The Hindu Business Line : Case for more realistic gold policy

Gold consumption in India is increasing as, amid political and economic uncertainty, the yellow metal continues to be a safeguard against currency fluctuations and will have a significant role to play in monetary controls, both internal and external. It is time the RBI and the Ministry of Finance put in efforts to evolve a suitable gold policy for the country to protect investors.

The recent gyrations of the dollar have looked to me more like a gold standard on the booze than the ideal managed currency which I hope for.

— Sir John Maynard Keynes (1933)

THE changes happening in the currency exchange market are bewildering. There was a time when the American dollar was considered the big bully in the international currency market, forcing developing countries to devalue their currencies to safeguard their export markets.

In the lastfour years, the situation has been reversed. The appreciating Indian rupee is a cause of concern to export houses, especially in the software sector. Till 2000, Indian exporters were enjoying the benefit of one-way depreciation and were quoting cash rates for export. All this has changed.

The appreciation of the rupee means sizeable losses to exporters who have not hedged against currency risk. According to one estimate, the American Current Account Deficit is running at about $618 billion, (about 5.5 per cent of its GDP) . It absorbs about two-thirdsof the current account surplus of other countries.

The savings rate in the US is low. The current account deficit is, therefore, going out of control in the US and the dollar is bound to depreciate further. The budget deficit is also spiralling in the US.The emergence and strengthening of the euro has deepened the crisis in foreign exchange management. The euro-dollar market has been evolving since the 1950s, when the demand for dollars to finance international trade and investment coincided with the greater supply of dollars. The European Currency Unit (ECU) was created in 1979 to act as the reserve asset and accounting unit of the European Monetary System.

The value of the ECU is calculated as a weighted average of specified amounts of European Community (EC) currencies; its value is reviewed periodically as currencies change in importance and the membership of the EC expands. It also acts as the unit of account for all EC transactions.

Private transactions using the ECU as the denomination for borrowing and lending have proved popular. The European community was also moving towards a European Monetary System to enable participating countries to maintain the value of their currencies and provide stable exchange rates — a goal that the Euro seems to have achieved.

This means that the Indian exporter and the Reserve Bank of India need to keep a constant watch on the movement of multiple currencies . It is necessary to monitor the sensitivity of the earnings-exchange rate in order to reduce the loss from currency risk.

Even the euro is reeling under the pressure of the EU-25 expansion. Commodity currencies such those of Australia and New Zealand have reached the upper end of their cyclical upswings.

Gold as a hedge

In a world of a steeply depreciating dollar and an unstable Euro, the only stable alternative left for countries like India to manage currency risk is to use gold as hedge and reserve. Alex Wallenwein, Economist and Author of The Euro Vs Dollar Currency War Monitor, says that in times of crisis, governments would negotiate (just as they did in 1945) to fix an exchange rate system based on gold.

This is because every dollar sold will increase the price of gold and more dollars will be required to buy more gold. The collapse of the dollar will make countries move towards accumulating gold. It is for this reason that Central banks in the developed countries have a higher percentage of gold in their reserves when compared with Asian economies (Table 1).

India is known to have the largest share of gold in the world (Table 2), yet the Reserve Bank's holding of gold is low. Three years ago, the RBI had planned to permit banks to issue `Paper Gold' to be traded like shares. The concept has worked in the West but has not taken off in India. India, with a 700-tonne market, has good potential for gold futures trading. It has been estimated that in April 2005 alone there was an average daily trading volume of 4 tonnes of gold, valued at around Rs 250 crore.

Global gold consumption is on the increase, at 26 per cent in volume and 32 per cent in dollar terms for the quarter ending March 2005, when compared to the previous year. The increase is attributedto political and economic uncertainty, according to the World Gold Council.

Gold units

An announcement was made by the Finance Minister in Para 91 of his Budget speech of 2005-06:

"Ten years ago we embarked on the process of ensuring that gold inflows are through the official channels alone. I believe that we are now in a position to introduce `gold units' and create a market for such units. I propose to ask SEBI to permit, in consultation with the RBI, mutual funds to introduce Gold Exchange Traded Funds (GETFs) with gold as the underlying asset, in order to enable any household to buy and sell gold in units for a little as Rs 100. Such units could be traded in the same manner as units of mutual funds".

Hundred days have passed since this announcement and no action has been taken towards its implementation . Gold continues to be asafe optionagainst currency fluctuations and will have a significant role to play in monetary controls, both internal and external.

A die-hard monetarist, Allen Greenspan observed: "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation... This is the shabby secret of the welfare states' tirade against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights".

Both the RBI and the Ministry of Finance should help evolve a suitable gold policy for the country to protect investors. There should also be a proper gold reserve system to hedge against currency fluctuations in the global market.

(The author is a former Chief Commissioner of Income-Tax.)

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