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Money Jan 3, 2013

Govt wants you off gold: Say 'no thanks'

By R Jagannathan

The finance ministry is miffed that the people of India think gold is a better bet than rupee-denominated assets. This can be the only reason why it is repeatedly trying to wean people off gold purchases by floating proxy investment ideas in gold.

In the last budget, the government raised customs duties on gold.

A few days ago, the Reserve Bank of India banned banks from lending any money for the purchase of gold.

In March this year, the central bank tightened lending norms for non-bank finance companies against gold jewellery, they can now lend only 60 percent against the value of gold offered as collateral.

And now, in yet another move to deflect a gold-obsessed nation away from physically trying to possess the yellow metal, the ministry has called for the introduction of a Gold Accumulation Plan (GAP) based on the report of the committee for "Deepening India's household financial savings," reports BusinessLine.

Put simply, the committee wants Indians to invest less in gold and more in financial assets that are denominated in rupees - whether it is shares or other pieces of financial paper.

In doing so, they are operating on the assumption that gold is a "dead" investment, which does nothing to promote real growth, investment or savings. We shall discuss the flaws in this assumption later.

But, first, how is GAP supposed to work?

Will GAP ultimately wean people away from accumulating gold, when the promise of the scheme is to go for paper gold, with the promise of real gold at the end of the waiting period? AFP

According to the committee, Indians will be asked to sign contracts with banks to contribute regular amounts like they do with recurring deposits. This money will then be used to buy gold in the futures market - but not gold itself. Thus citizens will be able to accumulate claims on gold, but not gold, even though owning an underlying futures contract means the account-holder can ask for the gold at some future date and it will have to be delivered.

BusinessLine suggests that since the money is being used to buy futures contracts in gold rather than gold itself, there will be no immediate import outgo.

But the flaw in the scheme is this: as the metal starts accumulating in the customer's GAP account, at some point of time he or she can indeed demand gold coins or bars in exchange, as promised by the underlying gold contract.

Moreover, why should any investor buy gold futures on a monthly basis when he can invest in gold exchange-traded funds (ETFs) through the same monthly contributions coming through SIPs (systematic investment plans)? SIPs in ETFs give you underlying gold value today as against gold tomorrow under GAP schemes. In the last one year, gold ETFs gave returns of 8-10 percent, lower than inflation, but ETFs do better over the medium or long term.

The immediate motive for suggesting GAP is that the country's external balance is going for a toss, with the current account deficit refusing to fall significantly below 4 percent of GDP even this year. Discouraging gold imports is thus an important goal of short-term policy.

In 2011-12, gold was the second largest item of import after oil, and a serious contributory factor to the decline in current account deficit and, consequently, the rupee.

But will GAP ultimately wean people away from accumulating gold, when the promise of the scheme is to go for paper gold, with the promise of real gold at the end of the waiting period? Is the finance ministry only postponing the demand for gold by shifting demand from present to future?

As usual, the finance ministry appears to be taking a short-term view of gold import demand without understanding why Indians like gold.

Gold has three characteristics which Indian love.

One, it has held value for so long that they know it is ultimately better than paper money.

Two, it is portable, and a useful hedge against adversity. It is held for distress situations and is easily encashable.

Three, equity has not been a fail-safe deliverer of value for most ordinary Indians. For those who seek safety of capital, gold is the alternative to fixed deposits.

In fact, both the finance ministry and the Reserve Bank are being hypocritical in trying to de-emphasise gold here.

In 2009, they themselves bought 200 tonnes of gold in order to bolster official reserves - indicating that they have less trust in paper reserves (even US dollars) than gold. What is sauce for the RBI is not sauce for us ordinary folks?

The RBI's accounts for 2011-12 show that while foreign currency assets went up by 14.2 percent, the value of gold holdings went up by 31.5 percent.

The RBI's returns on foreign currency assets were a pathetic 1.47 percent in 2011-12 - when global inflation was much worse. By holding dollars, the RBI actually lost money in real terms.

But note: the foreign currency assets include actual net inflows, while the increase in gold reserves relate to the increase in the value of the same amount of gold held by the RBI. Gold gave the RBI far superior returns than US dollars.

If gold is a must in the national portfolio, why must Indian nationals be treated like fools for making the metal a part of their own prudential holdings?

GAP is based on the wrong premise. The only way to get people hooked on gold to invest in other financial assets is to run a tight budget surplus and get inflation down and offer better real interest rates.

But here the finance minister is on the opposite trip: he is trying to force banks to reduce deposit rates. When consumer inflation is at 10 percent and banks are asked to reduce deposit rates well below 9 percent, it is like an open invitation to invest in gold. In financial assets, Indians lose in real terms. Who is the finance ministry trying to fool with GAP?

There is a serious credibility GAP between what the government itself does and what it is asking you to do.

by R Jagannathan

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