By Rajeev Malik
Policy making in India is often like unwanted pregnancies - what one sets out to achieve and the actual outcome are not only different, but the by-products also complicate matters. Consider the following: Policy makers have been averse to volatile capital inflows, but India today is hooked on to them. Our low-beta economy now has a high-beta equity market and a high-beta currency - the latter often clubbed with the riskiest emerging market currencies. Inflation is double the pace of real gross domestic product (GDP), the reverse of the desired combination. The government's fiscal policy has encouraged consumption at the expense of investment. It should scale back populist spending, but instead it is squeezing other categories of expenditure.
It is this context of a plethora of unintended consequences that the Reserve Bank of India (RBI's) recent guidance of offering alternative financial products to "dematerialise" gold should be assessed. Let there be no doubt that the proposed new investment channels are long overdue and a welcome addition for financial planning. But, unfortunately, the fashionable focus is yet another instance of policy makers trying to address the symptom rather than curing the underlying disease.
According to the World Gold Council, India is the world's largest consumer of gold. The quantum of gold imports accounts for a quarter of world demand. Crude estimates suggest that Indian households are sitting on around $1 trillion (53 per cent of GDP) in gold savings. Unfortunately, this pool of savings is not intermediated between savers and borrowers, hence doesn't contribute to the virtuous growth-enhancing savings-investment cycle. However, higher gold imports increase the stress on the balance of payments (BoP).
A sizeable portion of gold imports is retained domestically for both consumption and investment. In 2011-12, gold and silver imports hit a record-high of $61.3 billion. A key point which is often overlooked is that the surge in import of gold took off after the 2008 global financial crisis. Net gold and silver imports skyrocketed to $44.9 billion in 2011-12 from $6.2 billion in 2007-08.
What caused this surge in residents' demand for gold after the crisis? This is the key issue which goes into the heart of the matter of the high demand for the yellow metal,and one that the RBI and the government should be collectively addressing. Instead, the focus is on meeting the high demand for gold, but without a similar reliance on its physical import.
Interestingly, other countries do not show a similar pattern of a post-crisis surge in gold imports - although some countries, especially the peripheral European economies, suffered sustained capital outflows. This suggests that there are India-specific factors, over and above the country's penchant for gold, that carry greater weight in explaining this surge in gold demand.
Gold has a split personality for India. Retained imports of gold are abnormally large and unique, as it essentially functions as a store of value that is recorded as a current account transaction. This causes the current account deficit (CAD) to worsen - it hit a record-high of $78.2 billion (4.2 per cent of GDP) in 2011-12.
The increase in gold imports in recent years has several drivers apart from the higher export of gems and jewellery and higher prices for gold. There is an increasing demand for gold for investment as household incomes have been rising. The yellow metal has also been used as an inflation hedge locally and for parking illegal wealth. The thin spread of formal banking facilities means that a sizeable portion of household savings are locked up in physical gold. Unlike real estate, gold can be bought with small outlays. This is especially relevant for the vast sections of the population, especially the rural and urban poor, without access to the formal banking system.
The jump in gold imports also appears to go hand in hand with concerns about macroeconomic stability, policy incoherence, entrenched high inflation and rupee depreciation. Persistent worries over India's twin deficits, especially ballooning government borrowing, have contributed to increased concern about macro-financial stability. It is striking that local deposit rates do not compensate depositors for inflation and inflation expectations.
It is ironic that the RBI, which bought around 200 tonnes of gold in 2009 from the International Monetary Fund, is now worried about Indians' preference for the yellow metal in physical form. At best it is offering only a band-aid solution and is treating the symptom of high gold demand rather than addressing the underlying factors behind the strong demand for gold.
In its annual report for 2011-12, the RBI states the following about gold and property: "These two markets have not only provided effective inflation hedges, but also enabled savers earn good real returns amidst high inflation." The RBI's inflation fight is less aggressive than its rhetoric suggests, and it should be embarrassed about its track record of controlling inflation in recent years, even if this is partly because of a government that doesn't appear to fully appreciate the macroeconomic outcome of its policies. Recently, there have been press reports that the RBI might revisit its medium-term inflation guidance of four to five per cent - this is hardly something that will make households more confident about a low inflation regime.
Also, the RBI's suggestion of new products does nothing to check the underlying demand for gold as a vehicle to park unaccounted wealth. Traditionally, gold and real estate have been the natural options for this. An important motivation for holding gold is to avoid a money paper trail. That is unlikely to change anytime soon.
A meaningful portion of Indian households holding of gold is capital flight captured in the current account of BoP. Thus, the claim by some that lower gold imports will necessarily lead to rupee appreciation as CAD will narrow is not entirely correct. This is because the overall BoP impact, which is what matters for the rupee, may not change much. Indeed, if India allowed easy legal ways to take money abroad, a part of what is captured as gold imports (and widens CAD) would have been captured as capital outflows. In such a situation, even though CAD would have been lower because of lower gold imports, the capital account balance would be under greater stress, leaving the overall BoP largely unchanged.
Indians are not being irrational in their preference for gold. That preference partly reflects low confidence in the current policy regime, and the promise of low inflation and macro-financial stability. Policy makers will be better off in addressing those shortcomings rather than peddling another band-aid solution.