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Realty, gold can create asset bubble

Lon-to-value cap on gold loan, customs duty hike on gold will see a shift in asset allocation in favour of silver

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The customs duty hike on could have an interesting effect in itself. Coupled to the new Reserve Bank of India (RBI) restrictions on lending cash against gold, it could lead to a small but significant shift in asset allocation. There is a logical case for suspecting that there will be a refocus on silver.

Briefly, the global economic situation remains unstable as it has been for over a year. The Indian economy is going through a slowdown coupled to large deficits. In the circumstances, it’s not surprising that gold has been one of the best performing assets of the last year.

The enhanced customs duty on gold is designed to dissuade imports. Indian households have a default tendency to hoard gold. The has a delicate task in setting customs rates. If the rate is too high, there would be an incentive to smuggle. It’s easy enough to buy gold cheap in the Gulf and land large quantities on west coast beaches. This happened daily in the old days of the Gold Control Act. That legislation created the legendary dons of what was then Bombay.

Assuming the Finance Minister has got the rate hike right, there will be somewhat lower demand for gold. But the demand for hard assets, like precious metals or gemstones won't diminish. It will be diverted into other channels. The obvious substitute is silver. is easier to trade than platinum and the average Indian is quite comfortable holding physical silver. in silver is fairly liquid and this might be a good alternate asset play.

The RBI’s forcing a cutback in lending against gold is part of a consistent policy by the central bank. It is very conservative about debt exposures against ‘risky assets’ such as real estate and now, precious metals. The logic is inescapable. Real estate, gold and so on, can develop pricing bubbles. Loans offered when rates are high can go dramatically sour.

Again, the devil is in the details. The wants a capital adequacy ratio (CAR) of 14 per cent for Non-banking Finance Companies (NBFCs) and its capped the loan-to-value (LTV) ratio for gold-backed loans at 60 per cent of the value of gold. Is the too high or too low? Is the LTV too low or too high?

One can create lots of theoretical models to assess the key variables but we’ll have to see what happens in practice. The move will definitely impact an entire class of fast-growth NBFCs, which generate most of their business from lending against gold. Their margins will be hit and so will volumes.

The flip side of preventing bubbles is that over-conservative financing impedes legitimate activity. Gold doesn’t generate income. A loan against gold is one way to capitalise an asset that is otherwise idle. Households take gold-backed loans for many reasons varying from emergencies to social obligations like weddings (which support an entire ecosystem of businesses), to starting up small businesses. charge pretty hefty rates for gold-backed loans but it is one route to capital.

Access to capital is a serious problem for everyone at this instant. India has been reeling under a regime of high interest rates and massive government borrowings for the past two years. The impact on corporate balance sheets is pretty obvious. Less obvious but equally serious in aggregate is the negative impact on small businesses.

The real estate market has also been hit pretty hard by the RBI's reluctance to allow lending, either to developers, and its requests to member-banks to ease off retail mortgage exposures. Here, the central bank is still responding to bubbly conditions that developed as long ago as 2007 and 2008. Retail mortgaging on floating rates became popular in the early 2000s. By 2007, housing loan volume had grown massively. In addition, many developers had listed in order to access cheap equity capital.

While real estate prices have not technically, fallen all that much since 2008, there has been a significant drop in transaction volumes in the past year. There’s lot of inventory and many incomplete projects are stalled for lack of working capital. Every developer is struggling to de-leverage its balance sheet. Listed real estate companies have been far more bearish in their share performance than the overall market.

Rebounds in the real estate market could also lag the rest of the economy. Even when the economic cycle turns, the real estate sector will take a longer time getting its act together. Various developers may eventually, be forced to liquidate inventory at lower rates. That would be the final stage of the RBI’s plan for a controlled bubble deflation

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