In an economy that is as open as ours, it is, to my mind, a patent foolishness to try and constrain gold imports by increasing import duties. First off, this threatens to undermine one of the greatest victories of the 1991 liberalisation: the demise of the havala market. Second, if people want to buy gold – and, from the import figures, it is clear that they do – they will find ways to do it. Administering prices to try and control demand (or to mop up revenue) creates distortions in the economy, which are usually more pernicious than the original problem.
Currently, the threat is of a widening current account deficit, in turn a weaker rupee, and in its turn higher inflation. However, if, as a result of the duty hike, the havala market does get stronger – and there is considerable evidence that it is coming back to life – it will exert a continuing drag on the onshore rupee, exacerbating any downward moves and undercutting efforts at inflation control.
Rather than trying this patch-up of the current account deficit, we need to acknowledge that in a world where export markets remain subdued, where India's growth is modest (to, hopefully, strong), and where the fiscal deficit keeps inflation high and real interest rates low, getting the current account deficit back below three per cent will be a long – and, in the near term, unwinnable – struggle.
The government's frightened gambit of raising the import tariffs on gold suggests that this is its number one concern, and this signal could turn into a self-fulfilling prophecy - I note that the rupee's strong rally since the end of last year appears to have halted on the announcement.
It would be much better to not worry so much about where the rupee might go and focus instead on structural ways of improving our twin deficits. The finance minister is already hot on the job and the results are plainly visible in both the stock market and the rupee. He needs to stick to the deficit-reducing knitting, as he claims to be doing. This will itself give some pause to gold demand - as the deficit and, as a result, inflation, eases, the attractiveness of gold as an investment will also decline.
The government should immediately rescind the import duty hike (in fact, it should rescind the earlier one as well) and implement a simple scheme to bring as much of India's huge gold holdings as possible into the financial system. Unfortunately, the schemes currently contemplated do not address the main constraint on success: people will only deposit gold if they are certain they can retrieve it on demand. Any holding period in excess of overnight will render the collections minimal.
An effective solution would be for banks to offer gold savings accounts providing an interest of, say, one per cent per year. These would be like rupee savings accounts, where the depositor could withdraw her gold across the counter (or overnight, in rural areas), addressing the primary constraint. Additionally, people could "buy" gold by simply depositing the cost of the gold in their gold savings account with the bank, which would buy and hold the gold on their behalf. Again, the gold would be retrievable on demand.
The bank would hold, say, 20 per cent of the deposit in physical gold, since not all deposits would be withdrawn at once, and hedge its price risk on the balance in the futures market. After accounting for interest and hedging costs (less than one per cent a year currently), the balance of the deposit (at least 75 per cent) could be lent out or invested in gilts. This would make the scheme extremely attractive to banks, and, critically, gold imports would decline by 75 to 80 per cent of the amount attracted to the scheme.
The total amount of gold held by individuals in India is in the region of 18,000 MT to 25,000 MT, and it is reasonably well established that about 40 per cent of this hoard is held as bullion - this translates to 10,000 MT (or 7,200 MT) of "accessible" gold. If the scheme were to attract 100 MT of gold a year (just one to 1.5 per cent of accessible gold holdings) and attract, say, 10 per cent of fresh annual demand, it would reduce gold imports by around $7-8 billion, which is around 10 per cent of the current account deficit.
Of course, it would take some time for the scheme to mature and, in the meantime, there may well be some fallout on the currency (and equities), particularly if we suffer a serious risk-on episode. But even if that does happen, the decline will be contained (and will reverse rapidly, when sentiment turns) since markets will see that, given current circumstances, bringing dormant gold holdings to life is the only way to structurally improve our current account.