Shooting the Messenger - India's Gold Imports (Part II)

(In this two-part series, we look at India's gold imports in the context of its foreign exchange problems. Click here for the first part of this article) 

But, aren’t gold imports, however small, a waste of money? After all, gold has no intrinsic value.

Fig. 3: World's Central Banks are sitting on huge Gold Reserves

Neither does paper money! Let us first look at some more points of data (Figure 3). It is known that all Central Banks are holding large reserves of Gold  as part of their foreign currency reserves. The adjacent table that shows that even those countries who are facing severe economic stress, are holding  large amounts of gold as part of their foreign exchange reserves. (Even China is playing catch up and is in fact set to emerge as the world’s largest gold importer)

Fig. 4: Central Banks have become net buyers in Gold in recent years

Not only are the Central Banks holding large quantities of Gold, but are increasing them further (see Figure 4). In 2012 too, Central Banks have remained net buyers of the yellow metal, as these reports suggest (click here or here). If gold had no intrinsic value, why are the Central Banks themselves, who supposedly understand money better than us, sitting on so much gold and buying more?

The fact is, Central Banks understand that gold is money, and money does not have intrinsic value. Your currency note derives its value from the promise of the Central Bank printed on it. Gold derives its value from the value attached to it by thousands of years of human civilization. To destroy value of paper money, you just need to print more money (to elaborate on this is beyond the scope of this article, but the interested reader can refer to this excellent article on inflation). To destroy value of gold, you need to change the subjective opinions of billions of people (and Central Banks) all over the world. The reader can decide what is easier.

Even India's Central Bank, which itself bought 200 tonnes of gold in 2009 had this to say last week: "Gold is easily accessible. It is a store of value, has no credit risk and is relatively liquid thereby incentivising many households to buy gold” (RBI's Financial Stability Report (FSR) released on 28^th December 2012). 

But gold has no cash flows, pays no interest or dividends and is risky to store.

A common argument made against gold, but gold is not an equity share at all. So aren't we comparing apples with oranges here? Gold is not an investment at all. Gold is money, gold is currency, gold is wealth. I would use the cash flow  argument only to evaluate an equity share, not gold. 

But of course, you can’t take a milligram of gold to the grocer to buy your stuff, right?

Right. Nobody disputes the need for paper (or digital, these days) money. This article should not be construed as an invesmtent advice, nor am I saying that gold prices will continue to rise perpetually. The purpose of this article is only to highlight that gold imports are nowhere as problematic as they are being made out to be and one needs a different perspective to understand gold.

Conclusion

It is estimated that Indian households own more than 17500 tonnes of gold accumulated over centuries of civilization. Despite two decades of economic reforms, it is pointed out that India’s equity investor population has actually shrunk – a surprising statistic given the importance the stock markets are attached to by policy makers and the media. Performance of mutual funds has been disappointing, to say the least, and double digit inflation has made investing in fixed income instruments a loss making proposition. Gold and property are the only assets where Indian people have seen their wealth grow. Since buying property needs deep pockets, gold has emerged as the only asset which people can accumulate in small quantities. In fact, in the FSR mentioned earlier, the RBI has admitted low interest rates have caused households to shift away from financial assets to physical assets and valuables such as gold. “Gold prices have increased the most in comparison with other assets and are significantly above the movement in WPI (i.e. inflation)” it said. It has proposed inflation indexed bonds as an option, which it hopes can reduce demand for gold.

Blaming gold imports suits the political class, as it shifts the blame of India’s economic ills away from its own mismanagement to the Indian public. But it is for us to analyze data, ask the right questions and make intelligent judgement. Gold imports are neither frighteningly high, nor the cause of India's currency problems. Nor are Indians alone in buying gold. If people are buying more gold, there are reasons for the same. Those reasons need to be addressed. Other avenues to park money need to be made more attractive. Raising taxes or banning imports will only encourage smuggling, punishing the honest and rewarding the dishonest. Key non-gold imports, such as oil or defence need to be reduced by increasing domestic production. Exports need to be increased by controlling inflation (since higher domestic costs reduce export competitiveness). Interest rates need to be increased, and should be higher than inflation rate, in order to encourage savings in financial assets like bank deposits. Until that happens, people will continue to buy gold, and for a good reason.

