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Economy Jan 22, 2013

Do your worst, Mr C; India isn’t about to give up on gold

By R Jagannathan

As threatened, the finance minister has hit gold buffs on the head with higher import duties. The duty rate is up from four to six percent for gold and platinum, but the real hike is six-fold between last January and now. In January 2012, the duty was just one percent.

The ostensible reason for hiking duty is the skidding current account deficit (5.4 percent in July-September 2012), partly due to high gold imports. The finance ministry says gold imports in April-December 2012 were as high as $38 billion despite the duty hike earlier in the year. In 2011-12, the gold import bill was $56.5 billion.

To slash the bill, the government has come up with a scheme to link exchange-traded funds (ETFs) and banks' gold deposit schemes in the hope that direct gold imports will come down. The idea is that ETFs will park their gold with banks, who will then offer the gold to jewellers, and churn some business out of it. Among other things, the government plans to reduce the minimum quantity that can be deposited and the tenure of deposits from three years to six months. The Reserve Bank and Sebi will provide the details shortly.

Will it work?

Yes and no. Yes, because any duty hike will impact demand for gold, and so it will work in that sense. We can see the import compression that happened ever since Pranab Mukherjee raised duty rates last year. But as Indian demand for gold is largely price-insensitive over the medium turn, duty hikes are like band-aids for cancer. And the cancer relates not to the Indian fetish for gold, but our policy-makers' tendency to debase paper money by printing too much of it.

Gold demand in India has changed from merely being a jewellery-cum-rainy-day investment to a hedge against inflation. This is why the calculations of policy-makers may go awry.

Let's delve deeper.

First, when duty is raised, all it does is bump up domestic gold prices. Rising prices provide further confirmation to the Indian buyer that gold is valuable. So we will buy more gold whenever we can afford it, even if in small quantities.

Second, if the official channels gets crimped, supply will come from the smuggling route. BusinessLine reports that gold seizures by the customs department at international borders more than tripled in April-October 2012 to Rs 50 crore from Rs 15.81 crore the year before. And since actual gold seizures are a fraction of the amounts smuggled in, one can be sure that smugglers are making a killing.

Raising duties and banning this or that is no solution to the problem of a repressive fiscal policy that debauches the value of the rupee. AFP

Third, ETFs are currently very small in size. Business Standard says that mutual fund ETFs hold gold of the value of around Rs 11,674 crore - just over $2 billion worth. If this is right, asking them to park a part of their gold with banks will be far lesser than $1 billion - a drop in the ocean of total expected gold imports of nearly $45-50 billion this year.

Fourth, since ETFs have to buy gold when subscribers increase and sell when redemptions take place, they can't deposit too much gold with banks just to earn some nominal interest. But if ETF performance improves with bank interest, we may find more people buying ETFs at the margin - which would need more gold imports. The advantages and disadvantages of asking ETFs to deposit gold with banks more or less cancel each other out. ETF officials do not think their lives are about to change.

Fifth, gold deposit schemes have not worked for two reasons: when locking up gold for long tenures, investors can't benefit from short term spikes in gold prices. Moreover, the main thing about gold is that it assures you control of your resources in tough times. Keeping the metal with a bank is not a good enough substitute for having the metal under your pillow or in the locker. Given the negativity spewed by government ministers on people holding gold, the trust factor is fast evaporating. If you think I am anti-national for buying or hoarding gold, why would I give it to your public sector bank for safe-keeping? Can the fox be trusted to guard the henhouse?

Sixth, bringing gold - often bought with black money - into the formal domain of banks carries its own risk for ordinary folks. The bulk of the physical gold is bought by individuals, not ETFs. The linkage between ETFs and gold deposit schemes is very tenuous and will barely begin to tackle the problem of gold imports. The reason why even ETFs have barely taken off is that people prefer to keep their gold with themselves. Part of the pleasure in holding gold is to touch it and feel rich whenever you feel low. A piece of paper isn't as good.

Seventh, the real problem, as Arjun Parthasarathy noted in Firstpost, is not gold, but the rupee. Between August 2011 and December 2012, international gold prices declined, but the rupee's huge decline actually boosted gold prices in India.

This is really the crux and why finance ministers have been unsuccessful with all their gold schemes.

Investing in gold is an indictment of the government's fiscal and monetary policy. This is what P Chidambaram hates, and why he is making such a song-and-dance about gold imports.

Raising duties and banning this or that is no solution to the problem of a repressive fiscal policy that debauches the value of the rupee. Indians' attraction to gold will be inversely related to the trend in the purchasing power of the rupee at home and abroad.

After the duty hikes in March last year, gold demand fell for a while. But look what the World Gold Council reports: "India was the strongest performing market in the third quarter, with year-on-year growth rates of 7 percent and 12 percent in jewellery and investment demand respectively. The market accounted for 30 percent of total consumer demand, 223.1 tonnes in total. Improved consumer sentiment, positive price expectations and the onset of festival demand fuelled the recovery."

Gold is the only insurance people have against official government policies to destroy people's wealth by fiscal waywardness.

by R Jagannathan

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