Emerging Markets: India's Central Bank Instability Could Push Gold Prices Higher

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Includes: EPI, GLD, GTU, IAU, IIF, INDA, INDL, INDY, INP, INXX, OUNZ, PHYS, PIN, QGLDX, SGOL
by: Gold Traders

Summary

Recent policy changes at Reserve Bank of India could have unforeseen consequences.

Emerging markets continue to constitute a major portion of global precious metals demand.

Underlying inflation and central bank instability could bring significant momentum to gold prices if markets fail to stabilize.

Raghuram Rajan, one of the most outspoken governors at the Reserve Bank of India (RBI), recently announced the end of his term after a mere three years in office. The Rexit, as it is popularly called, surprised the nation (who still holds Rajan in high regard), and it was widely expected to shake the Indian markets as well.

But because of Rajan's foresight and well-timed statement release (which was made public while markets were closed on a weekend), the damage could be contained and volatility avoided to a large extent. So the real question precious metals investors should be asking is whether or not these recent changes at the Reserve Bank of India will have a marked influence on gold markets.

Emerging Markets Influence

When Rajan assumed office in 2013, he was looking at a nation crippled with extreme rates of inflation. This is a large part of the reason why it should not be surprising to Western investors when we see emerging markets in Asia flock to gold as an alternative store of value. Rajan took strong measures to ensure that India's problem inflation will subside and the country's banking sector will fall in line with the overall regulatory policy that has been established by the RBI.

India, as with most agricultural economies, is still hugely dependent on the monsoon for a successful annual crop. Despite relatively good monsoon forecasts, a late monsoon season has the power to send the stock markets in a tizzy, and the resulting turmoil can easily make its influence felt in precious metals markets. The weaker-than-expected rain activity so far this year has caused several negative economic shocks within the country, and this has fallen in line with some significant moves in the underlying price of gold.

Chart View: Spot Gold Prices

Chart Source: Atlanta Gold & Coin

When Rajan reduced the repo rate in April to 6.5%, a lot of factors were favorable for businesses, and as a result, the market welcomed the move. But since then, the rate of inflation has risen and even gone beyond the target level of 5% on more than one occasion. Monsoon activity has been below expectations, and crude oil prices have increased. We have also seen certain supply inefficiencies in the import of crude oil, a factor which may further raise inflation figures. The rate easing cycle, therefore, had to come to an end - and the RBI didn't disappoint with its announcement for no change to status quo in its latest policy release.

Lack of Monetary Transmission

One huge problem plaguing the Indian monetary system is a lack of monetary transmission, and as long as this continues, we could see continued flows into gold-related assets. Despite a cut in repo rates by the RBI, banks were not following suit and the benefits couldn't be passed on to Indian consumers and businesses. One reason for this was the problem of daily liquidity deficits. To ease the pressure, the Reserve Bank of India bought INR 70000 (more than USD 1 billion) in bonds in open market operations during the April-May period of this year.

Ultimately, this will help in the mechanism of monetary transmission - but only in part. Regional banks took $26 billion in Foreign Currency Non-Resident (FCNR) deposits soon after Rajan took over in 2013. The primary motive was to support the rupee (which was under major pressure then). The banks swapped these deposits with the central bank. These deposits will start maturing in September. For the purpose of redemption, banks will return the amount in rupees to the RBI and obtain dollars to redeem the deposits.

Rajan has assured that the RBI is prepared for the redemption, but easing of the liquidity position as well as monetary transmission will be possible only after successful completion of the redemption process. Further rate cuts will be a reality only if the redemption process goes as planned and the other factors remain favorable. All of these factors, in combination, should be viewed as critical for gold investors, as we are likely to see ripple effects well into the latter part of this year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.