Managing gold, a policy challenge

The lure of gold in India is an age-old phenomenon. Stringent legal or physical measures to curtail the appetite for gold did not succeed in the 40 years after Independence; they only encouraged smuggled imports at a very high cost.

Ultimately, gold policy was liberalised in the reforms period, starting in the 1990s.

A spate of measures was introduced to wean away households from putting their financial savings into gold, so as to conserve foreign exchange and increase the use of paper-based financial products. These have, however, not led to the ultimate goal of curtailing gold consumption and imports.

In the recent past, measures such as hiking import duty, dissuading banks from dealing in gold, and discouraging non-bank financial companies from extending their gold loan portfolio, have been tried. But if the past experience is to offer any lessons, such efforts will be in vain. The annual import of gold in 2011-12 is reported to have crossed 900 tonnes.

Rising Gold demand

Arguments against high consumption of gold are well known: it is an unproductive asset, it weans away financial savings, and it is a drain on foreign exchange. But there are several qualities of gold that make it an attractive investment option.

Apart from the fact that gold is embedded in the Indian psyche and cultural ethos, it is almost a perfect inflation hedge. During periods of high inflation, as in the recent past, gold demand remains high.

Except that its storage is risk-prone, the ability of gold to insure against any kind of instability and crisis is well established. It can be easily converted into cash, and provides almost instant liquidity. It is also a part of international liquidity and has universal acceptance.

According to a study sponsored by the World Gold Council, the demand for gold since the twin global crises has increased substantially globally.

The trend is likely to continue in the coming few years, partly due to uncertainty and weakness of the US dollar as the reserve currency. Many central banks, including India’s, have augmented their gold reserves.

Policy Shift needed

The policy focus since the period of liberalisation has been on curtailing the physical demand for gold, or by deferring the demand for gold by encouraging varied financial products. While there is nothing wrong in this approach, the problem is that it has not made a visible dent.

Instead, it would be worth trying how far the existing supplies in the country can be diverted to the financial system, so that the unproductive nature of the gold asset is turned into a financially-productive stream. A few of these approaches are considered here.

Augment gold reserves: Gold imports are viewed as a drain on foreign currency. But it is equivalent to foreign currency, since it forms part of international reserves. As part of augmenting its reserves, the Reserve Bank of India can purchase gold from the domestic market to augment its reserves base in the face of dwindling foreign currency reserves.

A suggestion has been made earlier that the central bank can deal in gold as part of its market operations. In a way, augmenting gold reserves will help the central bank sell dollars in the domestic market to preserve the value of the rupee, without losing its reserves base.

Encourage gold deposit schemes: Commercial banks, in particular, State Bank of India, offer gold deposit schemes at low rates of interest. Gold savings deposits and term deposits can be encouraged. Here is a ‘good’ Turkish example. Turkey, like India, is a large consumer of gold.

Gold, handed down through families over generations, is hoarded as savings. But in recent months, commercial banks have entered the fray to mobilise gold deposits, encouraged by the central bank policies, according to a Reuters report.

Such deposits have increased four-fold in the past one year. The country’s commercial banks are pouring their technical expertise and marketing resources into offering their customers gold deposit accounts. Customers give their gold to a bank and can make withdrawals from their accounts in gold bars or the lira currency; the accounts offer interest rates that are substantially lower than those on normal time deposits.

Allow banks to hold CRR in gold: Turkey pursued this goal by adjusting reserve requirements, the proportion of deposits that commercial banks must hold at the central bank.

In September 2011 the central bank increased the ratio of lira reserves that could be held in the form of gold from zero to 10 per cent, raising it further to 20 per cent in March 2012 and 25 per cent last month. This had the effect of drastically increasing banks’ appetite for gold.

Allow banks to issue gold bonds to augment capital: In the context of banks facing constraints in augmenting their capital base due to the more stringent Basel III, a possible solution is to allow them to issue long-term gold bonds on a preferential basis to augment their Tier II capital, as part of a host of other innovative products already introduced. In fact, this should provide banks an avenue for mobilising capital at a lower cost.

Legal Issue

To handle any of these, no major legal amendments would be required. The RBI Act, 1934, permits the Reserve Bank to purchase and sell gold. It does not apparently permit allowing banks to hold CRR balances in terms of gold.

However, the Banking Regulation Act, 1949, permits banks to maintain SLR in gold. One way out is to amend the RBI Act to permit CRR balances in gold. But, given the flexibility at the disposal of RBI, it can prescribe a liquidity ratio — combining both CRR and SLR — which will bring gold under the ambit, along with cash balances and investments in government securities.

(The author is Director, EPW Research Foundation. The views are personal.)

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