What will be the Kahaani of the Union Budget this year? With the entire nation in its annual speculation mode, everyone is wondering will Pranab Mukherjee deliver one that makes sense to the masses or one that appears to be just as useful as a fifth wheel.
 
Amidst this electric atmosphere that’s causing markets to ride a rollercoaster of its own, where is gold heading? Traders, suppliers, end consumers all present one common query to Mr. Mukherjee, “Will the Budget do anything for the surging import bill by implementing measures that discourage Gold consumption?”
 
Import Duties Wasted by Hoarding
There is a widespread view that gold imports are causing a strain on the country’s balance of payments. Gold imports have also been credited by the Prime Minister’s Economic Advisory Council (PMEAC) as one of the reasons behind India’s high Current Account Deficit (CAD) levels, even higher than levels during the Balance of Payments (BoP) crisis in 1991. The PMEAC is further expecting India’s CAD to climb up to 3.6% of GDP (CAD levels were at 3% during the ‘91 crisis). 
 
The RBI has expressed a similar concern about the increasing CAD levels in its recent macroeconomic report.
 
Since the demand for Gold (and Oil) is largely inelastic in nature, the rising cost of importing such commodities does impact the overall deficit levels.
 
An equal concern is that the billions spent towards importing gold in 2010-11 was largely unproductive because the imported gold was used for either for making jewellery, kept as gold bars and coins or would be locked up in safes. What an absolute waste! On the contrary if this hoarded gold were channeled towards investment avenues that would yield productive returns, it would add some much needed leverage to the growth of the economy.
 
This hoarding has actually helped investors when it mattered the most recently. Be it the crisis of 2008 or the stock market turmoil of last year. And what would investors do given the increasing uncertainty and negative real interest rate prevailing – just resort to this time tested element.
 
Gold Imports are actually Re-exported
The proof of the pudding lies in the eating. Take a look at some of these facts to understand the magnitude of the situation at hand.
 
Imports not only to blame: The imports on a year-on-year basis have remained fairly constant –  969 tonnes this year as compared to 958 tonnes a year before.  In reality, rising prices partly on account of depreciation of the rupee have added to the burdening deficit problem.
32% of India’s gold imports are actually re-exported: In recent years, India has evolved into a significant exporter of gold jewellery.  The demand for gold has increased beyond that required for domestic consumption (for jewellery and investment).
Gold imports up 40.23%: During the April-December period of the current fiscal, gold imports were valued at $28.16 billion. Gold jewellery exports were up 41.59% from $8.56 billion in the corresponding period of the last fiscal. The growth in value of gold import and export of jewellery roughly match.
Over the past three years, India’s gold jewellery exports have grown by a cumulative 88% to reach a substantial Rs 65,000 crore in 2010-11. Gold imports grew by 64% during the same period.
 
In 2010-11, Net Gold imports were about Rs 1,00,000 crore, comprising 5.7% of total imports and about a third of the current account deficit. Net gold imports (as opposed to simply gold imports) must be considered while assessing the impact of importing gold on the balance of payments.
Jewellery manufacturing is a skill intensive industry and India holds its own as a specialized manufacturer and exporter of world-class designs.  With the right kind of stimulus, this industry could emerge as an even bigger hub of jewellery manufacturing leading to increase in exports and employment. In the light of this, banning gold imports or increasing customs duties threaten to re-introduce loopholes like smuggling and would also prove to be counter-productive for the economy as a whole. 
 
Mistakes of the Past 
Mainstream economists and policymakers have always had a rather hostile approach towards gold. This approach was fueled by a perception that gold barely added to productive capacity, and was rather a reminder of the cultural and economic backwardness of the past.
 
From an economic standpoint, the process of gold accumulation by the private sector in India was seen as adding to the demand-supply imbalance of the foreign exchange market caused by the diversion of precious foreign exchange resources towards importing gold.  Excess demand for gold was considered as one of the main reasons for the so-called external constraint, which supposedly hindered development and technological progress.
 
