Rethinking India’s Gold “Imports”

Received wisdom among India watchers holds that gold imports are a threat to Indian economic development, the rupee, the current account, and everything else we hold economically dear. This fear manifested itself in an outright (if ineffective) ban for the better part of the country’s history post-Independence, and has more recently involved all sorts of quirky taxes and duties to prevent the import of gold.

A few things are clear. Indians are crazy about gold. Last year India overtook China as the world’s largest consumer, which was particularly detrimental to the official balance of payments, where gold was 3% of the country’s 4.7% trade deficit. This frenzy reached a point where, this April, an executive director of the RBI proposed a loony scheme of a government gold monetization plan arguing that the government wouldn’t invest the capital in other schemes as it would open itself to delta risk unless it is perfectly hedged (as, astonishingly, financial transactions tend to work…)

The Indian financial commentary hive mind would be better off understanding the systematic reason for gold imports (and fixing that) rather than obsessing over imports using terms that make little sense in this context, such as current account deficit. Even the Economist seems to completely miss the context of such “imports”:

Some argue that India’s gold imports should be reclassified as a capital flow, which would make the current-account deficit look less scary. But the official fear of gold is rational. Whatever the accounting treatment, money flowing out of India to buy bullion strains its balance of payments. And wealth stored in ingots or jewellery rather than bank deposits or shares is unavailable for investment. India’s household savings rate is high, but as much as half is now squirrelled away in physical form.

Pune’s wide boys aside, the traditional gold consumers are southern peasants buying jewellery. They have no access to formal finance; gold requires no paperwork, incurs no tax and is liquid. But over the past decade the mania has spread. By weight consumption has doubled, for several reasons: a surge in money earned on the black market; investors chasing the gold price; and the dismal returns savers get from deposit accounts. Real interest rates are low, reflecting high inflation and a repressed financial system that is geared to helping the state finance itself.

Unfortunately that’s just now how savings works (indeed, by identity, savings are investment – not necessarily business investment, but investment nonetheless and the heart of this debate is whether gold purchases imply deferred consumption and hence greater inventory accumulation, accounted for as investment in national income accounts). In fact, just reading the emphasized, there should be no fear of gold: since deposits seem to be highly oversubscribed and therefore a poor investment, gold seems like a fair alternative for store of value.

But let’s dispel fears of “money flowing out of India” first. Let’s say an Indian exporter sells canonical widgets to an American producer, receiving dollars in return. That is a current account inflow. It can do a few things with this income. Let’s explore three common alternatives:

1. Reinvestment in US Treasuries,
2. Purchase of gold, then repatriated to India (though physical location really doesn’t matter),
3. Investment in India (let’s say a national infrastructure bond).

Surely the accounting effect of the first two options is the same. In the former case India is exporting capital directly to the US government and in the latter case it is exporting capital to the American bank from which it purchased its gold which is then recycling that capital back into the American economy. These are indisputable accounting relations that hold in every transaction.

Now the Economist wants to blindly compare (1) and (2) with (3) without detailing a third transaction in the process. Say the firm wants to “invest in India” and purchase government-issued bonds to build a high-speed rail service between Bangalore and Bombay. That would be rather noble of them, indeed. Unfortunately, having exported to a US firm, the firm has no INR with which to participate in this auction. Therefore, it first needs to identify a US exporter that sold goods to India and received INR in return. Even after it does this, and trades its USD for INR at USDINR, it’s not like investment in India suddenly improves – indeed the original INR was already invested in India in the first place. (Of course, this doesn’t mean both investments are equal and one might perform much better than the other. If this is your anti-gold argument I suggest you open a hedge fund shorting gold rather than writing for the Economic Times).

A household buying gold really is no different. It either has to buy it in rupees or dollars, but ultimately someone ends up with the rupee which is in some form invested in India. A current account surplus is a capital account deficit – that’s how these things work.

The question we’re implicitly answering is whether gold constitutes deferred consumption (investment) or not. To the extent there is a strong consumption aspect to gold (and there might well be) the fear is self-contradictory as it reflects nothing about inability to invest the savings as the Economist reports: indeed in this case these purchases wouldn’t be savings at all.

But the more likely situation is that gold does, in many ways, confer deferred savings and many other attributes of wealth including:

1. A store of value,
2. A source of liquidity – as gold-collateralized loans are an effective means by which an otherwise underbanked population can access financing,
3. A source of wealth effect consumption increases.

Indeed the official fear about gold treats it as if it is a poor investment, which ipso facto means it shouldn’t be included in the current account. Even then, for many poorer Indians gold offers access to a banking system that otherwise requires 10th grade board exam results to borrow money at reasonable rates. Gold is an investment in an alternative source of financing to loan sharks that charge annualized rates north of 60% on a good day. Gold also doesn’t depreciate or perish. It might loose value but that is completely a capital loss.

This is a mistake that anyone who doesn’t understand why S = I might be prone to make. Business investment, i.e. a firm investing in machinery or platform development, isn’t the only form of investment. If I earn $1000 and place it under a mattress that is an interest-free investment in the form of deferred consumption (indeed if I burn it, it will be an investment to that amount rolled over in perpetuity, with an ultimate value of (1/discount rate)*1000).

This isn’t intuitive to most people. It’s very, very common to hear that gold is an unproductive investment or that “Americans are saving too much and not investing enough”. In fact, what they really mean to say is that interest rates as they stand are creating an investment situation in which an inefficient amount of funds are invested in very low return areas (such as inventory) and are not optimally productive.

In India this means opening up sources of safe, high quality investment allowing just the sort of liquidity transformation that finances the “development” everyone wants. In fact, if anything, gold import bans and taxes worsen the current amount by the premium one has to pay for smuggled gold, which in some part accrues to foreign smugglers and miners who have some claim on the delta between black market and open market gold. That is a pure current account loss and one which Indian policymakers need to address by removing import controls completely.