Gold In The Indian Economic System

For many centuries India has been known to possess large stocks of gold and studies show that they are mostly accumulations from centuries of trading rather than a result of production of her mines. The position appears to be true even today. What is of contemporary interest, however, is the demand, supply and price-movements and their link with policy. On the demand side, evidence shows that about 80 per cent is for jewellery fabrication for domestic demand, 15 per cent is for investor-demand and barely 5 per cent is for industrial uses.

There is reason to believe that a part of investment demand for gold assets is out of black money. The annual consumption of gold which was estimated at 65 tonnes in 1982, has increased to 505 tonnes in 1995. In the near future, the annual demand will continue to be around 400 to 500 tonnes, growing at the rate of around 4 per cent in tandem with anticipated growth in per capita real income.

 

As the domestic production of gold is very limited, around two tonnes per year, and supply from fabricated old gold scraps estimated at around 62 tonnes per year being not adequate, the rising demand has to be sourced from abroad. While currently there are some efforts to promote gold mining domestically, especially involving private sector, there are no indications that domestic supply would increase in any perceptible manner.

Policy debates

A number of issues relating to gold policy are reviewed by the RBI from time to time.

In recognition of the importance of gold in the changed circumstances, the RBI came out with a discussion paper in 1992, underscoring its bearing on external debt. Considering the complex interactions of both demand and supply forces, an institutional mechanism called `Gold Management Corporation was suggested. Almost concurrently, a Committee within the RBI has made a comprehensive set of recommendations for an integrated national gold policy.

Major criticism of liberalisation of gold policy has been on five grounds. These are:

First, we have been the largest consumer of gold in the world in 1995. The total quantities of gold imported, legally and otherwise, have risen sharply after liberalisation, particularly in the recent past. This has been a drain on savings.

Second, the liberalised policy of allowing official imports through NRI-route and SIL-route has, in fact, made little difference to the quantities of gold imported illegally.

Third, the so-called NRI imports are actually funded by hawala market, and professional NRI couriers are used for importing gold. Hence, the objective of reducing hawala market has been defeated. Also much of the movement of this gold is not easily traceable in India, since some of it is not traded in legal channels. So this did not reduce black money operations either.

Fourth, recent increases in gold smuggling are attributable to increased narcotics trade and any change in policy-tightening or-loosening would be of no use.

Fifth, the real issue as far as hawala market financing relates to inefficiency and high cost of banking services in handling NRI remittances from the Gulf and not in export under-invoicing and import over-invoicing, as much as the gold smuggling activity is Gulf-centered. However, there are others who ad-vocate further reforms, and come up with the-ir own arguments and proposals. They are:

First, to the extent hawala margins have come down, and the spurt in gold demand reflects increased genuine demand for gold jewelery, there is need to further liberalise gold imports and improve market efficiency. Further, liberalisation would in fact reduce transaction costs and role of unsocial elements. It will open up pros-pects for more agg-ressive export trade and help the econo-my. There could be fiscal gains also thro-ugh import and export taxes.

Second, it is better that the central bank and/or public sector institutions take some sort of monopoly over imports. Liberalisation should go hand in hand with a transparent regulatory mechanism.

Third, while launching a programme for encouraging public to use gold as a financial asset, the RBI and the government of India should use their own gold stocks more dynamically and earn income.

Fourth, efforts to mobilise domestic gold or permit their use as a financial asset in banking sector require institutional development.

Fifth, though current proposals to liberalise forward trading exclude gold, it would be necessary to permit forward trading soon.

Management of gold reserves

The RBI has a modest holding of about 13 million ounces or about 397.5 tonnes. It still has the largest holdings in the developing world in 1995 as per International Financial Statistics, 1996. Traditionally, we have been holding gold as an idle asset. The dormant reserves were, however, activated in the critical periods of the forex crisis in 1991.

This provided a clear signal to the world that we were taking serious action. This also showed that the gold held in the central bank provides a bedrock of the forex reserves of the country. Currently, about 15 per cent of the gold holding of the Bank is located offshore, which is now being deployed in short-term interest bearing deposits in terms of the provisions of the RBI Act. In this regard, the recommendation of the Rangarajan Committee on balance of payments in 1993 appears very relevant. The committee had expressed that it would be advantageous to locate about one-fourth of the gold holding of the RBI at an offshore center, so that the same could be utilized at times of need.

Gold as a financial product

With the reform of the financial sector and development of the financial markets, it is possible that demand for physical gold as a form of insurance-cum-investment would reduce.

Firstly, the availability of financial instruments in the non-government financial sector, could help in mobilising idle gold with households. Secondly, the ban on forward trading may have to be lifted, so that hoarding demand would come down and help in bringing the idle gold into the market/official pool.

Thirdly, if the import of gold is to be liberalised, it would be necessary to evolve a framework for regulating the import, trading and market making in gold and gold related products. And fourthly, the issue of development of financial market in gold is linked to the critical issue of capital account convertibility.

The Issues

To sum up, there a number of issues that we have to address.

Is there a need to review our current overall policy stance to gold?

If so, should the direction of change be in terms of imposing more

restrictions on domestic demand? What are the instruments and their possible effectiveness in restricting such domestic use both in terms of quality and the end use?

From the supply side, is it possible to encourage domestic production and if so, what would be the relative roles of public, private and foreign investment?

How should trade policy be re-oriented to the new policy?

Are there advantages in managing the gold import if such imports are restricted to select corporates or banks that satisfy well defined criteria?

What would be the impact of more liberal imports on balance of payments and exchange rate?

Is it advantageous to mobilise idle gold assets lying with households and bring them into the official pool to provide support for raising external resources?

Is it possible to build fiscal gains by adequately taxing imports of gold and would this be more effective if imports are done through institutions?

What would be the role of the RBI in managing gold imports?

Is there an advantage in allowing the use of gold by the RBI in a more dynamic way?

Is there any advantage in terms of permitting a more active role for banks in the gold market? If so, what should be the regulatory framework to be considered by the RBI?

How should policy stance of gold as a commodity and financial instrument be differentiated? In such a scenario, who would be the regulator?

What would be the sequencing of any change in the context of liberalisation of the economy and globalisation of the economy? Is it appropriate to initially concentrate on trade policy liberalisation and subsequently arrange for enabling forward market provisions followed by use of gold as a financial instrument?

Finally, how should the policy towards gold be integrated with financial sector reform and in the final analysis, what would be its link with currency convertibility on capital account?

(Excerpted from a speech by Y V Reddy, deputy governor, RBI at the Gold Economic Conference organised by the World Gold Council)

With the reform of the financial sector and development of the financial markets, it is possible that demand for physical gold as a form of insurance-cum-investment would reduce