Indian Finance Minister Palaniappan Chidambaram released a statement the other day indicating the government's deliberation of an additional hike to taxes on gold imports. Given that India has been the world's largest gold consumer for quite some time (although China is close to usurping that title), any policy measures aimed at crimping gold demand in the country warrant consideration. Policymakers bemoan gold's role in India's record high current account deficit. The Reserve Bank of India (RBI) published data indicating that the nation's current account deficit for the third quarter of 2012 reached an all-time high of $22.3 billion - a figure that represents 5.4% of India's gross domestic product.
The International Monetary Fund (IMF) describes the current account as:
the difference between the value of exports of goods and services and the value of imports of goods and services. A deficit then means that the country is importing more goods and services than it is exporting-although the current account also includes net income (such as interest and dividends) and transfers from abroad (such as foreign aid), which are usually a small fraction of the total.
In a report drafted by the RBI, members of the central bank espouse gold's role in the country's current account deficit:
The management of demand and supply of gold has important policy implications for fiscal policy and exchange rate management. With domestic production of gold falling to insignificant level, the gold consumption is met entirely through imports. Though it is generally considered that a CAD [Current Account Deficit] of 2.5 to 3.0 per cent is sustainable for India, in the more recent years CAD is very high. In 2011-12, external sector resilience has weakened mainly due to higher current account deficit, which in turn was largely on account of worsening trade deficit. Two commodities that led to higher imports were oil and gold. Gold contributed nearly 30 per cent of trade deficit during 2009-10 to 2011-12, which is significantly higher than 20 per cent during 2006-07 to 2008-09. The large gold imports, thus, have led to major concerns in the macroeconomic management.
The drag on India's current account due to gold imports has been present for some time, but as the excerpt indicates, the drag combined with slowing economic growth and a weakening export outlook has created an environment in which further gold import taxes are being considered. India adopted similar measures in 2012; in January the tax on imported gold was changed to 2% of the value as opposed to the prior tax system based on weight. Then again in March the government raised the tax from 2% to 4%. Much of this policy shift was in response to record Indian gold imports in 2011 totaling 969 tons. Slowing economic growth and the fact that the rupee is down over 20% against the dollar since September 2011 - which makes gold more expensive for Indians - have weighed on India's 2012 gold imports, which the World Gold Council estimates will be around 800 tons. These reasons probably had more to do with slumping 2012 gold demand in India than the gold import tax hikes adopted in January and March.
The RBI report linked above addresses the relatively inelastic Indian demand for gold and cites the opinion that policy measures alone will be insufficient to stymie the nation's well-established desire for the yellow metal:
Demand for gold appears to be autonomous and a function of several influences and factors in India and may not be strictly amenable to policy changes. Supply of gold, through organised channels can be constricted, but buyers may take recourse to unauthorised channels to buy gold. The share of banks in importing gold has already been on decline over the years. Since it is difficult to vary the demand for gold the policy focus will have to be directed to (i) design and offer gold investors, alternative instruments that may fetch positive returns with a flexibility of liquidity; and (ii) increased unlocking of the hidden value locked in idle gold stocks through increased monetisation of gold.
In the ultimate analysis, demand for gold is a function of economic growth, import duty, exchange rate, inflation, interest rates, alternative financial instruments, easy availability of credit and the current account transactions. Any strategy to reduce the demand for gold will have to consider the trends in each one of these parameters to evolve an appropriate gold policy. The crux of the problem is the absence of financial instruments that provide flexible liquidity options, while providing real rate of return to investors. Part of the solution lies in innovating them to provide hedge against inflation to the investors.
As the RBI report pointed out, Indian demand for gold will not be so easily stemmed by merely raising the cost of acquiring the metal. Rather, the government will need to address some structural components of the Indian economy as it progressively offers citizens an ever-rising array of gold alternatives. However, in the short-to-medium term, there are a couple considerations that will complicate and ultimately protract this reform process (assuming Indian policymakers follow the recommendations provided by the RBI report).
