The older I’m growing, the more difficult it is becoming for me to understand the rationale for some of the central bank’s decisions. In recent weeks, I have been puzzled by the decision to buy 200 tonnes of gold from the IMF at a cost of $6.7 billion, as also by the proposal to introduce credit default swaps in the Indian market. The decision to buy gold was described as an “earthquake” in a recent Financial Times editorial (November 7). The editorial went on to comment that “central banks are as easily tempted as other investors to buy high” and sell low. (This, of course, is just one example of why market prices move significantly away from fundamentals: Higher prices, instead of reducing demand as theory dictates, too often increase it!) At the time of the RBI purchase, the price was at an all-time high — conversely, the Bank of England sold gold at $250 per ounce a decade ago, when the price hit a 23-year low. One had thought that the fascination with gold as money had died with the Reagan administration — but one is obviously wrong.
Our finance minister, as reported by the Financial Times on November 4, believes that the purchase “reflected the power of an economy that laid claim to the fifth largest foreign reserves in the world”. This would suggest that the act is an ego trip — if so, it is on a par with the action of the NDA government in prepaying long-term, zero-interest external debt as a manifestation of how we do not need aid. While boasting of having the fifth largest reserves in the world, our esteemed finance minister seems to have overlooked their quality — they are not built from the earnings of the economy, that is, surpluses on the current account, but are purely the result of capital flows in the form of remittances and FII investments in the equity market.
Others argue that the purchase of gold has to be viewed as an act of strengthening our resources in the event of any crisis. In support, they cite the fact that back in 1991, a default was avoided only by pledging gold with the Bank of England to borrow dollars and carry us through until the IMF money came through. While this is factually correct, if, instead of gold, we had had that much extra foreign exchange, other things being equal, there would have been no need to borrow the dollars we did by pledging gold! In fact, the crisis of 1991 was the result of unsustainable deficits on the current account, financed mainly from external debt. I have argued several times in this column that, net of remittances which are more in the nature of capital transfers, our current account deficit is extremely high, and the ease with which it is being financed because of capital inflows should not blind us to this fact.
A few other facts are worth taking note of. Taken together, central banks have been selling an average of 400 tonnes of gold every year for the past 20 years. Second, our purchase represents as much as 50 per cent of the global sales proposed by the IMF. Third, other Asian central banks do not seem to be keen on buying gold, at least at present. To quote the Thai central bank Governor, “Gold is a secure asset but historical statistics show that, excluding its speculative side, it yields a low, long-term rate of return from collateral fees.” The internal rate of return on purchased gold, in dollar terms, over the last 30 years (average price of 1980 over average in 2009), ignoring storage costs and any returns on gold lending, was barely 1.5 per cent per annum.
There is obviously a case for diversifying reserves away from the dollar. But surely, the euro, the yen and the yuan are a better choice? Or oil? Copper? Why gold which has no intrinsic utility? Zhang Yuyan, head of the Institute of World Economics and Politics in Beijing, was recently quoted as saying “From the point of view of diversifying FX (foreign exchange) reserves, you can spend part of your money on gold; but if you want to increase the share of gold significantly, especially when prices are so high — it’s unnecessary… In addition, its liquidity is poor, it pays no interest and the cost of storage is high.”
For decades, we banned import of gold on the sound economic logic that investment in it is unproductive, overlooking the place of gold in the Indian’s cultural value system. The end result was the growth of powerful and enormously rich smuggler gangs, and a huge, illegal hawala market in currency exchange. One would have thought that the central bank would be more rational in its investment decisions than the average Indian; that, even if it wanted to augment gold in our reserves, there was a case for not doing it at record high prices. Speaking personally, I subscribe to Keynes’ description of gold quoted in the introduction to this piece.