Gold imports are widening the current account deficit but buyback could monetise domestic savings for infrastructure investment
National Leader, Global Financial Services, Ernst & Young
“The share of gold in the country’s total import bill has gone up from 8.1 per cent in 2001-02 to 11.5 per cent in 2011-12. Its increasing share in imports exacerbates the current account deficit”
The Reserve Bank of India should not allow banks to buy back gold. That could possibly result in currency devaluation and inflationary spikes. While the monetisation of gold assets will boost liquidity in the system, capital market instruments will be better than allowing banks to hold gold assets. The regulator has allowed banks to sell gold while prohibiting bank finance for the purchase of gold and loans against gold, except for working capital finance.
India is the largest gold consumer globally — accounting for 22 per cent of the world’s jewellery and 35 per cent of the retail investment demand. This was 27.1 per cent (933.4 tonnes) of the global demand in 2011, valued at Rs 2.2 trillion. Growing at a compounded annual growth rate (CAGR) of 4.7 per cent since the repeal of the Gold Control Act (that barred possession of gold in bar form) in 1992, according to various estimates, India possesses about $1 trillion worth of gold. Domestic production of gold in India is limited, and it imports around 90 per cent of its total demand. It imported 969 tonnes of gold in 2011 (94.4 per cent of the total demand), valued at Rs 2.7 trillion. Other sources of supply in the country are gold recycling (5.5 per cent), local mine production and others (1.1 per cent).
The country’s gold imports have grown at a CAGR of 34 per cent from FY03 to FY12, increasing from Rs 0.2 trillion to Rs 2.7 trillion. The share of gold in the country’s total import bill has gone up from 8.1 per cent in 2001-02 to 11.5 per cent in 2011-12. Its increasing share in imports exacerbates the current account deficit. In addition, the size of the cash economy has added to gold demand.
Most Indians have an emotional affinity towards gold – regarded as a symbol of purity, wealth and prosperity – thus driving their desire to possess it. Since the early 1990s, with the repeal of the Gold Control Act and economic prosperity, the demand for gold has increased strongly. A prime reason for an increase in gold purchase is the liquidity factor — the flexibility to sell off gold in return for cash.
Gold has shown less price elasticity than other asset classes. Even as the prices have increased six times from 2001 to 2011, the demand in volumes has still risen at a strong pace. Unlike the common belief, gold demand for jewellery is quite price elastic as its demand has gone down, while gold as an investment has gone up.
Gold as an investment vehicle is regarded as a safe haven, especially during times of financial market distress. It is also believed to act as an inflation hedge, since its real value has remained stable over time.
Gold has proven to be an asset that has low correlation to most financial assets, both in expansionary and recessionary periods. A positive relationship between money supply and gold can exist in either case. First, if money supply is accompanied by economic growth, the increase in wealth and access to capital can increase the demand for luxury consumer goods, including gold. Second, as excess money enters the system and the economy remains stagnant, inflation pressures may prompt investors to safeguard their wealth by increasing their exposure to hard assets, such as gold.
Gold has proven to be a critical component of central banks’ reserves across the world. It is considered a strong defence against contingencies, since its value tends to appreciate at times of stress and is a generally acceptable means of international settlement. While holding gold has some merit for central banks as a reserve currency, investment by banks in gold can be avoided.
In 2012, the organised gold loan market in India was worth Rs 1,25,000 crore, of which the non-banking financial companies’ gold loan had a share of about 46 per cent, according to IMaCs.
In conclusion, allowing banks to buy and invest in gold may help monetise the large reserves of gold with the general public, but it might lead to inflation and rupee devaluation. Commodity and capital-market instruments through dematerialisation perhaps are better options. Furthermore, such a move would end up introducing commodity risks into banks’ books. Banks should remain lending and savings institutions rather than transforming into commodity trading organisations.
Chief Economist, State Bank of India
“The investment in gold bars and coins is rising faster than in jewellery. Allowing banks to buy back gold will help financialisation of savings and increase the domestic savings rate”
Indians have always had a yearning for gold and, according to the World Gold Council, India is the largest consumer of gold, accounting for over a quarter of the annual global production. After oil, gold is the second largest item of imports. Gold imports equal 75 per cent of India’s current account deficit (CAD) and the sharp increase in gold imports to $57 billion in FY12 from $41 billion in FY11 is a major factor behind the widening gap on the balance of payments account.
Rising gold imports to meet domestic demand has seen a doubling in gold imports between FY09 and FY12. The demand for gold has not only remained high – as reflected in the rising volume of imports – but the demand is also set to go up for several reasons. One, in the current inflationary scenario, gold is seen as a hedge against inflation. Interestingly, the sharp spike in gold imports in FY11 and FY12 was against the backdrop of high average inflation of 9.6 per cent in FY11 and nine per cent in FY12. Second, alternative assets like equity and debt have become unattractive with slowing Gross Domestic Product (GDP) growth. The global uncertainty has also seen gold gain against hard currencies. Third, there are limited avenues available to savers particularly in rural and semi-urban areas. So, gold has usually been held to meet unexpected exigencies. Finally, and more importantly, gold has a huge social value as it is traditionally purchased for marriages, social customs, and so on.
Households contribute 80 per cent of the demand and an estimated 25,000 tonnes of bullion is held by Indian households. By some estimates, gold savings will be around Rs 3,50,000 crore by 2016 from Rs 2,44,000 crore in 2012.
From the consumer’s point of view, gold is seen as a highly liquid asset and, even though it does not earn any return, it protects the saver’s wealth, given the persistent and sharp rise in gold prices. However, savings in gold remain idle and not available for productive investment. Recent measures to curb the demand for gold, including doubling of import duty on gold imports, and cut in loan limits of non-banking financial companies to 60 per cent of metal value, have not had much impact.
To meet the retail demand for quality gold, banks have been allowed to sell gold coins. However, the Reserve Bank of India (RBI) has refused to allow banks to buy back the gold that they have sold. In my view, it is now time to reconsider this decision for several reasons.
First, the investment in gold bars and coins is rising faster than in jewellery. Therefore, allowing banks to buy back gold will help financialisation of savings, increase the domestic savings rate, deepen household savings in financial assets and help intermediate savings into productive investment. This would have a huge positive impact on growth and would be very beneficial for the economy.
Second, with banks buying back the gold sold by them, it will increase the supply and turnover of gold in the market. There would of course be no loss in quality and banks can be allowed to hedge in the domestic market to protect them against any fluctuations in price. As more gold comes out into the market, it will reduce the demand for gold imports and thus curtail CAD. In fact, if gold imports are eliminated, CAD can become less than one per cent of GDP.
The issue has assumed added urgency given the fact that we need to raise resources for investment in infrastructure to support and sustain eight to 10 per cent of GDP growth. There is an urgent need to not only step up the pace and volume of household savings (which is now seen shrinking), but channel household savings increasingly into financial assets.
Since India is one of the fastest growing countries, in the future as incomes rise, consumption of gold will also go up. Empirical evidence shows that as incomes increase, there is a propensity to buy more gold. In fact, for every one per cent increase in income, gold consumption increases by 1.554 per cent, showing that gold consumption is highly income elastic. Since around 40 per cent of the gold is held in bars and coins – even if we are able to convert this gold held in physical assets into financial assets and deploy these for productive purposes – GDP growth of nine to 10 per cent will become a reality. Therefore, RBI should now allow banks to buy back gold.