The Goldilocks Saving Option

The two-pronged move by the finance ministry on Monday, January 21, to choke India's gold imports is likely to be futile. At best, the combination of an increase in import duty and a link between banks' gold deposit schemes and Gold ETFs (exchange traded funds) can marginally slow down India's imports.

Not surprisingly, the finance ministry statement announcing the move was reduced to making requests of citizens. "Government also appealed to the people to moderate their demand for gold," said the statement.

Gold's outsized role in the economy is best captured by some statistics: India's share in world trade is less than two per cent and its share in world gross domestic product is less than six per cent, yet it accounts for 25 per cent of world gold demand.

The World Gold Council has estimated that Indian households sit on the largest stock of gold in the world: 18,000 tons.

Gold imports, on average, have accounted for two-third of India's current account deficit over the last three years. Gold imports in 2011/12 amounted to $56.5 billion. In the first nine months (April-December) of financial year 2012/13, gold imports were estimated to be worth $38 billion by the finance ministry.

All of this makes gold Indian households' goldilocks savings option.

A goldilocks economy is one that is neither too hot nor too cold. Gold seems to have evolved into a goldilocks savings option in India, one that doesn't have the volatility of returns associated with equities or the low rates offered by bank deposits.

At times in the past, particularly during wars in the 1960s, Indian governments tried to monetise the existing stock with households through gold deposit schemes. Savings in the form of physical assets such as gold adversely impact the economy, as there is not enough to be lent to people or companies willing to make investments and create jobs.

However, the kind of moves made by the government may not help much on account of the way the economy and society have evolved.

A visit to outlets of gold loan finance companies would show that most people monetising gold for loans are traders or other small businessmen in need of working capital. Banks, given the way they function, don't seem to help these people.

Other customers tend to be people in need of emergency cash to meet healthcare expenses and other kinds of personal expenses.

People, typically, tend to pledge jewellery. According to a December 2012 Kotak Institutional Equities report, about two-thirds of India's gold demand is for jewellery. The report added that the average loan value of gold taken from banks and finance companies is less than Rs 1 lakh (typically for around 35 grams of gold). Simply put, the ticket size in India is small - far smaller than the 500 grams banks seem to prefer in gold deposit schemes.

However, it is not just the mechanics of schemes that has led to this voracious appetite for gold. The larger problem that the government has been unable to solve is inflation. In combination with an economic slowdown over the last few years, inflation has led to declining returns on financial assets and triggered an exodus to gold.

Inflation, as measured by the wholesale price index, averaged 5.25 per cent between 2000/01 and 2007/08. From 2008/09, the year of the global financial crisis, India's inflation averaged 7.6 per cent till the end of 2011/12.

Hole-in-the-wall jewellers in urban India have been offering recurring deposit schemes to allow people to buy gold. People make monthly deposits with jewellers that are supposed to eventually translate into some pre-determined gold holding.

"On a year-on-year basis, gold offered the highest returns among asset classes for a majority of years after the global financial crisis," said the Reserve Bank of India's financial stability report of December 2012, explaining the large-scale move of household savings into gold.

Is there a solution, a way to wean households away from gold?

The finance ministry has a solution, but not one that lends itself to a quick-fix. "The ideal solution to this problem would be to bring down inflation so that households see good returns from traditional financial instruments," was the ministry's conclusion in its mid-year review of 2012/13.

Till that happens, gold will remain a rational investment for the Indian household.