The Magpies Of India: How The Cash For Gold Market Came To Dominate The World's Oldest Democracy

Includes: GLD
by: Kyle Spencer

Economists like Paul Krugman often point out what a bad idea a Gold Standard is. Others argue with the notion that gold can be an investment. Gold doesn't pay interest, or dividends. You can't eat it, drive it, talk on it or use it to pay your utility bill. As Warren Buffet famously quipped:

Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility.

That may be true - in the West. But in India, gold can do anything for you that a rupee can do. In fact, gold can do something for you that rupees can't do, namely, land you a spouse.

"No gold, no wedding" is a simple fact of Indian life. Weddings account for 50% of Indian gold purchases annually, and roughly 70% in aggregate due to incremental purchasing. Parents start accumulating gold for their daughter's wedding day as soon as she is born.

This gold represents the financial assets that the bride brings to the union. It also gives the bride economic status in a country shot through with poverty. The following quote from a survey conducted by Development Outlook illustrates this imperative in the mind of many Indian fathers:

Surveyor: Do you often buy gold?

Respondent: No

Surveyor: Any specific reason why you don't show much interest in buying gold?

Respondent: I have two boy children and so I don't care! If I had a girl child, I would start accumulating gold from the minute she was born.

Weddings and "lucky day" holidays are the stories trotted out by hard currency advocates such as the World Gold Council. In a nutshell, India is presented as a modern day Shangri-La: A land filled with gold aficionados wise to the corrupt ways of fiat currency and the West. And like all most bedtime stories, it's not true.

Beyond Exceptionalism

India's love affair with gold has been described in terms of various sales pitches that touch the surface of the phenomenon without penetrating the real reason for its perpetuation. For starters, it has nothing to do with the anti-Fed/U.S. government tropes popular among gold aficionados in America, who naively assume that they have successfully exported their own ideas and investment theses abroad.

In reality, 99% of gold purchasers in Delhi and Mumbai couldn't care less about quantitative easing and couldn't tell you who the present Fed Chairman was, any more than 99% of the Americans purchasing gold in Atlanta, Georgia could tell you who the current leader of India is without Googling it. The government that most Indian gold investors distrust is located in Delhi, not Washington D.C. Indians believe in the USD. Petrodollar diplomacy all but guarantees that. What Indians don't believe in is the rupee.


That's because in India, it's always 1974. India has had one of the highest rates of consumer inflation of any country on earth. The charts below illustrates the runaway inflation that's firmly fixed in the minds of Indian gold investors.

(Source: Trading Economics)

But what really makes the yellow metal a different animal in India is that you can use it just like cash.

What Indians Are Really Doing With Gold

Indians are spend in rupees, but they save in gold. These "savings accounts" are rarely liquidated outright, but are instead passed on for generations as an inheritance. However, the family gold can be mortgaged, if necessary - and rising gold prices over the last decade have ensured that it pawning gold becomes as necessary as possible.

Gold is routinely pledged daily to companies like Muthoot Finance or Mannapuram Gold and walk out with rupees in as little as few hours. If a customer only wishes to borrow 50% of the value of their gold, they can borrow at a rate of 8-10%, depending on the creditor. Customers who require significantly more cash are saddled with higher interest rates - usually 12-15%. Yet, even this rate is quite low compared to personal and agricultural loans available at interest rates of 15-26% per annum.

(Source: Muthoot Finance)

This shadow economy of lending against gold has also made middle class Indians into de facto commodities speculators. So long as the price of gold is rising, it's possible to game the system by taking out a second loan with a higher margin of safety and consequently receive a lower interest rate to pay off the original, higher rate loan.

(Source: Muthoot Finance)

Where middle class Americans used the equity in their houses to play a booming real estate market, middle class Indians use gold to play a decade-long commodities boom. They just don't tell themselves that when they buy the gold.

According to the revised norms of Microfinance Institutions (Development and Regulation) Bill [PDF], microfinance clients are required to use 70% of their loans "for income generating activities or productive purposes." However, there's no clear line between productive and non-productive purposes.

There's also a wide gulf between what Indians tell themselves they're going to do with their gold and what they actually do with it. The chart below lists the reasons that Indians tell themselves at the point of purchase.

(Source: Development Outlook: Research on Financial Service for the Poor)

Note the disparity? 19% of Indian gold consumers tell themselves that they're going to use the gold for marriage. Maybe they do. But 31% believe that they're purchasing gold for "emergency purposes", 27% as a store of "traditional value", 20% for "savings" and only 3% for "investment."

Now what actually happens? 24% of gold borrowers use the money they receive for "consumption smoothing" - that is, for making ends meet. But most low income Indian households do not have a stable path of consumption due to the nature of their employment resulting in a lack of regular income, so these loans are the ones that are most often forfeit. 18% spend the money on their health. 17% use their gold loans for business enterprises, a risky venture in a high inflation environment. 16% purchase household assets, 10% use the money for their education, but only 9% use gold for marriages.

Simply stated, Indians are engaged in riskier activity than surveys of their intentions at the point of sale would imply. We'll revisit this point in just a moment. For now, just remember that Indians are much further out on the risk curve than most Western investors are being led to believe.

A Fly In The Ointment

Delhi's unofficial policy of straddling the center of the road between a de jure fiat currency system and a de facto gold standard produces the worst of all possible worlds. The government is obliged to either defend the rupee at the expense of gold, or defend gold at the expense of the rupee; but is incapable of defending both simultaneously. Without closing the account deficit, Delhi can't engage in deficit spending to combat unemployment and recession or lower interest rates.

The result is a vicious cycle: The less the rupee is worth, the more gold Indians hoard to hedge against inflation, the greater India's deficit; the greater the deficit, the less the rupee is worth. Businesses rarely thrive in such an environment. If Indians insatiable demand for gold drives the price of gold higher, it also erodes their ability to purchase more gold.

Monetizing India's gold reserves would be an efficient method of restoring Indian confidence in its unit of account. However, an official gold standard would tie India's ultimate fate to the commodities cycle and eliminate Delhi's ability to run deficits during economic downturns. What India's government is looking for is a way to keep the shadow economy, which is a de facto gold system, going and, at the same time, to re-inflate the rupee.

And the best way to do that is for India to deal gold to itself. There are over 35,000 tons of gold in India, and some of the biggest holders are Hindu temples. The Sree Padmanabhaswamy temple in Kerela (pictured below) alone holds an estimated $18 billion in gold and jewels.

Putting some of those reserves into banks would reduce imports and provide depositors with cash. However, the trial balloon recently floated by the Signh government for the outright appropriation of sacred gold ran into stiff opposition from India's nationalists, and the idea was quickly withdrawn. Aarin Capital's T.V. Mohandas Pai's notion of reducing sales taxes on gold (currently around 20%) is likely to face less resistance. If the government abolishes the tax, "you can expect 150 to 200 tons to come into the market" each year, he says.


Sharp-eyed readers will note that a) dipping into the family gold for consumption smoothing and investment purposes is fine when the price of gold is going up, and b) the system can be gamed; as long as the price of gold is rising. In fact, Indians are engaged in precisely the same dynamic as American home owners who dipped into their home equity in order to fund their own consumption smoothing and investment activities. So long as the value of real estate was rising, there was no problem. But the moment prices collapsed, home owners were underwater in a hurry.

The same applies to the Indian gold market. If the price of gold falls a little, Indians have and will use it as a buying opportunity. But if the price of gold falls a lot, say, below $1,100 an ounce, the Indian cash-for-gold system will collapse in short order.

Disclosure: I 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.