Reining in gold imports

In an attempt to reduce gold imports, the Indian government has proposed three new schemes – gold monetisation, sovereign gold bonds, and domestic production of branded gold coins. In this article, Prof. Gurbachan Singh diagnoses the market failure and government failure involved in large gold imports, and provides a broad perspective on the issue. He examines the potential effectiveness of the schemes, and suggests policy alternatives.

India is among the largest importers of gold. India’s import of gold has increased from 471 tonnes in 2000-01 to 1,017 tonnes in 2012-13 (Rangarajan 2013). The Government of India (GOI) has once again taken the view that these need to be reduced. It is considering launching three schemes: Gold Monetization Scheme (GMS), a scheme to issue Sovereign Gold Bonds (SGB), and a scheme to mint high-quality branded gold coins domestically (GOI, 2015a, 2015b).

In this article, I diagnose the nature of the market failure and analyse the role of the government in the gold market. I analyse the fundamental reasons for large gold demand. This is important for finding a realistic and lasting solution to the problem of large gold imports. Moreover, I argue that, in this context, there is a need to go beyond notions of black money and white money; there can be grey money as well (more on this later).

Gold Monetization Scheme

Under this proposed scheme, anybody can deposit gold with banks, and the latter can, in turn, lend the gold to jewellers or even sell it to them. The jewellers can accordingly reduce their imports of gold, and so the country’s foreign exchange can be used for other productive purposes. The incentive for people to switch from possessing physical gold to bank deposit denominated in gold is that they can earn interest on the deposit. It is proposed that withdrawals can be made after one year, although, as in the case of fixed deposits, breaking the lock-in period will be allowed; however, the penalty for doing so has not yet been specified. The interest rate is to be decided by banks, but is likely to be much lower than that of usual bank deposits.

Tradition and customs play an important role in households’ demand for gold. Also, many people in India find banks intimidating and their returns unattractive, non-bank finance companies (NBFCs) somewhat risky, the financial markets risky and confusing, and the real estate market out of reach in the context of routine and regular savings. So, there is a tendency to use gold as a store of value. It is also important that buying gold is simple; there is hardly any paperwork and it is easy to keep away from intended or unintended harassment by tax authorities. Of course, it is also easy to evade taxes for the richer section. This is consistent with some survey data on gold demand in India (Sharma 2014).

Given all this, can modern gold deposits with paperwork in the financial sector replace physical gold holding? Unfortunately, the answer appears to be no. If people felt comfortable with ‘modernity’, the financial sector, and paperwork, then many people would not be holding gold anyway – at least not on the scale that they do!¹

There is another aspect which may be controversial. Many people inherit gold from their parents who may not have disclosed their gold holding to the tax department for a variety of reasons that are not limited to tax evasion. Given that it had not been disclosed earlier, it can become difficult for those who inherit to do so subsequently. This story of non-disclosure can go on and on. In this context, it may help if GMS can be used and no questions are asked. In such cases, it may not be appropriate to use neat notions of black and white money. It may be grey money.

It is true that such a provision can be misused. It can become a way for money laundering – at least for those with ‘small’ amounts of black money. If this happens, then it may appear that GMS has succeeded but there is hardly any actual genuine monetisation of gold.

There is a push factor from the banking system that leads to an increase in demand for gold. For this, there is a need to reduce financial repression in banks and to reduce barriers to entry which make banks uncompetitive (the many public sector banks are in many ways effectively a monolith). This could reduce, if not obviate, the need for complicated and confusing GMS.

Sovereign Gold Bonds

According to some estimates, investment demand for gold as a share of total demand increased from 24% in 2009 to 36% in 2012 (Rangarajan 2013). Pure investment demand is similar to the demand for stocks and bonds in financial markets. It takes the form of gold coins, gold bricks, and 100% gold-backed exchange traded funds (ETFs), which are paper instruments.

The SGB is a bond in the usual sense with the only change that it is denominated in gold, not rupees. It can, however, be purchased and redeemed in rupees (Cowen and Koszner 1994). The investor will get possible appreciation as in the case of investment in physical gold – plus an extra return in the form of interest on bond (possibly 1%). Besides, there is also saving of various costs involved in holding physical gold. All this implies that from the viewpoint of the investor, it makes sense to shift to SGB – at least in cases where the initial investment is in ETFs, a paper instrument in which case the involvement of black money or grey money is likely to be minimal.

