Gold Rush

In most of the countries of Asia and Middle East, millions of people buy gold regularly. Gold is considered to be the best protection against political and economic upheavals. This is because of the prime fact that, even today, gold is one of the most liquid and widely accepted forms of exchange, quite simply the most efficient store of value they possess.

Millions of Indian households regularly buy gold. The main reasons are twofold. One is to marry off their daughters with gold jewellery and second is the protection during the times of distress.

Gold’s Share in India’s Imports:

Gold’s share in total import bill of the country has gone up from 8.1 per cent in 2001-02 to around 12% per cent in 2012-13. The percentage share of gold and silver combined has risen from the 3rd most imported commodity in 2000-01 to the 2nd most imported commodity in 2012-13 behind only crude oil.

As per a consumer demand report by the World Gold Council the consumer demand figures in selected countries suggests that India accounts for nearly one-third of the total world demand for gold. Indian consumer demand for gold is 37.6 per cent more than that of China.

Policy Towards Gold Import

Prior to liberalization, India’s Gold Policy had major objectives as follows:

• Discourage people from purchasing Gold
• Reducing domestic demand
• Regulating supply of gold
• Curbing smuggling and black income
• Conserving foreign exchange.

To achieve these objectives, the bullion imports and exports were banned under the Foreign Exchange Regulation Act, 1947. The proportional reserve system was replaced by the minimum reserve system, for purposes of note issue. Then, to mobilize the vast Gold Reserves in the country, a 15 year Gold Bond with 6.5% interest rate was issued as back as in 1962. These bonds were issued in exchange for gold, gold coin, and gold ornaments. In 1962 when India was struggling against the aggression of China, forward trading in Gold was banned. In 1963, the diversion of savings into the bullion market was sought to be controlled by the promulgation of the Gold Control Rules. The Rules prohibited manufacturing of gold ornaments of more than 14 carat purity. Individual gold holdings had to be declared. In July 1963, refineries were prohibited from manufacturing gold of more than 14 carat purity. By 1964, the full Government control over internal trade and distribution of gold had been established in India. In 1965 another 15 year 7% Gold Bond was issued. At that time, opportunity was given to the holders of accounted money to convert them into these Bonds.

The Gold Control Rules were amended in 1966 when they allowed the manufacture of ornaments of more than 14 carat purity. The amendments also placed ceilings on individual holdings and extended control over refineries and dealers. In 1968, the Gold (Control) Act 1968, was passed which gave a legal backing to the measures taken by the government via the Gold Control Rules.

The result of such strict policy and legislative measures was that Gold Smuggling flourished. In 1978-79, the government strongly disapproved the smuggling operations and started Gold auctions. One of the agencies to auction Gold was RBI, but there were few takers of the auctioned gold, so the auctions were stopped very soon.

During the early nineties, Indian Economy faced severe Balance of Payments crisis. This led to a shift in the approach of the Gold policy. Gold market was gradually liberalized and efforts began to integrate the Gold markets into Financial Markets. In 1990, Gold Control Act was repealed and in 1993, provisions of FERA 1973 were repealed. During those times, some relevant observations came up in the report of Tarapore committee on Capital Account Convertibility (CCA). This committee observed that the Gold related issued are linked to the Capital Account Convertibility. It recommended a liberalized policy regime for Gold, transparent and well regulated Gold Market and introduction of Forward trading and Gold derivatives in India. In 1999 RBI allowed commercial banks to accept interest bearing gold term deposits against gold.

Demand for & Supply of Gold: Important Observations:

• Demand for gold has an autonomous character. Supply follows demand. The demand is considerably price in-elastic, however, shows elasticity in rural areas.
  
• Historically, price difference between international and domestic price of Gold has created the import demand. This led to illegal imports prior to 1990s.
  
• However a look at the gold trade figures since the onset of liberalisation in 1990 shows that, while the price differential narrowed from a high of around 53.1% in 1991 to about 5%-10% currently which reflects customs duty, transportation cost, local cess, etc), the import volumes rose unabated.
  
• Demand is also caused by the need to stash away the unaccounted wealth.
  
• The inflation crisis of the last six years, coupled with a persistent lack of financial inclusion alongside a decade of high GDP growth, has given an upsurge in demand for gold.
  
• One part of the story clearly lies in India’s failure in financial reforms. By failing to transform the financial system, we have failed to achieve financial inclusion. A very large share of households in India are unable to save money in banks as either there are no accessible bank branches, or the amounts the households save are too meagre. Other financial instruments such as equities are out of question.
  

Recent Hike in import duty

The government has recently raised the import duty on gold and platinum by 2 per cent to 6 per cent, the second such increase in less than one year. The move is aimed at discouraging gold buying and controlling the ballooning fiscal deficit. The objective was to curb the widening current account deficit. India’s current account deficit reached an all-time high of 5.4 per cent of gross domestic product in the July-September quarter. A current account deficit is not always bad for a developing country, but in case of India the deficit has reached unmanageable proportions. The widening current account deficit has increased India’s need for foreign capital inflows and evoked memories of the 1991 balance of payments crisis, when the Reserve Bank of India (RBI) sent 47 tonnes of gold to Europe as collateral for a loan to avert a sovereign default. Alarmed by the mounting current account deficit, driven by large scale gold imports, the government was forced to raise the import duty on gold.

Substitution of Gold Purchases:

The experts are of the view, that the hike in duty may not work, giving several reasons that:

• Gold demand is inelastic largely
  
• Increase in the import duty could spur smuggling across porous borders.
  
• There are no attractive alternatives in the financial markets.
  
• India still lacks financial inclusion.
  

The viability of the Financial Alternatives

Some more often discussed tools to divert the gold investments into financial instruments are as follows:

• Financial institutions will sell products that are proxy for gold
  
• Households will be encouraged to deposit family jewels in special fixed deposit schemes that will earn a small interest and pay back the gold in the form of bars and coins some years later
  
• Pension schemes will be launched where a person receives a fixed amount for the rest of his life against gold she surrenders to the bank.
  

The sole objective of these tools to to put existing gold to the best use and discourage citizens from buying more gold. However, it is not certain that any of them would work because:

• In India, the “fixed” pensions are being phased out there will not be many fund managers who would be willing to offer a fixed pension
  
• The Gold backed financial products would need the financial institution to buy Gold as underlying. This implies that the individual gold buying will be replaced with gold purchases by banks. These institutions and exchange traded gold funds may lend the gold they buy to jewellers. Result is that it will not have substantial effect on the Gold imports.
  
• In India, people are reluctant to melt down their jewellery.
  

It is easier for a rural person to buy gold jewellery than opening a deposit account in a bank, due to various documentary formalities that are required. In the competitive environment, banks have to contend with the transaction cost associated with servicing retail deposits and credit accounts. (CGS-14 Target 2013 Prelims Content)