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All that glitter is not gold

The Reserve Bank of India (RBI) needs to begin with the recognition that a substantial part of the demand for gold results from its policy of subsidising borrowers at the expense of lenders

Recently, the vaults of the centuries-old Padmanabhaswamy Temple were opened after some 150 years to reveal a treasure trove of gold, silver and precious stones running into $ 40 billion. India has a long history of burying its wealth in vaults as a hedge against political risk or outright expropriation. India’s small principalities, split among many independent princes, never had a universal currency valid throughout the subcontinent. Instead, gold and silver coins, valued by weight rather than nominal value, played the role of a currency. Indigenous banking systems never went much beyond the local money lender who lent against gold, helping provide liquidity to the metal. Hence it is gold, rather than a universal currency, which served both as a store of value and a medium of exchange.
Circa 1890, a young man of 30 was sitting under a Banyan tree, at what is now Hornsby Circle opposite the Mumbai Library close to Dalal Street, beseeching passing merchants to buy shares in his new venture. His name was Dorabji Tata. He needed but a tiny fraction of the capital locked up in the Padmanabhaswamy Temple’s vaults. Not many thought Indians could make steel; others dismissed him as a crank. He had to go door to door in Colaba, literally begging people to buy his shares. That was India’s first Initial Purchase Offer (IPO). It took him months to put together the capital he needed. His Tata Steel has since created more wealth than was locked into the temple vaults. Moral of the story: wealth locked up in vaults may preserve wealth but it does not create wealth if it is not put to use by entrepreneurs. How many Dorabjis have missed out on their dream because India lacked the systemic ability to put its entrepreneurs and capital together?
We take great pride in the fact that our engineers and management graduates go on to lead venerable corporations in the US. We see that as an affirmation of our being as good as any in the world. Yet that success mostly comes abroad and not at home. Why? What we miss out is the enabling software imbedded in the US system that sustains and nurtures ideas, merit and entrepreneurs. It is not just one thing. It is the system that recognises and rewards talent, respects ideas and intellectual property, provides venture capital to entrepreneurs, and a capital market that helps monetise their ideas into wealth. Think Twitter. It has not made a dime yet. Where is the system in place to sustain such an enterprise in India? The key to success of the US is deeply imbedded in this culture of recognising and rewarding innovation that we as a society simply ignore. India is poor, not for lack of wealth, but for the poverty of ideas and institutions that sustain and create wealth. Investment in gold is a singular affirmation of our lack of faith in our own social and economic institutions of wealth creation and preservation.
India imported approximately 1,000 MTs of gold valued at $ 64 billion this year. The capital used to buy gold went abroad; not to sellers in India. Most of these imports are by households. What happens to the gold so imported? Much of it remains un-monetised with households — the equivalent of locking up treasure in temple vaults. It is a store of value to households, and still works as a hedge against government debasement of currency. But it is of little use to entrepreneurs like Dorabji Tata. Needless to say, it creates no further wealth for society. That needs to change, not by fiat, but a proper mix of institutions, financial instruments and government policy.
A bank deposit should be a superior store of value to a household than locking up wealth in gold. When you park your savings in a bank deposit, the bank creates a loan against it. That in turn is used to create an income generating asset. At the end of the day, it is the income generated by such an asset that pays the bank its agency fees, your deposit together with interest, while still leaving a profit for the entrepreneur who puts the asset to use. As this form of saving is by far superior to locking up wealth in a metal, it behoves the system to ensure that households save in bank deposits rather than gold. Bank deposits fetch households a higher real return than gold. That this is not so in India should be a cause for worry.
The government’s interest policy has traditionally been skewed in favour of borrowers over depositors. This was done largely to (a) provide ‘cheap’ capital to industrial borrowers on the one hand and (b) give the government access to cheap capital with which to build infrastructure. Most households do not pay income tax. So shaving off a few percentage points from the interest rate was seen as a ‘harmless’ way of taxing them in the larger public interest. In practice this had the unintended effect of reducing the overall supply of capital as households substituted physical assets like gold for savings in financial instruments. The skewed policy also drove up the cost of capital to new entrepreneurs. Innovation and entrepreneurship suffered as a consequence.
To the economy as a whole, $ 64 billion is a dead loss since capital used to import gold will never come back to India unless the gold is sold abroad again. This loss is incurred not because households are irrational but because government policy is irrational. If it did not debase its currency, or favour borrowers over lenders, the investment demand for gold would drop sharply, freeing up that much more capital for productive use within the economy.
The Reserve Bank of India (RBI) needs to begin with the recognition that a substantial part of the demand for gold results from its policy of subsidising borrowers at the expense of lenders. As such, a major portion of the $ 64 billion loss is simply the subsidy it has been giving to the borrowers by stealing from the depositors. That sum should be added to the total interest payments by the government for its borrowings to reflect the true cost of such skewed policies. Only then can the RBI begin to pare down the total cost of government borrowing and not just the nominal interest cost as of today.
If the RBI is honest about introducing a fair rate of return to bank depositors through a neutral interest rate policy, then it can also consider writing one to three year call options on gold. To the extent investment demand for gold abates, gold funds can continue to sell units in gold to investors without importing physical gold immediately. Instead the fund could rely on call options from the RBI, or its suitable agency, to hedge itself. The RBI in turn could set aside a small portion of its gold reserve to write such covered calls, and actively manage its portfolio of physical gold, call options, and puts where necessary, to provide this service to gold funds. Every MT of physical gold import avoided is real wealth saved to create more wealth in the local economy. The suggestion will not obviate gold imports but has the merit of moderating them in a transparent fashion. The RBI needs to be more proactive in managing gold. After all, the metal is our second largest import, next only to oil.

The writer is a trader. She can be reached at sonali.ranade@hotmail.com

Categories: Uncategorized
  1. sammeer
    August 29, 2011 at 2:43 am

    Agreed. RBI should introduce scheme similar to reverse mortgage for gold in order to unlock value in gold and reduce imports as well. Gold market should be regulated as resale of gold at times even with branded items is an issue. Any ways gold loan schemes are mushrooming.

  2. Venkatesh
    August 29, 2011 at 5:46 am

    Interesting view point. However since gold is one of the older trade-able commodities that is not prone to turbulations of the paper market, I think it has more value. An asset is an asset. The issue is that RBI has insufficient metrics or methodologies to ascertain the collective value of that asset.

    As per your article, the fact that 10,000 MT was bought, can be held as an asset in the national balance sheet, because upon a catastrophic event such as collapse of civil society, the paper that shares are printed on are going to be worthless and what is going to matter is the bricks-and-mortar and other non-liquid assets!

  3. August 31, 2011 at 5:16 pm

    I agree with this one but still i do not understand your fury for Anna,calling him stupid is not decent.

  4. September 5, 2011 at 2:46 pm

    Regular investments in gold units and regular disinvestments with a fixed target rate of return may be a good strategy alternative to being burdened with a heavy stock and constant heart pulsations.

  5. September 22, 2011 at 12:59 pm

    Good one! Glad I am not holding any gold! 🙂

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