Besides an entrenched cultural affinity for gold, policymakers in India seeking to minimize gold imports will need to address one of the economy's preeminent concerns: inflation. Data compiled by Bloomberg shows that inflation has stayed above 8% for 21 out of the 26 months between March 2010 and April 2012 despite the RBI raising interest rates 13 times during this time frame. November's wholesale price index showed India's inflation rate moderate to 7.24%, but even at this slightly lower level, India still has the highest inflation rate amongst the BRIC nations (Brazil, Russia, India, and China). As the RBI report points out, investment options that provide a real rate of return (i.e. a return higher than the prevailing inflation rate) are a must before policymakers can expect to wean Indian consumers away from gold.
Another integral consideration within the context of minimizing Indian gold imports is the availability of banking and financial services to the country's one billion plus population. As referenced by the Business Week article linked immediately above, 92% of small businesses and 65% of the Indian population do not have access to bank accounts. This is a fairly monumental stumbling block for the Indian government to surmount if it wants to supplement citizens' gold with alternative financial products.
We can take for granted that inflation and an underwhelming availability of viable investment alternatives to gold are two of the major obstacles the Indian government is facing as it tries to curtail gold imports. With this in mind, neither consideration has a short-term fix. The Indian government has to juggle slowing economic growth and uncomfortably high inflation, meaning their ability to aggressively raise interest rates to combat inflation is limited because it could exacerbate slowing growth. With regards to the prevalence of banking relationships, or lack thereof, it's a matter of these institutions expanding and building out infrastructure to service India's sprawling population.
When we consider the time frames associated with taming inflation or expanding financial services to a population with observable inexperience in traditional financial and investment services, it becomes obvious that the measures submitted by the RBI's report cannot be successfully incorporated overnight.
The RBI report also indicates that an increased monetization of gold via new gold-backed financial products could be a way to diminish the allure of physical gold. India has a well established, and growing, industry of non-bank lenders that underwrite loans using physical gold as collateral. The Business Week article referenced above cited a report by the Financial Stability Board which indicates that assets of Indian non-bank lenders have grown by 20% every year for the last five years - totaling $670 billion. However, using your physical gold for a loan with the anticipation of getting the metal back upon maturity of the loan is still a far cry from the paper-gold products (many of which do not provide delivery options) that have gained prominence in the U.S. and Europe. In a culture where 65% of the population doesn't have a banking relationship, is it safe to assume these individuals will trust paper alternatives to the physical metal their families have held for generations?
The proposed measures and mechanisms aimed at stemming physical gold demand in India, it seems that the vast majority require structural - or cultural - changes that will take time to incorporate. Being one of the few feasibly implemented measures in the short term, it is entirely conceivable that the Indian government may proceed with raising the gold import tax in the near future as it combats the stigma of a record high current account deficit.
However, it is important to realize that marginal rises to the cost of importing gold will not dramatically influence a cultural demand for the metal that goes back hundreds of years. If anything, this measure may divert some funds away from gold towards other precious metals like platinum. Many analysts anticipate growing demand for platinum jewelry in India as the metal maintains its discount to the gold price.
In 2011 India imported 15 tons of platinum, which was a little less than 8% of the global supply. Of this amount, approximately half went to the production of catalytic converters for cars and the rest was used for jewelry. During 2011, it is reported that platinum jewelry consumption in India grew 40-50%. Total platinum imports into India are expected to be around 20-22 tons - which would represent a rise close to 40%. Considering this burgeoning platinum market, higher gold import duties may indeed achieve slightly lower gold imports as Indians change their purchase patterns to accommodate increasingly attractive platinum. However, given platinum's nascent presence in India as a store of wealth, gold will probably remain the premier asset for Indians despite higher import taxes and a government anxious to change this dynamic.
Given the Indian government's relative impotence to affect the change it desires in the short term, and the likelihood of its adoption of higher import taxes as a result, we can probably expect gold prices to react negatively in the aftermath of such an announcement. However, the move will be fleeting as aggregate gold demand in India will probably not be significantly affected by the measure. If anything, a reduction in gold imports following a tax hike will most likely be a corollary of increased Indian demand for other precious metals like platinum.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.