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Indians' love for gold puts govt in a spot

Publication Date : 24-04-2012

 

From the way Indian policymakers are reacting to the increasingly important role that gold is beginning to play in the economy, it appears that they are starting to view 'the barbaric metal' - as economist John Maynard Keynes once described it - as a big threat to stability.

They could be right.

Recently, the central bank in Mumbai asked commercial banks to rein in their exposure to non-banking finance companies that make loans against gold as collateral. It also set up a committee that will study the business of such gold-backed loans and submit a report by July.

The move follows a decision in the government's March 16 budget to double Customs duties on imported yellow metal.

The policymakers' anxiety has two sources. First, rather than being used as capital in small businesses, loans against gold usually end up financing consumption. That's a bad idea because if those loans are not paid off, the lender will seize the collateral.

In Indian families, it's the women who own the gold; in the absence of a social safety net, gold is the one asset that provides a modicum of financial safety to households. Policymakers, therefore, have a reason to worry.

Second, it is not just the existing gold that is getting pawned. New gold is being bought. India's annual gold imports have jumped more than eightfold to US$34 billion over just a decade.

Indians need to pay in dollars to import gold. Those dollars need to come from somewhere. Risk aversion is high globally, so foreigners can't be counted on to keep making investments in Indian stocks and bonds.

But if India is unable to finance the gap between the dollars that are coming in - sent home by overseas Indians and earned by exporters - and the dollars that are going out to pay for imports, the rupee may tank, endangering financial stability. A measure of this gap, known as the current-account deficit, has already reached about 4 per cent of India's gross domestic product.

To the extent that gold imports exacerbate the deficit, they are unwelcome. But how to dissuade people from demanding more gold? Discouragement of imports through legal channels will only force the trade to go underground. The infamous Mumbai dons of the 1960s and 1970s who made their fortunes by smuggling goods into the country would make a return. Unlike in the past, B-grade Bollywood movies will not be the avenue for deployment of smuggling profits. The underworld can potentially reap higher returns by financing the working-capital needs of myriad terrorist and secessionist groups that need to import arms but cannot open letters of credit.

Policymakers must tread lightly. If they do not discourage the use of gold in the economy, they would end up planting the seeds of leveraged overconsumption and financial ruin, especially in the lower- and low-middle income segment. But if they try to choke the supply of new gold into the economy, they would only empower smugglers and gunrunners and worsen the country's internal-security challenge. A nuanced approach is needed.

In the first instance, policymakers must remind themselves that the problem they are dealing with is not entirely local.

Larger forces are at work.

The reason gold is increasingly important in the global economy is because people almost everywhere are beginning to view it as a superior substitute to all that we today know as money.

Earlier, when companies and households demanded loans to set up a new factory or buy an apartment, the machines and the house would be pledged, but it was the expected future cash flow of the debtor - the company's revenue or the householder's wages - that truly gave banks the confidence to create credit. Banks could, in turn, tap the money market for funds by pledging their own holdings of government bonds and bills.

In today's uncertain global economy, the worth of future corporate cash flows and wages is hard to assess. Sovereign debt is under stress, too. Pieces of government bond don't look like great warehouses of value any longer. (As Democrats and Republicans in the United States haggled in July last year about increasing the ceiling on federal debt, CME, which runs the Chicago Mercantile Exchange, imposed higher 'haircut' norms on US Treasury securities, crimping investors' ability to use them as collateral to raise funding.)

Amid the confusion, the gears in the global credit machine are not shifting as smoothly as they used to. That has made room for gold - which has proved to be an excellent store of wealth during turbulent times - to be used as a lubricant. In the past couple of years, it has become possible for investors to post gold as collateral with a counterparty like JPMorgan or a clearing house like ICE Clear Europe to obtain funding.

In India, the government needs to set its fiscal house in order. Only when banks do not have to retain high inventories of government bonds - they are mandated to park 24 per cent of deposits in such securities - will the latter move about more freely in the economy and be used as collateral to generate private credit.

Anything short of meaningful fiscal correction will create room for gold to step into the breach and act as a substitute for money. That must be avoided.

 

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