The only alternative to gold: inflation-indexed bonds

By Rajrishi Singhal

Just one data point and it generates so many ripples. The recent data release on the third quarter (Q3) balance of payments data has inadvertently drawn attention to the savings problem in the economy. But, at the same instant, it also points to the most glaring inadequacies in the securities market micro-structure.

Balance of payments data for Q3 in 2011-12 (FY12) showed a worrying deficit of $12.8 billion (implying Reserve Bank’s foreign exchange reserves were depleted by a similar amount), against an increase of $4 billion in the same period of the previous year. This deficit was caused by higher imports of oil and gold, and lower capital inflows, which could not be compensated by even increased inflows of invisible receipts (software export proceeds and remittances).

One of the villains identified by analysts is the burgeoning import of gold. India’s gold imports have jumped 54 percent in the first nine months of FY12 to $45.5 billion. It is a well-known fact globally that the Indian appetite for the yellow metal is ravenous. In fact, India is the largest gold consumer in the world (though it might cede that position to China soon).

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Higher gold consumption also diverts money from financial savings (which, theoretically, could be used for building productive assets in the economy) to physical assets like gold (which remained locked in and are, therefore, unproductive).

The government is now scrambling to discourage gold imports by erecting tariff barriers and other disincentives. Rates of customs duty on gold imports, as well as excise duty on refined gold, have been doubled. The Reserve Bank has imposed tougher conditions on finance companies which provide loans against gold as collateral - their Tier-I capital has been raised to 12 percent and they can’t lend more than 60 percent of the value of the gold hocked.

However, like all well-meaning government actions emanating from Delhi, this too misses the point.

Indians have been buying more bullion this year because it is the only form of savings which, in their belief, won’t get eroded by rampant inflation. Given the government’s push to consumption-led growth in the aftermath of the global financial meltdown, inadequate supply capacity stoked inflation and inflationary expectations. In such a situation, Indians turned to the one asset they feel will stand rock steady in times turbulent and inflationary.

So, instead of depriving savings-challenged Indians, the government should explore some alternative investment avenues that provide investors with pretty much the same attributes - positive real rates of return while keeping risk to the minimum. Some long-dated bonds can also be conveniently handed down to the next generation.

Enter the securities market. If investors had the opportunity of buying government bonds - which are inflation and capital-protected - they might reduce their purchase of gold (it will be difficult to eliminate all consumption since gold is also considered an auspicious shopping item).

But the problem is: it’s still difficult for any individual to buy government bonds. Consider the irony: the riskiest market (equities) has the lowest entry barrier while the only risk-free market (gilts) makes it all but impossible for individuals to trade.

The Reserve Bank is now trying to put in place measures that will make it convenient for individuals to buy and sell gilts. However, this might take some time and might require the central bank to make sure that the public sector banks, which have built a fairly extensive branch network, use their distribution capacity to sell down government bonds without adding a steep bid-ask spread.

There are also lessons to be learnt. The Reserve Bank had introduced in 1996 a network of small shops - called satellite dealers – to retail government bonds. The scheme had to be shut down in 2002 for a variety of reasons, including the fact that the market micro-structure was not evolved adequately to allow for retail participation.

The time might now be ripe for taking another shot at retailing government bonds, including variants of the vanilla bonds.