of expropriation and worse, in addition to taxes. Hence the preferred method of saving was to horde gold and silver. Buying gold and silver was synonymous with saving for the future in the Indian culture for centuries right up to the 1900s. We have done little to change that culture through education. Little wonder then that the demand for gold, even if it is known to be ruinous for the economy as a whole, is insatiable.

Distrust of sovereign power is ingrained into our historical psyche and rightly so given the numerous invasions, local wars, multiplicity of small principalities and the capricious nature of the rulers who ruled. Gold and silver were sovereign-proof and easily concealed. While the British went about establishing a fiat currency in India, they took care to fully back it up with gold in India itself. Right up to independence, the Indian rupee under the British was fully backed by gold and indeed some of the earlier coins of the British Raj were in gold and silver species. One of the first acts of the Indian government after independence was to abolish the gold standard. Who is to say that the domestic investors are wrong about not trusting the government with their money?

If bank deposits and the Indian banks are to be trusted with household savings, then the minimum that they can do is to give the investors a return on bank deposits that exceeds the total return on gold over a period of time by way of capital appreciation adjusted for storage costs. Unfortunately, the banking system spectacularly fails to meet this test. On an average, inflation has exceeded the nominal interest rate by some 500 basis points, eroding the real value of bank deposits in relation to gold that usually occasions no capital loss. Why then would savvy households trust bank deposits over gold even if speculative demand occasioned by rising world prices is ignored?
The RBI must proactively think in terms of creating an institutional structure for comprehensive management of gold in the domestic economy. Given the deregulation of all interest rates, the RBI has considerable leeway in using markets to create a market for gold that minimises the use of physical gold as an investment vehicle while being transparent to all investors.
The RBI should set up Gold Bank of India, which would take in deposits in gold and also lend gold against adequate collateral to other banks and institutions. It would have complete freedom to import or export gold. The Gold Bank would also write hedged call and put options on gold of suitable maturities, which would be traded on the NSE/BSE. The gold held by the bank would be independent of the official gold reserves. In return for taking in gold deposits, the bank would charge a safekeeping fee or offer interest rates determined by its reading of the market. Likewise, it would charge interest on loaning out of physical gold. The accounts of retail depositors could be held at authorised commercial banks. To separate this market from the normal rupee market, gold deposits would have a minimum maturity of one year with no option of premature withdrawal. So gold will not replace the rupee as currency.
Gold deposits will have to compete with bank deposits of corresponding maturity for business. Any mismatch would set up arbitrage that would be exploited in the markets. This link between physical gold and bank deposits will prevent the RBI from setting interest rates out of sync with inflation. It will also reassure the investors that the returns on bank deposits are in line with long term return on gold. The gold bank could begin with 100 percent reserves against deposits and reduce them over time as it gains more experience. There is no additional outlay on gold imports since the demand for gold is met from imports anyway.
To the extent education and experience can reduce the demand for physical gold; the savings to the economy from reduced gold imports could be phenomenal. That may be one creative way to make a virtue of an adversity for the RBI.

The writer is a trader. She can be reached at sonali.ranade@hotmail.com or @SonaliRanade on Twitter

Categories: Uncategorized
  1. February 21, 2012 at 4:21 am

    Sonali, r u combining China also in your figure ? because accor\ding to WGC gold off take of India was less than 2010. Who is right ? I am sure you would have researched the subject thoroughly but facts ?

  2. February 24, 2012 at 5:15 pm

    well, its quite long and detailed. I will finish it off for sure, just out of curiosity with no disrespect meant, did you write all this by understanding data or is it excerpts from other media ?

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