The FM’s gold schemes will not control gold imports. This simple measure will
To reduce gold imports what is required is a level playing field for gold and non-gold imports and not gold schemes as proposed by Arun Jaitley in the Budget
India needs to reduce gold imports, which were the single cause of the unprecedented over 30 year-high current account deficit of 4.7% of GDP in FY 2013 with gold imports accounting for more than 3%. The Finance Minister Arun Jaitley has proposed two important measures in his budget speech, to control gold imports. These are:
(i) Gold Monetisation Scheme, which will replace both the present Gold Deposit and Gold metal Loan Schemes. The new scheme will allow the depositors of gold to earn interest in their metal accounts and the jewellers to obtain loans in their metal account. Banks/other dealers would also be able to monetize this gold.
(ii) Also develop an alternate financial asset, a Sovereign Gold Bond, as an alternative to purchasing metal gold. The Bonds will carry a fixed rate of interest, and also be redeemable in cash in terms of the face value of the gold, at the time of redemption by the holder of the Bond.
Unfortunately, these two measures will not work. Take the first one. India has 20,000 tonnes of domestic stock of gold. Can it be monetised as the minister announced? Globally, deep and liquid metal gold deposit and lending markets exist but only for two reasons, the first being active trading and the second gold miners borrowing metal gold to raise money at ultra-low interest rates to fund their capital investment in either new mines or in expansion of their existing mines. And there is no third reason for this.
The dynamic of the global gold deposit and lending markets in New York, London, Singapore and Hong Kong involves gold borrowing demand coming from short sellers and large gold miners. In particular, short selling arises from speculators, hedge funds and other participants betting on declines in gold price so that they can make profit from their bet coming right by buying back gold at a price lower than the price at which they originally short sold and repaying the metal gold loan. But since, there is the market discipline of delivery into a short sale, short sellers have necessarily to borrow metal gold to deliver into the short sale, which gets adjusted after some time, when short sellers either buy metal gold back to cut their losses due to stop loss limits or to book their profits and using the gold so bought back for repaying the borrowed gold.
Another reason for short selling metal gold is engagement by market participants in cash futures arbitrage when gold futures are cheaper relative to the spot market i.e. when no-arbitrage argument/ law of one price of derivatives is violated. What then they actually do is buy cheaper gold futures and short sell expensive gold in the spot market and carrying the arbitrage trades into maturity and earning totally risk free profits due to such mis-pricing. Such arbitrage trades continue until, as a result of these trades, such price discrepancy eventually disappears.
Since globally there is large-scale demand for such borrowed metal gold, supply comes from gold deposits and like in any bank deposit and loan market, there are deposits and lending/ borrowing rates known as gold lease rates. These are way too low compared to currency rates because they are in theory and practice nothing but the difference between the uncollateralised currency interest rates and those collateralised by metal gold. Specifically, when gold is short sold, the sale proceeds of short sale are used by the short sellers to collateralise their borrowing of metal gold borrowing, which amounts to lending by short sellers of cash from short sale to metal gold lenders at an interest rate lower than the interest rate they will lend at otherwise. The more desperate the metal gold borrowers are to borrow, the less interest rates they will charge to the lender of the metal gold and so much higher will be the metal gold lease rates.
On the other hand in an aggressive bull market in gold, when prices shoot up, the demand for borrowed gold will relatively be far lower and therefore, gold lease rates will be lower and can be, and have indeed been, negative. These gold lease rates are in both theory and practice a fraction of a currency’s interest rates.
Illustratively, currently these are 0.09%, 0.11%, 0.15%, 0.25% and 0.40% for one month, two months, three months, six months and one year, respectively. Incidentally, in the Indian context, there has been frequent demand from some quarters that interest rates paid on gold deposits should be higher than currently paid without appreciating the fact that each asset has its own yield curve. Like for example, just as you cannot pay Indian rupee rates on yen and dollar deposits, so also you cannot pay Indian rupee interest rates on gold deposits.
Coming back to gold lease rates, they have also been negative during the episodes of aggressive bull market in gold when lenders of metal gold far exceed the borrowers of gold to a point that lease rates become zero but there are still storage and insurance costs, which make effective lease rates negative!
Other than short sellers and arbitrageurs, there is only one more kind of metal gold loan borrowers, namely, large gold miners. They borrow metal gold for longer periods to sell the metal in the spot market and use the sale proceeds to fund capital investment in new mines or in capacity expansion of their existing gold mines and have a natural hedge against gold price rise. This is because they use the metal gold mined to repay their metal gold loans without any price risk and thus have the natural advantage of raising capital at a fraction of cost of debt and equity capital unlike other non-gold businesses.
