Treating the gold bug

Explore new instruments to deal with the problem

A major contributor to the recent surge in India's current account deficit is the rapid increase in gold imports. From a little over one per cent of gross domestic product, or GDP, about five years ago, these have risen to over three per cent in the past year. The responsibility for this has been attributed to a number of factors, but so far, apart from a steady increase in import duties, no real effort has been made to address these causes. Even as the government struggles to deal with the short-term impact of the large current account deficit on the rupee, a strategy to contain this runaway import of gold must be quickly put into place as part of a wider effort to bring the current account deficit back to a more comfortable level.

Since there are a number of factors apparently at work, the strategy must combine different elements. First, high inflation is believed to be a significant driver of demand for gold, as a hedge against inflation. The obvious way to deal with this is to keep inflation low. But, apart from this, the availability of financial instruments that can provide a similar hedge will also contribute to restraining demand for gold. A beginning was made with the issuance of inflation-linked bonds by the government. But this may prove to be a false start, since these are indexed to the wholesale price index, which is currently showing inflation to be far lower than what is indicated by the consumer price index, against which individual investors are presumably trying to hedge. Second, there has been some talk recently about mobilising the large private domestic holdings of gold through a gold bank. As long as the gold thus realised can be fully melted down and sold and the depositor has no claims on the original piece of jewellery, such a scheme might work. However, the depositor needs to be reassured that the deposit doesn't invite scrutiny of his or her prior income. In effect, this can only work if it is accompanied by an amnesty, which raises deeper economic and political issues.

Third, a broader factor driving demand for gold could simply be the absence of alternative instruments that offer comparable returns. A direct approach is to introduce what might be called "dematerialised" gold products, which are essentially derivatives. These will allow people to invest in gold without requiring the quantity bought to be fully physically imported, thus saving on foreign exchange outflows. A number of such products were suggested by a working group set up by the Reserve Bank of India in a report published several months ago, but these have apparently not yet received the attention that they deserve. However, beyond this, the recent experience with tax-free bonds issued by some public sector undertakings suggests that there is a large retail appetite for highly rated instruments that now offer about eight per cent per year post-tax returns. Perhaps this can be widened in the form of a government-issued instrument, which is used to exclusively finance capital expenditure, thus killing two birds with one stone - thereby weaning investors away from gold and dedicating funds for much-needed public investment. At this point, the pressure from gold imports is so acute that every possible instrument needs to be experimented with.