III

President Roosevelt’s order had permanently pegged the price of 1 oz. of gold at $ 35 and committed the U.S. government to exchange dollars for gold at this rate with anyone on demand. After World War II, backed by gold, the U.S. Dollar emerged as the primary currency of global trade. All international transactions and agreements, no matter between which two countries and what their currencies, came to be denominated in U.S.dollars. But thanks to inflation, the dollar continued to lose its value while gold held its own. By the early 1970s, it was clear that an ounce of gold was much more valuable than the $ 35 that the U.S. government paid for it. The demands on America to redeem dollars for gold increased dramatically. In 1971, faced with a run on its gold, President Nixon announced that it was ending the peg of the dollar to the gold, letting it float freely in international markets. In the next 10 years, the price of gold shot up more than 10 times to more than $ 400 per ounce and is trading at $ 1650 today.

Shooting the messenger - India's Gold imports (Part I)

I

On 5^th April 1933, citing difficult economic conditions, the then U.S. President Franklin Roosevelt signed a decree. The Executive Order 6102, as it was called, made it illegal for American citizens to possess gold (with certain exemptions). The Order specified a date, 1^st May 1933 to be precise, before which all citizens were required to deposit all the gold bullion held by them with the U.S. Treasury or face heavy penalties and / or imprisonment upto 10 years. The U.S. Government would pay $ 20.67 per oz (troy ounce, i.e. 31.10 grams, the then official gold exchange rate) for the gold, the Order said.

A few months after the Order, the President signed The Gold Reserve Act of 30^th January 1934, outlawing private possession of Gold and suddenly changing the price of gold to $ 35 an ounce. In effect, wealthy Americans, who had amassed huge amounts of gold over generations of hard work and entrepreneurship since the onset of American industrialization in the mid-nineteenth century were short cheated for millions of dollars by the government in the name of saving the country. Mind you, financial markets were not as well developed in those days as they are today, and gold was one of the primary means of wealth accumulation in the U.S. at that time.

II

“Steps were being taken to control the Current Account Deficit…there was a need to control gold imports…” said India’s Finance Minister Mr. P. Chidambaram at a meeting of the National Development Council on 27^th December 2012. "We are worried about gold imports. It is an unproductive instrument", Mr. Raghuram Rajan, Chief Economic Advisor to the Government of India had said earlier. 

Over the last few months, there has been a sustained campaign in the press about India’s ‘soaring’ gold imports. The government has raised taxes dramatically on gold, quadrupling the import duty rate, changing it  from specific to ad valorem, and doubling the excise duty on jewellery as well. “One of the primary drivers of the current-account deficit has been the growth of almost 50 percent in imports of gold and other precious metals in the first three quarters of this year,”  Mr. Pranab Mukherjee, the then Finance Minister had said earlier last year, before announcing the tax hikes. “I have been advised to strengthen the steps already taken to check this trend.” To cut a long story short, Indians are buying too much Gold, and that is causing problems in managing the economy, we are being repeatedly told.

It is therefore time to take a look at the numbers and check out the facts. Take a look at the data on gold imports given in figure 1 below:

Fig. 1: Ninety percent of India's imports are non Gold

 We observe that:

1. Gold imports were 9.26 % of India’s total imports in 2011-12. Ninety percent of India's imports are other than gold.

2. Imports were in the 5 – 6 % range till 2008-09 but increased after that, roughly the time when the rapid deterioration of the economy began.

3. There has been a dramatic increase in the price of gold in the last decade. Increase in the quantity of gold imported therefore, is more benign. (It is in the range of 7 - 8 % per annum)

Gold imports have thus increased only in line with the overall growth of the economy, with only a small uptick in the last 2-3 years. They are in fact expected to come down in the current year and the next. The brouhaha around gold imports therefore does not seem justified.

Don’t they cite some data whenever they blame gold imports?