The scheme of SGB, however, raises an important question. Why have the banks, NBFCs or even ordinary firms not issued gold-denominated bonds so far? There can be two reasons.

The legal-regulatory framework within which gold-denominated bonds can be issued does not exist.
The price of gold is very volatile (Barro and Misra, forthcoming). So there is a risk for the issuer; the liability is denominated in terms of gold whereas the investment is typically in terms of rupees (unless the issuer of bonds is a jeweller).

The policy implication differs in each of the two cases. In the first case, there is no market failure; it is a failure of the government to provide an appropriate legal-regulatory framework, which rules out a possible market for gold-denominated bonds. Hence, the role of the GOI is to simply enable such a market to develop by changing the legal-regulatory framework of financial markets to incorporate gold-denominated bonds; the GOI itself need not issue the so-called SGBs². So instead of SGBs by the public sector, we can have gold bonds (GBs) by the private sector (banks/ NBFCs/ private firms). In the second case, the scheme to issue instruments like SGBs is not called for as the risk is high – unless a special case can be made.

Consider the case that (a) the risk-taking capacity is greater for the GOI than for the private sector, or (b) the social benefit of the scheme is greater than the private benefit of issuing SGB-like instruments. In case (a), there is indeed a rationale for the GOI to issue SGBs. In case (b), the GOI can issue SGBs, or incentivise the private sector to issue GBs through a Pigouvian subsidy³, provided a reasonably honest administrative machinery exists. If it does not, then in the long run, there is a case for improvement in the administrative machinery (which is required anyway).

The above analysis has focused on ways for a possible shift from physical gold to SGBs or GBs. However, it is important to question the basic rationale for a pure investment in gold or gold-denominated instruments as the average real and risk-adjusted return on pure investment in gold is very low (Barro and Misra, forthcoming). Why then do investors in financial markets use gold on a large scale?

Behavioural finance can throw light in this context as there can be irrational investors. The policy implication that follows is very different now. There is a need to enable the market for meaningful financial advice at reasonable cost that is paid for by the investor, and to make such advice mandatory for investors who are identified as less well-informed in finance⁴. This proposed practice is somewhat similar to what actually happens in the field of medicine (Singh 2009)⁵.

Scheme for ‘Make in India’ gold coins

There is a large demand in India for imported, branded gold coins. Under the third proposed scheme, it appears that GOI plans to make its own gold coin, with the Ashoka Chakra minted on it. However, the scheme raises an important question. What is preventing reputed jewellery firms in the private sector from producing reliable and branded gold coins at present?

India is ranked 142nd in the Ease of Doing Business Index that covers 189 countries (World Bank, 2014). It is possible that due to the general problem of lack of ease of doing business, there are also difficulties in the business of producing the required gold coins in India. If so, the long-term solution is for policymakers to remove various hurdles in doing business. This could pave the way for indigenously produced high-quality gold coins if India indeed has a comparative advantage.

Setting an example

As on 8 May 2015, the Reserve Bank of India (RBI) held gold reserves worth Rs. 122,930 crores (US$19.34 bn approx.) (RBI, 2015) - a large amount in relation to the value of gold that the GOI is expecting to mobilise under GMS. (A senior GOI official mentioned a figure of 50-100 tonnes of gold at a seminar at FICCI; the RBI holds 557.7 tonnes of gold!) Suppose the RBI reduces its own gold holdings to some extent, if not entirely (and there are indeed other good reasons for it do so), then public authorities have greater moral authority to convey the idea of reducing gold holdings to the public in India.

Notes:

I thank Ashok Kotwal for drawing my attention to this point.
The use of the word “sovereign” in the context of the scheme implies that the instrument can only be issued by the government; this is unwarranted.
When a market activity generates positive externalities (public benefits), those who receive the benefits do not pay for them and hence, the market may under-supply the product. In such a case, a Pigouvian subsidy can be created to make the users pay for the extra benefit and spur more production.
The Securities and Exchange Board of India (SEBI) can identify ‘money doctors’ (just as the Medical Council of India gives licenses to medical doctors); all others then become less informed in finance (just as in medicine, all except medical doctors are viewed as less informed or ignorant in the field of medicine).
In the field of medicine, by law, a patient cannot buy medicines on his own. He first needs to consult a licensed medical doctor who examines the patient and prescribes medicines. Such a law exists even in capitalist economies which emphasise freedom of choice. In India too such a law exists though it is not implemented seriously in several places.