Solving the gold riddle

Last Updated: Fri, Jan 04, 2013 04:56 hrs

Policy makers in India are justifiably rattled by the soaring gold demand, which has pushed the current account deficit in the second quarter of 2012-13 to a record 5.4 per cent of gross domestic product. Gold is the biggest contributor to imports after crude oil, widening the country's trade and current account deficits. In the absence of adequate foreign capital flows, it also raises questions about India's foreign exchange reserves buffer and its external vulnerability. Thus, Finance Minister P Chidambaram hinted at an increase in gold import duties. Yet it is debatable whether choking supply channels is the appropriate way to reduce demand. It didn't help much in the past year. In January 2012, gold import duty was raised to four per cent; still, after a blip in the first quarter, India's gold demand rose nine per cent in volume terms in the July-September quarter - a period that saw global demand fall 11 per cent. Also, further curbs on imports increase the fear of smuggling.

In that context, the Reserve Bank of India panel's suggestion seems more rational. While recommending restrictions on gold imports by banks and agencies such as MMTC, which control about 56 per cent of gold imports, it has also acknowledged that the answer to the problem lies not in just curbing the demand but in providing alternatives that give real returns, adjusted for inflation. Indeed, the finance minister's push for lower interest rates has increased investors' preference for gold. With real interest rates already close to zero, any further cut in interest rates could encourage a further shift to gold. So, a better option would be to convert the demand for gold into investment in gold-backed financial instruments through dematerialisation of gold. Currently, there are some options such as gold exchange-traded funds (ETFs), gold fund of funds, e-gold and others, most of which are doing reasonably well.

There are even suggestions to give incentives to investors who take cash delivery instead of physical gold. While the underlying asset of such products will be the yellow metal, it will be backed by derivatives. The proposal to increase the role of banks to help investors buy e-gold through their bank accounts will help attract more customers, many of whom do not prefer the route because they have to maintain a separate account with the commodity broker. The same is the case with ETFs where one has to use the demat account. The most interesting recommendation is a gold pension plan under which households will deposit their idle gold with banks and get it back in instalments in the form of a monthly pension scheme over the next 20-25 years. This will work like an annuity scheme. However, a similar scheme in the housing segment – the reverse mortgage scheme – has not done so well because of low interest rates.

In the past decade in India, gold has outperformed equities - in fact, all other instruments except real estate. Since 2000, gold has returned almost 16 per cent whereas the Sensex has returned 11 per cent. Naturally, India holds the largest stock of gold at an estimated 18,000 tonnes. The actual figures would be much higher if one took into account the stock lying idle in temples and private lockers. The dependence on gold reveals the inadequacy of India's financial sector. Solving the gold riddle will need the sector to raise its game, by devising products that offer returns more attractive than those from the yellow metal.

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