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What's missing in govt's fight against gold

Economy Jan 3, 2013

Gold imports: FM wants to fix symptoms, not disease

By R Jagannathan

The finance minister is on a gold-bashing trip once more, thanks to a deteriorating external front. He wants to raise taxes on gold imports, since gold is an important contributor to India's import bill after oil.

At a news conference yesterday, P Chidambaram said: "I would appeal to the people to moderate the demand for gold which leads to large imports of gold. I may add that we may be left with no choice but to make it a little more expensive to import gold. This matter is under the government's consideration."

The FM should ponder the consequences of his statement, for he is not only fighting a strong cultural preference for gold, but commonsense economics too.

Let's say he raises taxes on gold imports. So what will happen then? Domestic gold prices will rise due to constrained supplies. And what will you do if domestic prices rise? Will you be more convinced about gold's potential as an investment avenue or less? The chances are people will buy even more gold. Constricting gold imports is the surest way to make people cling more to the metal.

Some short-term import curbs may be warranted, but it emphasises that the real problem is lack of returns with normal financial instruments.Reuters

Another statement he made is interesting: "Suppose gold imports had been one half of the actual level (around $20 billion in April-September 2012), that would have meant that our foreign exchange reserves would have increased by $10.5 billion."

Sure, when people import gold, they use the country's exchange reserves to buy the metal. To that extent, the reserves will come down.

But something else has also happens. When people buy gold, they are effectively making official forex reserves private. Dollars become private gold. Ordinary people now own the reserves, not the government.

This has two implications. One, when I pay rupees to buy dollars to import gold, I reduce money supply in the economy. Two, I also save instead of spending my rupee. Put another way, buying gold is a form of private inflation combat. If the money had been spent on buying local things, like food on milk or eggs, it could have pushed up inflation.

There may also be another factor at work. The UPA's theme song has been cash disbursements for welfare schemes. Since NREGA and other schemes have pushed wages up, what is the likelihood that some of the increased gold demand is coming from the poor in rural areas? Quite high? It means government spending on welfare may be one reason for the spike in gold demand, though not the only one.

Another thought: if direct cash transfers put more cash (rather than goods) in the hands of the poor, will they use it to buy gold? Or booze? Or essentials? Since the money will be given to the women of the households, what do you think will happen? Chidambaram should ponder this possibility too when pushing ahead with cash transfers. You never know what the poor will do with extra cash.

The effort to curb gold imports through higher import taxes may be a short-term fix for the current account deficit, but in the long run, the government has to find a cure for the disease (inflation), not the symptom (private gold purchases).

"I believe gold imports will come down when inflation settles down...people consider gold as a hedge against price rise," said C Rangarajan, Chairman of the PM's Economic Advisory Council (PMEAC), the other day.

In fact, this is exactly the same point made by the Reserve Bank of India's Working Group on gold imports and gold loans headed by KUB Rao. Rao's report, put in the public domain by the RBI yesterday, also indicated that some short-term import curbs may be warranted, but it emphasises that the real problem is lack of returns with normal financial instruments.

Said the report: "It is necessary to introduce savings schemes and instruments that can provide real returns. The dominant reason why a person may like to hold his savings in the form of gold is to secure a hedge against inflation. Therefore, offering a real rate of return, considering the high inflation rate prevailing, as an incentive on a financial instrument would better address the issue of excessive clamour for gold imports. Therefore, products analogous to inflation-indexed bonds may be considered as alternatives."

So, Mr C, fix inflation and the problem of gold imports will melt away. Or offer better returns through inflation-indexed bonds, but we haven't heard anything on that yet. What we have heard you saying is that interest rates must come down.

Say that softly, Mr C. If India's gold bugs hear you talking about lower rates, they will buy even more gold.

by R Jagannathan

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