In what is, from all accounts, a clear and emphatic demonstration of the sagacity of Finance Minister Arun Jaitley, the finance ministry while notifying a draft of the Gold Monetisation Scheme for public comment, chose not to notify the other Sovereign Gold Bond Scheme. In my opinion piece on April 17, 2015, I had argued that such a scheme would not deliver in practice and could even potentially make the fisc/exchequer take a hit of trillions of rupees and might thus end up being fiscally overwhelming and way too disruptive. I brought out the fiscal risk to the exchequer of monumental proportions which, paradoxically, would be directly proportional to the extent of success of sovereign gold bond scheme, if short gold exposure is not hedged, and no reduction in gold imports, if it is hedged. A dissection of the draft Gold Monetisation Scheme recently notified by the Finance Ministry is required. Specifically, the draft Scheme delineates utilisation of gold deposits mobilised by banks for 1) buying foreign currency to lend to exporters/importers; 2) trading on commodity exchanges; 3) making gold coins and selling to banks' customers; 4) lending gold to jewellers; and 5) meeting part of banks' cash reserve ratio. ALSO READ: Gold and Budget 2015-16: How we can and cannot reduce gold imports As regards buying foreign currency to lend to exporters/importers, banks cannot , and must not , do this precisely for the same reasons that they don't buy foreign currency now with their Rs 94- trillion deposits for lending foreign currency to exporters/importers. The reason is that this will amount to banks going hugely short in rupees and therefore, will be exposed to the risk of the rupee appreciating because they will have to buy the rupee back with foreign currency loans repaid by exporters/importers to redeem their rupee deposits at much higher than their original sale price. Of course, banks do make foreign currency loans to their exporter/importer customers but only by way of deploying their FCNR deposits and by syndicating foreign currency loans abroad and not by buying foreign currency with their rupee deposits. Precisely the same logic applies equally to utilising gold deposits to buy foreign currency for lending to exporters/importers as doing that will amount to going hugely short in gold and will thus expose banks, as in the case of the rupee above, to the risk of gold price going up as they will have to buy back gold with foreign currency loans repaid by their exporter/importer customers to redeem their gold deposits at much higher than their original sale price. Coming to the next two purposes - banks trading deposited gold on commodity exchanges and making coins of gold deposits to sell to their customers - the same logic as above will apply because banks will be going hugely short in gold and will, thus, again be exposed to the risk of having to buy back metal gold at prices much higher than their original sale price.
This may, in extreme case, potentially create systemic financial instability and depletion of bank capital. This is precisely why prudent, sound and safe commercial banking is about banks lending to their customers what they borrow by way of deposits. If banks accept rupee deposits, they lend rupees and if they accept dollar deposits, they lend dollars and so also, if they accept gold deposits, they should lend only gold and not rupees and dollars by converting gold deposits into rupees and foreign currencies. If, therefore, banks were to utilise gold deposits mobilised by them for buying foreign currencies for lending to their importer/exporter customers, trading on commodity exchanges and for minting gold coins and selling them, as proposed in the draft Scheme above, it will be tantamount to banks short selling gold. It would also be appropriate, if only to remove any remaining scepticism, reservations and doubts about the above proposition , to note that banks do utilise rupee deposits for trading in foreign exchange markets for their customers but exchange risk is borne by their customers and not banks except for banks' own relatively small intra-day and overnight proprietary open positions which, significantly, are permitted by RBI largely and essentially for banks to buy and sell foreign currencies from and to their customers. As regards utilising part of gold mobilised by banks as part of CRR, it is ostensibly both counterintuitive and antithetical to monetary policy theory and practice as it will increase reserve/base money which, in turn, will increase broader money supply precisely when the opposite is needed. In other words, this dispensation will be tantamount to legally, and officially, circumventing prescribed CRR. To maintain the same level of reserve money, RBI will have to correspondingly increase CRR to the extent of allowance of gold deposits as part of CRR. For example, if banks are permitted to meet 1% of CRR by way of keeping gold deposits with RBI, the central bank will have no choice but to increase CRR by 1% because reserve/base money is always in the legal tender currency of the country concerned which, in the case of India, is the rupee and not gold. Finally, as regards lending gold deposits to jewellers, the borrowed gold will be converted into jewellery and sold in the domestic market to generate rupees and not gold. Jewellers will then have to buy gold back, as indeed in all the above cases except in the case of CRR, to repay their metal gold deposits/loans and which, given that supply from recycled domestic gold constitutes a measly 10% of total domestic gold demand, will have anyway to be imported as now and will, therefore, lead, in addition to huge potential losses, to no reduction in gold imports. The author is former executive director, Reserve Bank of India