Bending towards this earlier chain of thought, many are calling on the government to take measures to stem the rising demand for gold. Earlier this year, an increase in customs duty was brought in to check surging imports. There are suggestions to further increase tariffs to discourage imports and some extremists recommend a complete ban/restriction on gold imports.
 
Before embarking on such ill conceived notions, one should remember that historically, while the authorities have pursued policies to de-emphasize gold and to suppress demand for gold, the balance sheet of households showed more gold on the asset side.
 
In the past, there have been various restrictive policies like the ban on gold imports, the Gold Control Act, which prohibited the ownership of gold partly /completely, ban on forward trading, etc, but all in vain. Even the gold bond schemes met with little success each time they were introduced.
 
The Committee on Capital Account Convertibility (CCAC) put forward some precise and action-oriented recommendations on the liberalisation of the gold market. The CCAC stressed that it was essential to liberalise the policy on gold while simultaneously taking steps to develop a transparent and well-regulated market in gold, which would be integrated with other financial markets. In its view, the main ingredients of the change in the policy on gold should be:
Removal of restrictions on import and exports of gold,
Development of gold-related financial instruments,
Development of markets for physical and financial gold,
Encouragement of banks and non-banks to participate in the gold market.
 
The CCAC suggested mobilization of private sector gold for external adjustment and to remove external constraints.
 
There have been half-hearted attempts towards development of the gold market. Removal of tariffs and freeing the market are the prerequisites for this development. There were some efforts made in this direction and now it seems that we’re at a U-turn scenario.
 
Even considering that the recent change in customs duty apart from doubling the duty but making it “ad valorem”, is leading to various market discrepancies. The customs duty is paid at the time of imports whereas the consumption can happen at a later date. This leads to a discrepancy in the prevailing prices and the import price as the amount of duty prevailing currently would have undergone a change due to change in price.  Therefore, to avoid such market discrepancies, the government should adopt a fixed rate structure rather than an ad valorem rate.
 
Will the budget fall prey to all the noise?
 
We don’t know. Not as yet atleast.
 
But, restrictive steps such as those mentioned above could probably hurt the economy in the long run, and are not in line with the optimism of the India growth story.
 
According to recent reports, the All India Gems & Jewellery Trade Federation (GJF) was quoted as demanding the restoration of specified duty to support the domestic industry at the rate of Rs 40 per gram of gold.  We believe that they refer to the jewellery industry. They have also suggested a 0.2% on every transaction of exchange traded gold fund (ETF) be imposed, as most of the ballooning imports of the yellow metal are going for the purpose.
 
Let’s get the facts straight. India’s consumption has been above 900 tonnes for the last two years whereas the Gold ETF industry which has been into existence for nearly 5 years now has a total holding just above 30 tonnes. The gold ETF industry has just started but the other stakeholders seem to be worried as the market is showing an inclination to move towards efficiency.
 
One needs to remember that the government is looking at channelizing the physical gold savings into the mainstream. However, an easier way to do so would be if these holdings were not in physical but rather in demat form. This would enable easy transfer and could also settle transactions by payment of gold, thereby getting gold into circulation. This is best done though instruments like Gold ETFs which the government should be looking to encourage.  Added incentives and lowered taxation could encourage investments through this route.
 
It would be ideal if jewellers would consider gold ETFs as a complementary product. They should participate and aid in the development of the market. The starting point could be acting as market makers for gold ETFs and extending to sell jewelry in lieu of gold ETF units – that would be perfect, but then again, it’s just wishful thinking (for now).
 
Making some sense…
The government and the Reserve Bank of India (RBI) need to focus intensely on how to channel atleast a part of the huge savings in gold into more productive use rather than look for ways that aim at discouraging consumption. Gold ETFS have been a stepping stone towards bringing physical gold into mainstream investments through demat form. The RBI could also look at permitting a deeper paper gold market with a wider array of instruments to convenience institutional and other investors.
 
But we will never know till Mr.Mukherjee’s speech on Friday, March 16, 2012.
 
A hopeful nation awaits with bated breath.
 
Mr. Chirag Mehta, Fund Manager (Commodities), Quantum Asset Management Company Private Limited