Gold - A Symptom or the Root of the Problem?

While India`s total imports and transfers are higher than its total exports and transfers, the Current Account Deficit (CAD) was at 30-year record high of 4.2 percent of the GDP in 2011-12. High levels of CAD lead to the deterioration in the currency value, which eventually bruised the economy. High levels of CAD forced government to discourage what they think are not necessary and hence in a bid to do so they jacked up the import levy on gold. Policy makers point out that one of the primary drivers of the CAD has been the growth of almost 50 per cent in imports of gold and other precious metals during last year. Policymakers have blamed India`s addiction to gold contributing to the problem on the external account and have taken series of steps involving duty increases to curb imports and consumption. Are gold imports to be blamed and labeled as "unnecessary"? Is it a burden on the country?

At least, the data for the last few years suggests that gold has been a reliable asset to depend on when macro-economic conditions globally & domestically were not favorable for investors.

There are a few misconceptions that need to be cleared and few points that need to be reiterated.

The relentless pressure on the rupee is a constant reminder of the fact that we are running an unsustainable Current Account Deficit. This has made us hostage to the ebb and flow of global risk appetite.

We need to accept the fact that CAD is India`s structural problem, not merely a cyclical uptick driven by strong domestic growth. The data should make this abundantly clear. In 2011-12 we posted the lowest GDP growth rate of 6.5% in the last nine years. Yet, we simultaneously recorded the highest CAD-to-GDP ratio (4.2%) in post-independence history. In short, the CAD is not the result of high imports to fuel high growth - it is instead a manifestation of unsustainable structural imbalances.

Going further, a simple analysis of the inter-linkages between savings, investments and the balance of payments` CAD shows that the predominant component of savings is India`s domestic savings. The India Growth Story of the 2000s was fuelled essentially by domestic and not foreign capital. There is disproportionate policy focus on foreign capital inflows, rather than on domestic savings. While the objective at the present time is to stimulate domestic savings, there is a great divide between what should be done and what is being done.

In India, growth is relatively high, inflation is raging and interest rates are not high enough to offset inflationary pressures. In a situation where the stock market is extremely risky and inflation has hits savers, it is no surprise that intelligent savers are flocking to gold, thereby increasing gold prices.

The Chinese government is explicitly encouraging individuals to allocate their assets to gold. But, the Indian government is finding ways to discourage it. If the current negative interest rates continue it would not be surprising if savers flee from bank deposits. As far as the question of inflation measurement goes, the authorities continue to swear by the Wholesale Price Index (WPI), that doesn`t include the cost of services, which does not reflect consumer prices (end-user price). The world over, the Consumer Price Index (CPI) is used as an indicator of inflation. CPI is more indicative of inflation that the common man faces. The CPI is, in general, a better indicator of inflation than a wholesale price index.

In India, governments, from time to time, have toyed with the idea of introducing inflation-indexed bonds, but on each occasion the authorities have backed off. The real reason for rejecting the indexation idea is that governments do not trust their ability to control inflation. If the government is serious about the welfare of the disadvantaged segments of society and the elderly, it should be willing to float inflation indexed bonds at least for senior citizens. The scheme should offer a real rate of interest of only 2 per cent per annum; if the CPI at the end of the year shows an increase of 10 per cent, the saver should be paid a nominal rate of interest of 12 per cent for that year.

The elderly need to be protected from inflation through instruments that promise a real rate of return of, say, 2 per cent over the rise in consumer prices. This would also do well to set inflation expectation low. The move will, in fact, signal the government`s intent to contain inflation. Instead of being apprehensive about floating an inflation-indexed bond when the CPI inflation rate is high, as at present, the government should launch the scheme at precisely such a time. It would act as a signal that the government is determined to bring down the inflation rate to very low levels. A determined move by the government can alter inflationary expectations.

The fiscal deficit is out of alignment with the medium-term objective of fiscal consolidation. The gross fiscal deficit (GFD) for 2012-13 is estimated at 5.1 per cent of GDP as against 5.9 per cent in the previous year, but there could be serious slippages in 2012-13. Rating agencies have already issued warnings of downgrades. In short, the macroeconomic situation is uncertain and the political economy instability reflects in concerns about governance. Despite strong assurances and determined body language that hard policy options would be taken, political economy requirements do not give credence to such intentions. Government needs to bring its house in order to first create domestic conditions that enable citizens to take decisions to participate in the India`s growth story.

Gold purchases have increasingly become a key element of the portfolio choice of households in an environment of economic upheaval and high macroeconomic uncertainty.

The idea should be to develop conditions to divert people from gold. The idea of government forcing individuals to choose investment sounds like "Too much Government". If an individual wants to save his money in the form of gold, he should have the opportunity to do so. Government should not tax gold, silver or any of the precious metals. It just is arbitrary and against the rights of the citizens to choose their own investments. When the government cannot control the valuation of rupee which seems to go southwards every year with respect to almost all of the acceptable currencies, why should a citizen not hold gold or dollars or Euros instead of rupee or rupee based investments.

The government`s efforts to curb gold imports may have resulted in the collateral damage many feared - a resurgence of smuggling. There`s no official data but indications are abound. Cases involving gold seizures at airports have risen 10-fold in recent months, confirming the worst fears of critics that the strategy to raise duties to control imports of the precious metal would spawn a revival in its smuggling.

Between April and June this year, authorities impounded gold worth Rs 942 crore in some 200 cases of smuggling, up 272% on Rs 243 crore in the year-earlier period that involved 20 cases, as reported by the economic times article citing finance ministry data. During the same period, India`s official gold imports fell 56% to 131 tonnes, data from the World Gold Council showed, reflecting the impact of higher duties and rising prices. Has consumption really fallen or illegal means make up for the shortfall?"What should investors do?

Gold is not the problem but is really a symptom. In other words, soaring gold prices is an issue but it is not a root cause for the country`s woes. Trends in gold consumption and prices tells us too many things about the macroeconomic environment prevailing. Increased gold consumption is a signal of imprudent policies prevailing in a country driving people towards gold consumption.

Gold prices have continued to increase. There was an acceptance amongst the masses that interest rates have peaked and thereby were seeking to lock in deposit rates when they are high. This led to some diversion of flows to deposit. With some cut in deposit rates announced, they might not be more attractive on a real basis. The negative interest rate scenario is driving flows in gold. With the official numbers signaling a slow down, it needs to be assessed. And, with the recent revival in gold consumption seen, will the government look at ways to reduce intake or look at working towards an environment that automatically reduces our consumption; in other words peoples reliance on gold

Investors should consciously allocate a pre-determined percentage to gold to insulate themselves from the impact of high inflation often driving policy rates into a negative territory on a real basis. Gold works as an effective portfolio diversification tool and thereby adds more value.

Data Source: Bloomberg, World Gold Council