Jaimini Bhagwati: The lure of gold

Despite the problems it creates for current account deficit and currency management, weaning Indians off gold is difficult

The value of India’s gold imports has increased rapidly over the last five years. Concurrently, India’s current account deficits (CADs) have risen to worrisome levels. This article reviews India’s gold imports in the context of its CADs and the contributory causal role of an appreciation in the rupee’s real effective exchange rate (REER). 

Table I shows that gold imports increased from $14.5 billion in 2006-07 to $56.2 billion in 2011-12. Normalising for the increase in gold prices over this period, the value of gold imports has risen 1.64 times. Gold imports amounted to 151 per cent of CAD in 2006-07 and this number decreased to 72 per cent in 2011-12. Obviously, current concerns about gold imports are driven by the ominously high CAD of -4.2 per cent in 2011-12 (Table II).

Table II indicates that, from 2004-05 to 2011-12, the rupee’s REER based on six currencies (the dollar, the euro, the yen, pound sterling, the Chinese yuan and Hong Kong SAR) appreciated by 11.9 per cent, and the REER based on 36 currencies depreciated by 0.8 per cent. As of 2004-05, 40 per cent of India’s trade was with countries represented by the six currencies and 89 per cent with nations associated with 36 currencies. A simple conclusion could be that the 36-currency REER tracks the trade fallout of rupee movements better than the six-currency REER. This is not necessarily true since international trade is invoiced mostly in one of the six currencies included in the six-currency REER. For instance, major oil-exporting Gulf countries tend to price their exports in the US dollar. Oil prices are impacted more by changes in the US dollar than by movements of the currencies of countries from where oil is exported to India.
 

GOLD IMPORTS AND CURRENT ACCOUNT BALANCES
Year	Gold imports ($bn)	CAB ($bn)	Gold  imports as % of CAB	Gold price*
99-00	4.2	-4.7	88.0	279.0
00-01	4.1	-2.7	154.0	271.0
01-02	4.2	3.4	122.0	309.0
02-03	3.8	6.3	61.0	363.4
03-04	6.5	14.1	46	409.7
04-05	10.5	-2.5	427	444.7
05-06	10.8	-9.9	109	603.5
06-07	14.5	-9.6	151	695.4
07-08	16.7	-15.7	106	871.9
80-09	20.7	-27.9	74	867.1
09-10	28.6	-38.2	75	1,023
10-11	40.5	-45.9	88	1,294
11-12	56.2	-78.2	72	1,645
12-13#	19.1			1,611@

CAB: Current account balance; (-) deficit, (+) surplus; *$ per troy ounce - average price; # April-September; @ April-June; Sources: RBI; Kitco.com for gold prices from 1999 to 2008    

CURRENT ACCOUNT DEFICITS AND INDIAN RUPEE REER
Year	CAD (% of GDP)	REER* 6 currencies	REER** 36 currencies
04-05	-0.4	100.0	100.0
05-06	-1.2	105.2	103.1
06-07	-1.0	104.3	101.3
07-08	-1.3	112.8	108.5
08-09	-2.3	102.3	97.8
09-10	-2.8	102.0	94.7
10-11	-2.7	114.9	102.3
12-Nov	-4.2	111.9	99.2
REER (real effective exchange rate) base 2004-05=100; *Trade weights in six currencies; ** 36 currencies (RBI’s December 2005 Bulletin); Source: RBI

A November 2012 policy brief authored by William Cline and John Williamson of the Peterson Institute for International Economics, titled “Updated Estimates of Fundamental Equilibrium Exchange Rates (FEER)”, discusses updated FEERs and also lists movements in REERs for a number of currencies. One of the “points of departure” for the estimated FEERs is current account projections in the International Monetary Fund’s (IMF’s) September 2012 World Economic Outlook. This paper suggests that the ceiling for CADs should be three per cent of GDP and that this number should be fine-tuned to reflect the nature of capital flows that fund CADs. The implication is that the ceiling for CAD should be lower than three per cent for countries with volatile capital inflows.

The Peterson Institute paper reports that the rupee’s REER has gone up by 2.7 per cent between April 2012 and October 2012 while the renminbi went up by 0.3 per cent over the same seven-month period. According to IMF projections, India would have a CAD of -3.8 per cent in calendar 2012 and the corresponding number for China should be a surplus of 2.3 per cent. It is extremely surprising that, despite India’s dependence on portfolio flows to meet its CAD (net equity inflows from foreign institutional investors in calendar 2012 amount to $21 billion), this paper suggests that the rupee is a trifle undervalued compared to its FEER while the renminbi is close to its FEER. Given India’s lack of competitiveness as evident from its high CADs and relatively high nominal interest rates, the rupee’s six-currency REER should have depreciated substantially instead of appreciating 11.9 per cent in the last eight years (Table II). As nominal rupee interest rates have been relatively high, the nominal rupee exchange rate too should have depreciated more than it has in the last 10 years. It is inverted logic to argue that rupee depreciation would lead to higher inflation since causality is in the opposite direction. It is persistently elevated fiscal deficits that lead to higher inflation and the raising of nominal interest rates, and this combination of factors should result in a weaker currency.

India’s increasing demand for gold reflects: (a) societal mores and the widening of middle-income circles; (b) a need to hedge against inflation and country risks specific to India; and (c) preference for flexibility and anonymity to invest, in small or large amounts, in a liquid and potentially appreciating asset. In the past, several schemes have been suggested to induce private gold holdings to be deposited with banks. More recently, proposals have been made to promote trading liquidity in such assets by dematerialising gold deposit certificates.

As far back as July 1958, I G Patel predicted in an essay titled “Turning Gold into Base Metal”, carried in the Economic Weekly, that “gold bonds would prove unattractive to most people”. This essay concluded that “dethronement of gold from the position it occupies in India — deserves serious consideration”. Well, many Indians continue to want to keep their gold holdings confidential. Consequently, to reduce demand for gold, alternative investment avenues would need to be devised to facilitate anonymous cash purchases of inflation-proof, low-risk and potentially high-return instruments. Clearly, this may not be feasible or ethically justified.

To conclude on a positive note, in the first six months of 2012-13 gold imports were valued at $19.1 billion, less than half the $56.2 billion number in the previous year. This may be due to a less bullish perception about future gold prices and/or because duties on gold imports were raised. Anyway, it is a heartening sign since raising duties further could encourage smuggling of gold.

The writer is India’s High Commissioner to the United Kingdom. These views are his own
j.bhagwati@gmail.com