Jargon Busters - Economy
Gold Monetization - Gold mine or blind alley?

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The gold monetization idea mooted by the Finance Minister in the last Budget got many analysts excited at first, but that excitement then gave way to apprehensions and doubts. What is so important from an economic point of view of this idea, how will it impact the economy and consumers, what are the doubts, what are alternatives? What are Gold Sovereign Bonds and how are they different from Gold ETFs? Read on as we explore what may well turn out to be a game changer for the economy, if executed well.

In the 2015 budget the Government announced a scheme for monetization of gold. What is meant by 'gold monetization'? Is it something new or have other countries or India itself tried it earlier? What is the significance of this measure? How will this affect the current account deficit?

Rationale for the scheme

Indian people privately own an estimated 20,000 tonnes of gold.This amounts to seven times the annual global production of gold. Economists say that putting money in so much gold is a 'dead' investment. It would be wiser to divert this investment to productive channels that would fuel growth and create jobs. In India, a similar scheme introduced about fifteen years ago did not do well, while similar schemes have worked well in many other countries.

Reasons people invest in gold

On the face of it, there is no contradicting the theory of using money for 'productive' investments. Yet, people who invest in gold are not naive to do so. The first point to understand is that gold is a store of value. Investment in gold is a hedge against inflation. When prices of commodities rise, paper currency becomes less valuable, less capable of buying the same basket of goods as before. However in most cases, prices of gold rises in almost the same proportion that currency loses value. Thus when people save in terms of gold, they are assured of retaining value. Hence they tend to put a certain portion of their investments in gold.

Further, in India people traditionally buy gold in the form of jewellery. This is mostly either for own use or for future use say for a daughter's marriage or even children's education. Investment in gold serves a double purpose; it confers value in use as well as value in exchange.

Gold deposit Scheme

The government is keen to break this cycle and attract investors to invest in paper instruments, which can be redeemed in gold. The scheme envisages that when a person brings physical gold and deposits in a bank he or she would be given a deposit certificate. The deposit would carry interest and at the end of the period instead of paying money, the bank would pay in terms of physical gold.

According to the draft scheme, customers will receive incentives on their gold deposits (of as little as 30g), such as tax-free interest, while banks may be allowed to use the deposits to meet their requirements vis-a-vis statutory liquidity ratio and cash reserve ratio. It is up to the banks to determine the interest rates.There are suggestions that customers be allowed to avail a loan against the gold deposits in case of an urgent requirement of funds. (Livemint June 4, 2015)

Many suggestions have been made on interest rates ranging from 1% to 6%. Banks have also asked that KYC(Know Your Customer) norms be relaxed for deposits lower than 500gms. This is because most of the jewellery is likely to be inherited and thus many people would not be able to produce receipts and invoices for the same.

Purpose

Banks would be allowed to treat the deposits as part of their reserves - boosting their balance sheets.In the time when it is held by the bank, gold can be put to productive purposes along normal banking lines. The metal would be refined and sold to meet demand in the world's top consumer market for gold. This would reduce the country's need for imports and help narrow the current account deficit. Gold is the second-biggest expense after oil on India's import bill.This is the essence of the scheme.

According to the RBI, there are likely chances that banks may hoard excess gold if it is included in CRR (Current Reserve Ratio) that banks have to maintain with the RBI. Further, existing RBI guidelines do not allow gold to be used as bank CRR. In its letter to the Finance Ministry, the RBI pointed out that inclusion of gold may weaken the effectiveness of CRR as a monetary policy tool. Gold as CRR would expose its reserves to the risk of commodity price fluctuations. (Metal.com June, 23, 2015).

Reservations about the scheme

Many people may sentimentally oppose having jewellery being melted down when deposited. This would naturally be a dampener for the scheme. Alternately jewellery might be held as such and rented out during specific occasions like marriages.

Many analysts expressed caution about the proposed gold monetisation scheme, saying it would not cover the costs of the deposit plan and that the government would have to give subsidies to encourage participation. Their main fear is that when customers' part with gold, mere bank certificates issued against gold would be unlikely to assure depositors of the safety of the deposits.Further the proviso for melting down the gold will not find favour with the general public.

Gold Sovereign Bonds - this seems more workable

The draft outline of the sovereign gold bond scheme was notified by the government on 18 June 2015. "The Bonds will carry a fixed rate of interest, and also be redeemable in cash in terms of the face value of the gold, at the time of redemption by the holder of the Bond," the Finance Minister said in his budget speech.It tentatively proposes a 2 percent per annum interest on bonds whose maturities would range from five to seven years. During this period, it would be tradable in stock exchanges and on maturity would be redeemed in rupees on the prevailing value of gold at that point of time. Gold bonds should be added to the list because it is for a laudable cause, stemming the import of gold. These bonds may be ideal for parents wanting to buy jewellery for their daughters a few years down the line.

Scheme's future

According to reports, the government is unlikely to drop its plan for gold deposits. However, it may consider launching of two separate schemes, one for retail customers and the other for institutions. Sources in the Finance Ministry indicate that it will soon take up the matter with the central bank.(Metal.com June, 23, 2015).Thesovereign gold bond schemestands more chance of success, according to analysts. In a way, it is an improvement over gold ETFs which financial advisors are familiar with. Not only does the value of what you hold move in tandem with domestic gold prices, but you also earn an interest of 2%, while in an ETF, there is no interest income. For gold ETFs, fund houses have to buy and store physical gold - which means that the purchase transaction of gold simply shifts from the consumer to the fund house. In Gold Sovereign Bonds, the Government need not buy additional gold, as it can issue Gold Sovereign Bonds against the substantial gold holding that it maintains with RBI.

Schemes like these must be attractive to the public and the Government must learn to 'market' them instead of relying on 'orders' to get the results. Its effort must be focussed on making the scheme attractive enough for the general public to willingly invest their money. "Educating consumers about the benefits of the scheme will be crucial, as will offering them attractive interest rates to part with their gold holdings," CARE Ratings said in a report dated 4 June.

The other sensitivity that the Government needs to carefully navigate is on finding ways to "release" substantial gold holdings held by temples and religious trusts, using similar bonds. The move would certainly bring into circulation vast amounts of wealth lying locked up in vaults in the form of gold holdings, but there are religious sentiments to be taken care of, before purely economic considerations can be looked at.

Structural game changer

A lot depends on how this Government is able to execute the idea of monetizing gold holdings. If executed well, it can be a true game changer for our current account deficit situation. We don't then need to only hope and pray for oil prices to stay low for our current account deficit to be manageable. If we are able to curb gold imports through this scheme, we will be able to tackle our current account deficit problem on a structural basis, with or without support from oil prices, which can change the dynamics of the rupee's gradual but continuous slide over several decades.

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