Why Indians will keep buying gold even at higher prices

Government or regulatory policies on gold will not help in curbing gold prices or gold demand.

Policy makers should instead focus on bringing the macro economy back on track with respect to inflation, the fiscal deficit and current account deficit.

Once that happens, the returns on financial assets will improve, leading to some movement away from gold by Indian consumers and investors alike.

Right now, gold is proving to be a hedge against everything in India from inflation and currency problems to bad government policies.

Gold prices, denominated in rupees, have risen to record highs on the back of a weakening rupee and an increase in customs duty on refined gold.

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Gold denominated in rupees has returned 3.7 percent over the last two months, while gold denominated in dollars has fallen 3.4 percent, and the rupee has fallen against the dollar by 7.5 percent in the same period.

Gold prices touched record levels in the National Capital Region on 30 April, 2012, highlighting the divergence of gold prices denominated in rupees and dollars. Globally, gold prices are down 12 percent from their highs seen in 2011 because of a rising US dollar. The dollar index has gained 6.5 percent from lows seen in 2011.

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Rising gold prices are proving to be a headache for the Indian government which increased the customs duty on refined gold to 10 percent from 5 percent in the Union Budget for 2012-13 to curb imports and prevent the current account deficit (CAD) from overshooting its target. The CAD, as a percentage of GDP for 2011-13, is higher by 1 percentage point from levels of 2.6 percent of GDP a year ago.

Rising CAD is taking its toll on the rupee, which has lost close to 15 percent against the dollar over the past year.

The rise in gold prices is a catch-22 situations for the Indian economy. Rising gold prices will increase gold imports despite a duty hike and higher gold imports will push up the CAD further, which will weaken the rupee, and the falling rupee will lead to a rise in gold prices.

Reports suggest that gold imports contributed to almost one-third of the incremental rise in CAD over 2008-2011. The government projects gold imports to touch $100 billion in 2015-16 against $34 billion in 2010-11.

Inflation is also affected marginally by a rise in gold prices. Gold has a 0.36 percent weight in the inflation index, but a sharp rise in gold prices can distort the inflation curve, leading to policy headaches for the Reserve Bank of India.

The fact that gold prices have touched records during the wedding season and the festival of Akshaya Tritiya, where Indians buy gold for future fortune, suggests that no price is too high for gold buying. Indians buy gold for every occasion and price is just a minor deterrent. Indians will, in fact, pledge gold to buy more gold, as seen in the fast growing business of gold financing, which is again proving to be a regulatory headache for the central bank.

The multi-fold rise in the assets of gold finance companies such as Mannapuram and Muthoot over the last few years has thrown up questions on the risk associated with such lending.

It can be argued that gold does not add value to the economy whatsoever, and financial assets are better than gold on the back of long-term outperformance and on the back of liquidity. However, no amount of argument can alter that gold prices have gone up over the years and that the notional wealth of Indian households, as a result, has risen. The wealth is notional, as no Indian will sell gold even if gold sales will make life more comfortable for them.

Arjun Parthasarathy is editor of www.investorsareidiots.com, a web site for investors.