Import curbs only helped gold smuggling; so reversal will have no impact on CAD

Restrictions were put on gold imports as part of the currency defence of 2013. One important step towards removing these restrictions was taken on Friday. Some people are thinking “How much will the current account deficit go up by, now that more gold will be imported?”

For this to happen, you have to believe that the restrictions actually made a difference to gold imports. I feel that there was absolutely no decline in the gold purchases by Indian households when the restrictions came in. All that happened was that instead of going to a formal sector firm, the purchases were made from smugglers, which required a whole chain of `black money’ transactions.

If you feel that the bulk of gold smuggling is paid for using hawala transactions i.e. misinvoicing, it seems that shifting between smuggling and legal imports makes no difference to the current account deficit. Ergo, removing the restriction will make no difference to the current account deficit.

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Scarcity value

I suspect that when we made it difficult to buy gold, there was a greater perception of scarcity, and people became even more keen to stock up on gold. It takes years of sustained good behaviour by the government, for people to get comfortable. One slip, and you unleash the psychology of scarcity all over again.

With gold, I think that after the liberalisation of the early 1990s, it took 5-10 years for people to get used to the idea that the government was not going to interfere with their gold purchases. These gains were lost in the 2013 rupee defence.

A similar story holds with outbound capital flows. Capital account restrictions came in 1942 and turned into a rigorous system of control in the 1950s. From that point onwards, Indian households have believed that there is value in holding assets outside the country. One big advance took place in the mid 1990s, when it became easy to travel abroad and use an Indian credit card. This solved the problem of needing hard currency to travel. But portfolio diversification remained a problem.

When the liberalisation of outbound flows began, this sense of scarcity started easing. Then came the capital controls on outbound flows as part of the currency defence of 2013. These controls have still not been reversed. This sent out the message that you cannot trust the Indian government, so it’s wise to hold assets outside India as much as possible. The attraction of gold went up: buying gold in India is actually a capital outflow. The value of gold is safe from Indian monetary policy or capital controls.

After the actions of the currency defence of 2013 are undone, it will take years before people get back to the pre-2013 modes of behaviour. MOF might probably manage to get rid of the restrictions by 2014 or 2015, and perhaps by 2020 people will start shedding the scarcity value.

This article first appeared on Ajay Shah’s blog.