A fall in CAD does not mean a fall in gold demand
With the government clamping down on gold imports, the hope was that it would lead to people saving more money in bank and other fixed income deposits. But is that really happening? The evidence available suggests it isn't because the basic problem in India is high inflation and that hasn't been addressed.
The current account deficit for the three month period of July to September 2013 has come in at $5.2 billion or 1.2% of the gross domestic product (GDP). This number is so good that it prompted the Reserve Bank of India(RBI) to release the numbers a month earlier than scheduled.
In technical terms, the current account deficit is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances. Or to put it in simpler terms, it is the difference between outflow (through imports) and inflow (through imports and foreign remittances) of foreign exchange .
The current account deficit for the April to June 2013 period had stood at 4.9% of GDP, whereas for the July to September 2012 period it had stood at 5% of GDP. Also, this is the lowest current account deficit that the country has seen since the period of three months ending June 2009.
A high current account deficit is not deemed to be good for a country primarily because it means that the outflow of foreign exchange is much greater than its inflow. So in India's case it means that the outflow of dollars is much greater than the inflow of dollars. This means a greater demand for dollars than supply. Hence, those who need dollars sell rupees to buy them. This leads to a situation where the value of the rupee falls against the dollar. This is precisely what happened between May and August 2013, when the rupee went from around 54 to a dollar to almost 69 to a dollar.
When this happened, Indian importers had to pay a significantly higher amount in rupee terms, for what they were importing. India produces very little oil and imports nearly 80% of its requirement. Hence, the oil marketing companies had to pay a higher amount for the oil that was being imported. But these companies are not allowed to sell cooking gas, diesel and kerosene at a price which is greater than the cost price. The government subsidies them for this under-recovery. This adds to the expenditure of the government and hence, leads to the fiscal deficit going up, which has its own set of problems. Fiscal deficit is the difference between what a government spends and what it earns.
There are two ways of controlling the current account deficit. One is to ensure that the country earns more foreign exchange than it was doing in the past. The other is to clamp down on the demand for foreign exchange. For a government it is always easier to clamp down. Hence, the government went about increasing the import duty on gold. The duty is now at 10% in comparison to 2% earlier. Another rule, which required a gold importer to re-export 20% of all the gold that he imported, was also introduced by the government.
These two significant changes ensured that gold imports came down dramatically. Gold imports during the June to September 2013 period stood at $3.9 billion, down nearly 65% from the same period in 2012, when it had stood at $11.1 billion. In the period of April to June 2013, the gold imports had stood at $16.4 billion.
This dramatic fall in gold imports is a major reason behind this fall in current account deficit. In absolute terms the fall in gold imports has been $12.5 billion($16.4 billion - $3.9 billion) between the three month period ending in June 2013 and the three month period ending in September 2013.
The current account deficit for the April to June 2013 period was $21.8 billion. For the period July to September 2013 period, it has come in at $5.2 billion. The absolute difference is $16.6 billion. Of this nearly $12.5 billion or nearly three fourths of the fall has been because of lower gold imports.A fall in the value of the rupee has also helped boost exports. Merchandise exports went up by 12% to $81.2 billion during the period in comparison to the same period last year. This was primarily on account of growth in export of textiles, leather and chemical products.
The major fall in current account deficit has been because of a massive fall in gold imports. And this has meant that the demand for dollars to buy gold has gone down dramatically as well. This has been one of the major reasons for the rupee increasing in value from around 69 to a dollar in end August to around 62.4 to a dollar currently.
The current account deficit was around $87 billion last year. With the clamp down on gold imports, the finance minister P Chidambaram has said in the recent past that he expects the current account deficit to be less than $56 billion in the financial year ending March 2014. Does a fall in gold imports also mean a fall in demand for gold? India produces almost no gold of its own. But things are not as simple as that.
