The Cure for Gold

I have been advocating that the RBI, on behalf of the Government, should issue gold bearer bonds to decrease the import of gold and to rein in the increasing current account deficit (CAD) and the problems emanating there from.

First, let me quickly represent the essential features of this bond.
* the bond should be issued in denominations of gold grams
* the bond will be bearer in nature with ownership transmitting by mere physical transfer
* the bond would be perpetual, but the holder can redeem the value at any time by presenting it to RBI
* the redemption would be in rupees and equal the value of gold prevailing at that time in India
* the bond can be purchased either in cash or by submitting an equivalent amount of gold

I have made the case that issuing such a bond is a much better alternative to increasing the import duty on gold as that would only drive the trade in gold underground to the smugglers and the black economy. Duty increase triggers gold smuggling rush. There is already an artificial scarcity being seen which is reflected in the domestic price of gold being at a premium to the landed cost. Due to the premium and the rupee decline, domestic gold prices have increased even while dollar prices have declined and this has reinforced the retail perception of gold being the only safe haven.

Let me now try and elaborate on the benefits of issuing such a bond:

Will decrease the current account deficit: A previous report by the RBI on gold imports states, "The working group is of the view that external stability appears to be an issue with large gold imports. Gold contributed nearly 30 per cent of trade deficit during 2009-10 to 2011-12. Due to falling gold re-exports, India's trade deficit as well as CAD as ratio to GDP worsened by 0.3 percentage points in 2011-12. Projections show that net gold imports as ratio to GDP is likely to be in range of 1.8 per cent to 2.4 per cent in the next few years."

The actual situation is much worse than feared. In 2012-2013, gold accounted for $54 billion of imports in a current account deficit of $88 billion. In the first half of calendar year 2013, India had already imported a record 566 tonne of gold, well on its way to exceed a 1,000 tonne in the year! That is nearly 40 per cent of the world gold production!

If the bearer gold bonds succeed in cutting the imports of gold by half, then we are cutting the CAD by over a fourth and equal to a reduction of $27 billion (compare that to trying to issue sovereign bond to the extent of 4-5 billion). Rupee depreciation will reduce significantly and we may even see the rupee appreciating if we structurally reduce our CAD by over a fourth, year-on-year.

Will decrease Inflation: One of the major causes of inflation in India has been the increasing rupee cost of petroleum products and other imported goods because of the depreciating rupee. The structural benefit in CAD will help in halting the depreciation of the rupee. This in turn will reduce the domestic inflationary pressures, which have currently become a significant issue. In turn, the RBI will be able to ease its monetary tightening, which has been impacting economic growth.

Opens up a new avenue to finance the fiscal deficit: The Government has been trying to figure out an inflation hedge financial instrument to offer to retail investors and wean them away from gold. This fits the bill perfectly. The additional benefit is that it gives the Government a new avenue of financing the fiscal deficit, away from the traditional institutional market. $25 billion dollars is equal to Rs 1,50,000 crore, nearly half the net financing requirement.

Domestic interest rates will decline significantly: Lower inflation and a reduced dependence of the Government to borrow from the institutional market will significantly reduce the crowding out of the market. The RBI will be able to reduce the incremental SLR ratio of the banks. More money in the hands of the banks for lending will result in an easing of the domestic interest rates and give a further boost to growth.

Start a virtuous cycle for the Indian economy: The wide spectrum of benefits of issuing such bonds has the ability to put us in a virtuous cycle of a reduced CAD, strengthening the rupee, lower inflation, lower domestic interest rates and higher investment liquidity leading to higher growth, leading to more foreign investment and back to a strengthening rupee.

Could significantly bolster India's foreign exchange reserves: The ease of storage will induce many holders of gold coins, biscuits, bars and ingots to exchange their physical gold for these bonds. As gold is part of foreign exchange reserves, this will increase India's foreign exchange reserves without a corresponding increase in our foreign exchange liabilities. Indians are estimated to hold more than $1 trillion of gold with them. If only 10 per cent of this is exchanged, it will boost India's foreign exchange reserves by $100 billion, leading to a significant strengthening of India's financial strength, ratings and investment flows. This will again have a positive impact on the value of the rupee.

A lot of people have asked me whether this could result into a significant open ended liability for the Government by way of increasing gold prices.

India is expected to import nearly a 1,000 tonne of gold this year, which is 40 per cent of world gold production! Anyway, we have been importing about 25 per cent traditionally. If India reduces its gold imports by half, world gold prices will crash and the Government will actually benefit by issuing these bonds, not to say the positive effect it will have of weaning people away from an unproductive investment like gold! A strengthening value of the rupee will also benefit the issuer.

Lastly, if there is continuing trust in these instruments, there will always be a net positive inflow as long as people value gold and if gold is expected to track inflation over the long-term, then the Government's liability will also be inflation linked -- linked to the purchasing power of the rupee.

Saurabh Sonthalia is a Chartered Accountant and a PGDM from the Indian Institute of Management, Ahmedabad. He has over 23 years of experience in the Indian capital markets.