Will import curbs on gold be effective? No

As long as there are no other attractive investment options available, gold would remain in demand, no matter what steps are taken to make its purchases costlier. The spike in gold demand in May was due to three factors. First, a sharp drop in gold prices in April – nearly 12 per cent in just one week; second, the wedding season in May; and third, an advance announcement by the Reserve Bank of India(RBI) to impose restrictions on gold imports, giving a two week purchase window before the measures came into effect.

The pent-up demand for gold jewellery was released in May due to a sharp decline in gold prices. In volume terms, gold jewellery purchases had grown very marginally in the four years up to 2012 – about 2-3 per cent.

With the price rising from its April lows, the wedding season now over, the RBI’s import restriction in place, and the latest government step to raise customs duty on gold to 8 per cent, gold demand will naturally moderate in June.

These measures may reduce gold demand in the short run, but are unlikely to be successful over the medium term, unless the reasons for the attractiveness of gold are tackled. Rather, it might lead to an increase in gold trade via unofficial channels.

Why is gold so much in demand? Gold, even in the form of jewellery, is a highly lucrative investment and insurance product -- it is a liquid asset, unlike real estate.

It is an asset with relatively longer price cycles compared to the stock market. It is an insurance product that involves no paperwork to purchase or sell, unlike the load of papers and proofs that are needed to make a successful insurance claim. In recent years, it has also turned out to be a good investment product, offering real returns in a persistently high inflation environment without any competing financial products.

When the other investment options are not good enough, households prefer to invest in gold, whether in the form of jewellery or, increasingly, bars and coins.

Curbing gold demand via imposing import restrictions and hiking customs duty, therefore, could result in increased imports through illegal channels.

Therefore, the right policy response would, be to focus on improving other investment options – liquid, less volatile, easy to purchase and sell, with returns that keep pace at least with inflation.

A step in this direction was the RBI’s recent announcement relating to the introduction of the inflation-linked sovereign bonds that will be open for retail participation. But, there is a long way to go – right from developing corporate bond markets to reducing transaction costs in financial products.

Read also: Will import curbs on gold be effective? Yes

(The author is Principal Economist, CRISIL Ltd.)