It is worth remembering here that gold imports were banned in India until 1990. At that point of time, gold smuggling was a fairly lucrative operation. As a recent article in The Economist points out "India consumed only 65 tonnes in 1982. Until 1990 imports were all but banned. Bullion had to be smuggled in and its price within India was about 50% higher than outside it." And that is precisely what has been happening over the course of this year.
A recent report in The Hindustan Times points out "The Mumbai airport customs has seized around 73kg gold worth Rs.19.71 crore between April and October this year, more than double the quantity (31kg gold worth Rs 9.8 crore) it had seized during the same period last year. The spurt in smuggling activities is a result of the widening difference in the yellow metal's price between the domestic market and Dubai. The price gap has gone up to Rs 5 lakh a kg in the past few months from being Rs 2.5 lakh a kg in June, and only Rs 1 lakh before that."
Gold smugglers are also using neighbouring countries to get gold into India. A November 17, 2013, report in The Times of India points out "In the past few months, over 50kg of gold worth more than Rs 15 crore has been smuggled across the Indo-Bangladesh border alone. Sources in Directorate of Revenue Intelligence (DRI) said Nepal too has come up on the radar with some recent seizures on the border. Sources said this was only a fraction of what was being smuggled through these borders."
A similar point is made by Dan Smith and Anubhuti Sahay of Standard Chartered in their September 12, 2013, report titled "Gold - India's government gets tough." As they write "There is much anecdotal evidence suggesting that increased amounts of gold are entering India through unofficial channels, which makes the official figures an understatement. Pakistan temporarily suspended a duty-free gold import arrangement in August, when gold imports doubled. According to media reports, much of this was crossing the border into India."
A report in the DNA quotes Somasundaram P R, managing director (India), of the World Gold Council as saying " demand in neighbouring countries such as Thailand has increased and some of this may be because of India demand."
The World Gold Council in a recent report also makes the following point. "Gold entering the country unofficially through India's porous borders helped to meet pent-up demand...It is likely that unofficial gold will continue to find its way into the country to satisfy demand. Reports that a good market for ten tola bars is re-emerging,due to the relative ease with which they can be concealed, reinforce this view."
The point is that a clamp down on gold imports leading to a major fall in gold imports doesn't necessarily mean a fall in gold demand. These are two difference things. An increase in gold smuggling has huge social implications. It is worth remembering that some of the biggest mafia dons of Mumbai in the seventies and the eighties started as gold smugglers before getting into other illegal activities.
That apart, there are financial implications to this as well. A major reason why Indians buy gold is to protect themselves from inflation. Over the last few years the consumer price inflation(CPI) has been higher than the interest being paid on fixed deposits and other fixed income instruments. In this environment, gold has looked like a good bet given that it has given positive returns in each of the years between 2002 and 2011. As Chetan Ahya and Upasana Chachra of Morgan Stanley point out in a December 2, 2013 note titled India Economics: 2014 Outlook: A Year of Macro Adjustment "Persistently high CPI inflation has kept real interest rates negative since the credit crisis, encouraging households to reduce financial savings and increase allocation to gold and real estate."
Hence, buying gold was a perfectly rational thing to do at an individual level. The Indian financial system is rigged towards helping the government borrow money at low interest rates (You can read the complete argument here). Given this, it is not surprising that Indians are fascinated by gold at an individual level. Though at an aggregate level it has led to major problems. One of the problems has been the weak deposit growth of banks. As Ahya and Chachra point out "This is reflected in deposit growth, which has stayed weak relative to credit growth now for the last three and a half years, elevating the loan-deposit ratio near full capacity levels (76.5% currently)."
This basically means that deposits have been growing at a much slower pace than loans being given by banks, due to the fact that people have been diverting their savings into gold and real estate, in the hope of beating inflation. And this in turn has led to higher interest rates. With the government clamping down on gold imports, the hope was that it would lead to people saving more money in bank and other fixed income deposits. But is that really happening? The evidence available suggests it isn't because the basic problem in India is high inflation and that hasn't been addressed.
(Vivek Kaul is a writer. He tweets @kaul_vivek)
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