Economy Jul 1, 2013
The rupee's fall has been dramatic and one of the reasons has been high import of gold besides the withdrawal of FIIs.
We always assume that oil imports cannot be avoided and non-oil imports are needed for growth, and the only superfluous component is gold. Gold imports have gone up because inflation was high, financial savings not so attractive and returns from gold were good (in last 2 years, it would be around 10-15% per annum, depending on the time of entry). The result was an increase in the trade deficit. Everyone is trying to curb gold imports and evidently we are not prepared to take a bold step in banning or restricting import of gold. The ultimate desperate measure of the government was 'moral suasion' where households have been urged to think of the nation and ( current account deficit ) CAD before their own irrational preferences!
The government has increased the duty on gold multiple times and the RBI has tried to use the credit route to choke off lending against gold. Bank credit cards will not always let you buy gold and some gold backed funds will retreat. But, the curious fact is that gold really appears to be a good buy at a time when the price is falling notwithstanding the rupee's depreciation. The price of gold has come down from around $1700/ounce in January 2013 to a low of $1210 a few days back. There is talk that the price could slump further towards the $1000 mark. The decline in price of around 25-30% has been at a time when the dollar has held stable against the euro at around 1.30, thus severing the link between the two. Normally declining gold prices is associated with a strong dollar which is not the case - the rate has been in the band $1.28 to $1.35 during these six months.
Two factors have worked in this decline of price: the fear QE withdrawal has made funds move out of gold. Simultaneously emerging markets currencies were driven down against the dollar as withdrawal of funds has been from debt, equity and commodity markets including gold. The other reason for declining prices has been the China factor, where a perceived slowdown in growth has led to a decline in demand for gold. In between the fear of Cyprus selling gold which could trigger other euro nations in trouble to follow suit also pushed the price down.
However, even today, gold appears to be attractive as an investment if one believes that the price will go up in future as the present price at around $1,210/ounce could be below the cost of mining which means that there will be a tendency for supply to be curtailed at some point of time in which case the price has to increase. A look at data since January shows some interesting features. First, the price of gold in dollar terms has come down sharply. Second, even when adjusted for the exchange rate, the price is lower than what it was in January when it was around Rs 90,000/ounce when demand was robust. Today it is close to Rs 75,000/ounce. The investor looks at the rupee price of gold and therefore, even while the rupee has fallen by over 10 percent, the decline in gold price has been steeper thus making the rupee price relatively still attractive. Clearly for an Indian saver or investor, the price is still lower by around 15-17% and hence even the increase in duty by say 6% still makes the present price a bargain, especially if the term looked at is 2-3 years and the view being that the price will go up in future.
The government has stated that gold imports have come down on account of their measures which is encouraging, though admittedly June is a month where there is typically lower demand for gold, as it comes just after the marriage season.
There would be three factors that will drive the demand for gold going ahead. The first is the physical demand where gold is held for the sake of 'honour' and prestige. Lower price levels imply bargain buying. Here higher duty or moral suasion will just not work. Second, gold as savings option is important. Here there are long term savers who would be looking at a time horizon of 3-5 years. With interest rates poised only to move down and not go up, financial savings for the risk-averse household would be less attractive. We are experimenting with inflation indexed bonds, but with low coupon rates, may not really be attractive. In fact, this attempt to migrate savings from gold to bonds will work only in case returns are better and provided tax sops. One of the two parties has to give in - either the lender receives lower return or borrower pay effectively a higher rate. Third, as an investor, a view on the future price will be critical. If the belief is that gold will appreciate in the medium term (2-3 years), then demand will tend to increase in case of both individuals or for ETFs. Further, from the point of view of fundamentals, a weak dollar, which is what the case is today, would have to get reflected in higher gold prices.
As long as demand for gold is being driven by the price, it would be hard to control such imports. The government has to consider increasing the duty to such an extent that the price becomes unattractive. Physical curbs would be a better option especially from the point of view of improving the current account deficit. It does sound retrogressive but could be effective. In fact, any physical curbs will mean the creation of a grey market, but to the extent that such markets do not operate on official forex, the balance of payments will not be affected though this would also require monitoring on forex purchase by individuals, which has liberal limits today.
The lesson really is that in the current state, when gold prices and the currency are falling, the metal is still retaining its luster. Perverse sentiment is driving down prices - commodities as well as bonds. Presently we are in the very short nervous run, which moves from day to day, where it appears that the price of gold could fall further. But once clarity is attained on the Fed action and funds move in a more rational manner, it could just be good times for gold again.
The author is Chief Economist, CARE Ratings. Views expressed are personal.
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