Significantly, as regards lending gold to jewellers, to call it a metal gold loan is an oxymoronic misnomer. This is because, effectively and substantively, it is simply nothing but a sale and purchase transaction as both in finance theory and practice, a deposit and lending transaction is one where whatever is borrowed has necessarily to be repaid. To that extent, it is no brainer to that the proposed monetisation scheme will not deliver because any genuine depositor of any asset would want his deposit back on redemption and maturity date and not sell it in the first place.
The Sovereign Gold Bond Scheme is, in its design and logic, is exactly like a Gold ETF. The difference is that the latter does not pay any interest but delivers gold returns to investors by investing the entire proceeds of subscription in metal gold, which is held in demat form.
Significantly, all the 14 Gold ETFs in India, between them, hold no more than 40 to 50 tonnes of gold, which is a mere 5% of annual gold imports of 800 to 1,000 tonnes mentioned by the Finance Minister!
Therefore, a gold ETF does not at all reduce metal gold demand. All it does is to substitute gold demand from individual metal gold investors with like demand from a professionally and expertly managed gold ETF instead! Exactly so will also be the case if the Government does the same to deliver gold returns to Sovereign Gold Bond holders on redemption.
In the highly unlikely event of the Government, even remotely contemplating using the subscription proceeds for a purpose other than investing only in metal gold, will expose the government to extreme price risk, as it will be committed to delivering gold returns to bond investors, on redemption, at the ruling gold price. Remember, gold price moved from an all-time high of $850 per oz. in late ‘70s to a life time low of $270 in the early 2000 and then to an all-time high of $1,920 in September 2011.
So to conclude whether the proposed gold deposit and lending scheme will deliver in practice will depend critically on whether we have in India both active gold trading involving, as I said before, short selling and arbitraging and gold mines of global scale. And as we already know the above necessary and sufficient conditions are not satisfied in the Indian context. In view of the foregoing reasons, both the Sovereign Bond Scheme and Gold Monetisation Scheme will not deliver. What, however, will is what actually and effectively did only as recently as in 2013-14 , that is, restoring by RBI of the status quo ante by again creating level playing field between gold and non-gold imports by stopping gold imports on 1) consignment basis 2) unfixed price basis and 3 ) metal loan basis !
What Will Work?
What will reduce gold imports is putting it at par with non-gold imports. Remember, gold imports surged because under the then current import regulations (of RBI’s FEMA Master Circular), there was preferential, and more favourable, treatment for gold imports as compared to import of any other item, including essential imports. Gold import was permitted 1) on consignment basis 2) on unfixed price basis and 3) metal loan basis.
This preferential treatment made gold imports free from both price and currency risks for overseas consignors of gold borrowed overseas as effectively it amounted to their short selling such borrowed gold in India and simultaneously covering their short position abroad, with both the risks being borne by end buyers of jewellery and gold exchange-traded fund (ETF).
This was not the case though with other items, say, coal and edible oils, imported on direct import basis. I had accordingly, in December 2012, suggested to the then Reserve Bank of India (RBI) Governor, Dr Subbarao and the present Governor Dr Raghuram Rajan, then Chief Economic Advisor, Ministry of Finance, to create a level playing field between gold and non-gold imports by aligning gold import regulations under Foreign Exchange Management Act (FEMA) with those for non-gold but essential imports.
And indeed, aligning gold import regulations with the rest of imports by RBI had the desired effect of taking away this significant, unwarranted and perverse incentive. It delivered the desired outcome of dramatically reducing gold imports in double quick time, merely by creating a level playing field between the two kinds of imports so much so that as its direct consequence, the current account deficit (CAD) narrowed dramatically to 1.7 % of GDP in FY 2014!
And this was achieved, as I said, not by imposing curbs and restrictions on gold imports, as was widely made out in media campaign by some quarters, but merely by creating a level playing field between gold and non gold imports and by aligning gold import regulations under FEMA 1999 with those for non-gold, but essential, imports like, as I mentioned above, edible oil and coal.
However, surprisingly, the RBI, only recently, rolled back these entirely wholesome and fair measures. No wonder, according to media reports, gold imports have again surged and the CAD for the latest fiscal quarter has increased to 2.1% from 1.2% of the GDP.
(VK Sharma is Former Executive Director of the Reserve Bank of India)