The Rs 55,80,000 crore question

Nilesh Shah Posted: Nov 20, 2012 at 0222 hrs
Government should consider financial schemes to replace gold holdings

Blame it on tradition or on its popularity as a hedge against inflation, but Indians are diverting a large portion of their savings to gold. This has reduced their financial resources for investment and added to the country’s problems, including twin deficit woes. It is also a major reason for high interest rates, low growth rate and high inflation.

India’s entire current account deficit of $57 billion (net of software exports and remittances) in the fiscal year 2012 would have turned positive if we had not imported gold worth $62 billion. The saga of gold imports has been continuing for many decades, with imports of gold, silver and precious stones making up the entire current account deficit. This means India is exporting its capital to countries producing gold, silver and precious stones. In return, we get a weak rupee, lower credit rating, higher dependence on foreign inflows, lower investments, lower GDP growth.

India’s obsession with the yellow metal has made us the largest holder of gold in the world. According to an official estimate, we hold about 18,000 tonnes of gold, importing more than 700-800 tonnes every year. The actual amount we hold is likely to be much more as gold stocked in temple vaults and private lockers is probably not accounted for. At today’s market price, the value of this gold is Rs 55,80,000 crore, which is almost 85 per cent of India’s stock market capitalisation, or just a little less than our banking sector deposits.

That said, an investor can raise several objections against slapping curbs on gold — he should have the freedom to invest where he likes, gold has given pretty good returns in the last decade, it is an ideal hedge against country risk and inflation, it is freely available across India and probably has a better distribution network than even the banking system. It is a fact that jewellery stores outnumber bank branches, insurance agents and mutual fund agents. What’s more, gold can be bought with cash and used as security for short-term finance. Such factors have increased the lure of gold for consumers and investors — but at great cost to the country.

In 1933, the then US president, Franklin Roosevelt, issued an order asking citizens to return gold held by them in a bid to tide over a crisis. Offenders were handed out a fine of $10,000 or 10 years in jail. The rest is history. The US fed became the largest holder of gold in the world. But Indian leaders may not be able to do a Roosevelt. Disturbed by the skewed rise in the prominence of gold, regulators have been trying to shift the allocation of domestic savings from gold to financial products. Measures like the Gold Control Act, the gold deposit scheme, gold exchange traded funds, the trading of gold derivatives on exchanges, tax sops for insurance and mutual funds and the gold import duty have not slowed down India’s huge appetite for the yellow metal. On the contrary, it’s increasing.

There could be a way out. A scheme with suitable features can slow down gold imports and ensure that domestic savings are available for investments. The government should consider setting up a Gold Corporation of India (GCI) to market the national gold plus scheme (NGPS), a scheme that should offer returns equivalent to those accrued from actually holding gold. It should provide redemption in physical gold, if required by investors, through tie-ups with banks and jewellers. The scheme would use financial derivatives to give Indians gold returns but save hard-earned dollars for investment within the country. The catch is that the NGPS should match physical gold in terms of pre-tax returns and outperform it in terms of post-tax returns, liquidity, safety, convenience, principal protection and quality assurance. It should be sold through direct as well as alternate channels — through banks, post offices, government offices, jewellers, financial distributors and brokers with appropriate incentives. Special incentives on income tax, wealth tax and gift tax should be given to make the NGPS lucrative.

The operational nitty-gritty is not difficult. The GCI will have to pay gold-linked returns to investors and buy “at the money” (a situation where an option’s strike price is identical to the price of the underlying security) American call options on gold in global markets. Buying gold options in the offshore market gives the benefit of historically low interest rates. The GCI can invest residual money in gilts or PSU bonds to provide much-needed alternative funding sources for the government.

The positive impact will be that lower government borrowing will release banking sector liquidity for private sector investments, which will support growth. The benefits of lower gold imports will be reflected in a stronger rupee, lower interest rates, higher liquidity, lower trade and fiscal deficits, and higher credit ratings, among other things. The NGPS can’t become a success overnight. But if executed well, it can rewrite India’s growth story.

The author is director, Axis Direct. Views are personal

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