Figure 2: India's CAD started deteriorating from 2004-05 itself

Most of the time, it is pointed out that gold imports are high as a percentage of Current Account Deficit (CAD, the excess of total imports to total exports). Read the Finance Minister's comment yesterday: ‎“Suppose gold imports had been one half of the actual level that would have meant that our ‎foreign exchange reserves would have increased by $10.5 billion,” Chidambaram said. “I would ‎therefore appeal to people to moderate the demand for gold, which leads to large imports of ‎gold.”  But this is a wrong metric to use, since it does not prove causation. As  Figure 2 shows, India’s current account started deteriorating as far back as 2004-05 itself, much before gold imports picked up. Current account deficit is caused not just by gold imports, but by all imports and all exports. The question is not why gold imports are rising, but why the CAD is rising. Contribution of gold imports to current account deficit is much smaller than what is made out to be.  In 2011-12, India's total imports were USD 607.158 billion and total exports were USD 529.003 billion. Gold imports were thus only 4.95 % of the total Foreign Trade of USD 1,136.161 billion, a very small portion, compared to other imports like petroleum or defence. Overall current account deficit on the other hand, has increased at 64 % p.a. in the last 7 years. 

  

But, aren't gold imports, however small, a waste of money? After all, gold has no intrinsic value.

We will look at these and other arguments in the next part of the article. 

(To be continued)

Returns or Inflation?

Between July 2008 and today, the Indian Rupee has lost 40 % of its value.

Talk about rising prices, and discussion in the media inevitably revolves around the Inflation Rate. The Finance Minister talks about the Inflation Rate, so does the RBI Governor, the experts on TV channels and journos from the print & electronic media – all you get to hear from them is the Inflation Rate. Further, more often than not, they refer to the WPI (Wholesale Price Index), while what matters to the people is the CPI (Consumer Price Index). A meaningful analysis of how rising prices are hitting the venerated (just for namesake!) 'aam aadmi' is therefore, conspicuous by its absence. To understand why I say so, you first need to know what the problem with the Inflation Rate is.

This is what they show you - falling inflation (click to enlarge)

The Inflation Rate shows the difference between price of a commodity (or price index) over a period of one year. It compares the current price of a commodity with its price at the same point of time a  year ago. So if the price of loaf of bread was Rs.20 exactly one year back, and it is Rs. 22 today, we say inflation rate is 10 %. (Rs.2 over Rs.20).

But the inflation rate completely ignores prices more than one year away. If your perspective is long term, as it should be, the current inflation rate will tell you nothing about how prices have risen over a longer period of time. If prices double in a year, and remain where they are for another year, you will get an inflation rate of zero, though over a two year period, prices would have gone up by almost 50 % per annum. Therefore, while inflation rate has its uses, it is also important to look at the actual price index itself, to get a proper perspective on prices. Unfortunately, the media, and their  so-called experts are rarely interested in such finer details.

This is what the truth is - ever rising prices (click to enlarge)

Take a look at the news items, such as this or this or this Rarely will you find a mention of the actual price index. So I thought it would be worthwhile to see what was has happened to prices actually, rather than the inflation rate since July 2008. I used the Consumer Price Index (CPI), and not the Wholesale Price Index (WPI), since that is what matters the most to the people. What I found out was what I told you in the first sentence of this article – the Rupee has lost 40 % of its value in the last three & half years. The CPI (IW) which was at 143 on  31^st July, 2008 stood at 199 on 29^th February, 2012, almost 40 % higher. What does this mean? In simple terms, what ever Rs.100 could buy in July 2008 costs Rs.140 today. 

Now, if you were to adjust any of the current prices to this, you will get the real picture of price increase / decrease during the period. Adjust Sensex or the Nifty to this, and the indices which apparently have given a return of 24 % during this period actually end up with a loss of 11% ! Even property price rise has been very modest (19 % in 3 & 1/2 years) while Gold has performed the best.

As on	31-Jul-08	29-Feb-12	29-Feb-12*	Real Returns
CPI (IW)	143	199	143	0%
Sensex	14356	17753	12757	-11%
Nifty	4333	5385	3870	-11%
Gold@	12530	28599	20551	64%
Property#	117	193	139	19%

(* Inflation adjusted level) (@ MCX Spot price per 10 gms) (# NHB's Residex for Mumbai) (All Returns are absolute, not annualised)

To assess the price performance of anything over the long term, you need to deflate it with the price level. That is when you will get the real picture.   

Note: In 2011, the Government issued a new series using 2010 as the base. As per the new series, the inflation rate is 9.45% and 10.30% for Urban India in February and March 2012 respectively, even higher than what the above figures indicate. For want of adequate history, I have used the old series of CPI in my calculations above.