RBI reserves. Should India pile its reserves with gold?

The Reserve Bank of India’s transactions in gold have always attracted much attention. The pledging of gold with the Bank of England in 1991 to meet the balance of payment crisis is still considered a nadir for the Indian economy. There was also much patriotic cheer when 200 tonnes of gold were purchased from the IMF in 2009.

It is, therefore, surprising that not much attention has been given to the RBI’s revised stance towards accumulation of gold reserves. India’s gold reserves have been increasing at a steady pace over the last three years. These purchases have added 137 tonnes to the gold reserves between December 2017 and March 2021. The share of gold in India’s foreign exchange reserves has increased to 7 per cent currently, from 5 per cent in March 2017.

India is not the only country purchasing gold. A few other emerging economies are also following a similar strategy and the main reason appears to be the need to reduce the risks emanating from excessive US dollar exposure.

But there are limitations to the gold reserves that India can hold.

RBI buys gold

The Indian central bank had not made any move to increase its gold reserves for many years after its purchase of the precious metal from the IMF in 2009. Its gold holding, therefore, stood at 558.1 tonnes in the period between November 2009 and December 2017.

But it has been gradually increasing its gold reserves since March 2018; annual gold purchases have averaged around 40 tonnes between 2018 and 2020. The resolve to buy gold is continuing in 2021, with purchases in the first quarter already amounting to 18.7 tonnes.

The RBI currently holds 695.3 tonnes of gold, ranking tenth globally in gold holding. While the quantity of holding is less than that of the US, Germany, France and Switzerland, it is far higher than other emerging economies, with the exception of China.

Why is India piling up gold?

Countries such as Turkey, Russia and Kazakhstan have also been avid buyers of gold over the last five years. The buying gold appears to be driven by a desire to reduce the dominance of the US over the global economy. One way to do so is to reduce the usage of US dollars in their external transactions as well as in their reserves.

But India’s desire to add gold reserves seems to be driven mainly by the fear of depreciation in dollar value causing capital loss. India’s forex reserves have been on an upward trajectory for most part over the last three decades as the RBI used the copious foreign portfolio and direct investment inflows to build its reserves. More than one-third of these reserves are held as US treasury securities.

The beginning of the RBI’s recent gold purchases in early 2018 coincides with two events. One, the US dollar fell sharply in 2017 as the trade war with China and crash in commodity prices led to selling in dollar assets. Two, yields on US treasury bonds spiked sharply between September 2017 and March 2018. These two happenings, taken together, would have resulted in a sharp loss in the value of US treasury securities held in foreign exchange reserves.

Gold prices have also been in a strong up-trend since September 2018, gaining almost 48 per cent since then. This rally would have bolstered the central bank’s resolve further.

The weakening of the US dollar due to the large stimulus rolled out by the US government in 2020 and 2021, along with near-zero interest rates further strengthens the case for diversifying forex reserves away from dollar-denominated assets.

According to a survey of central banks done by WGC last year, 20 per cent of central banks intended to increase their gold reserves over the next 12 months. Eighty-eight per cent of respondents said that negative interest rates are a relevant factor for their reserve management decisions.

The pitfalls in holding gold

While its not difficult to see why the RBI is adding to gold reserves, there are certain factors that restrict the extent of gold holding.

One, gold prices are volatile and can result in sharp capital loss. For instance, gold prices crashed around 30 per cent in 2013.

A country that held over 50 per cent of its reserves as gold would have seen its reserve deplete by 15 per cent that year. One of the objectives behind building forex reserves is to create a buffer to help tide over external account crisis or to support the currency in times of extreme stress. Exposing a large part of reserves to sharp swings in value is therefore not recommended.

Two, gold’s property as a safe haven has been questioned quite often in recent past. While it does provide a hedge in periods of extreme stress that last for short durations, as was seen in March 2020, over longer time-frames, gold is not an effective hedge for the portfolio.

Three, liquidity in gold is relatively lower when compared to other fixed income securities. Also, if central banks begin offloading large quantities of gold in the market, it tends to impact gold price adversely, affecting the residual holding in the reserves.

Four, the assets that make up the reserves should be decided based on the currency-composition of the country’s external trade, currency in which it has borrowed overseas, the key currency to which its value is linked and so on. Given these factors, India needs to hold a chunk of its reserves in US dollars.

That said, holding a part of reserves as gold is not a bad idea given that it acts as a diversifier and does not carry any default risk. But the RBI will have to decide how much exposure it wants in gold and regulate its purchases accordingly over the next two years.

In a BIS working paper, ‘What share for gold? On the interaction of gold and foreign exchange reserve returns’, Omar Zulaica has examined the question of the optimum gold holding by central banks and concludes that: “Given the volatility of gold returns, only a very small share of gold appears quantitatively adequate under most circumstances. However, there is evidence of a potential insurance value of gold in adverse scenarios, which can support higher allocations of gold in cases where the protection against tail risks is a key reserve management consideration.”

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