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Don’t go for gold

Misdiagnosis and policy errors created alarm about the current account deficit.

October 29, 2013 4:55:26 am

Misdiagnosis and policy errors created alarm about the current account deficit.

Over the last three months,policymakers and market players have cheered the sharp decline in India’s trade deficit. The annualised rate of the current account deficit (CAD) is running at around $25 billion,based on the last three months’ of trade data — about a third of what one had feared at the start of this year. This run rate will likely rise as gold imports pick up on seasonal demand,but for the year as a whole,the CAD should be even lower than the government’s estimate of $70 billion.

The taming of the CAD has elicited cheers all around for the government’s draconian restrictions on gold import and hikes in import duties. And why not? The rise of the CAD from an average of $11 billion over 2005-07 (around 1 per cent of the GDP) to $88 billion (nearly 5 per cent of the GDP) last year was seen as the mirror for all that was wrong with the Indian economy: dysfunctional politics and policymaking,loss of investor confidence,falling growth and rising inflation. So much so that credit ratings agencies,while downgrading India’s outlook,repeatedly cited the rising CAD as their biggest fear,even though the runaway fiscal deficit was the root cause.

While the export growth slowdown is a big reason why the CAD blew up,most will point to the astonishing rise in gold imports as the key driver. Gold imports rose from an average of $15 billion (1.5 per cent of the GDP) through 2005-07 to $55 billion (3 per cent of the GDP) last year,peaking at $67 billion (3.6 per cent of the GDP) in 2011-12. Some of the $40 billion-increase in gold imports is clearly due to the growth in gems and jewellery exports,but not very much. India’s national income data provides a stark reminder of how much gold was used for pure investment purposes. Household investment in gold rose from an average of 1 per cent of the GDP over 2005-07 to nearly 2.5 per cent of the GDP. Using this and the pace of growth of jewellery exports,it is not unreasonable to surmise that roughly $30 billion of the rise in gold imports,that is,about 1.5 per cent of the GDP,was for investment.

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Why did Indian households turn to gold as a store of value in such a big way? The reasons are not hard to imagine. The collapse of equity prices in the aftermath of the 2008 global crisis shook the faith in a market which,in the previous decade,had only moved up. Equities revived in late 2009 but households’ faith did not return. In fact,the subsequent growth slowdown and policy dysfunction further damaged it. Real estate was an option but concerns surrounding the soundness of housing companies clouded the sector. Yields on bank deposits — the traditional safe haven for households — turned sharply negative in real terms,thanks to raging inflation and a central bank that moved glacially to raise interest rates. With rising macroeconomic and policy uncertainties,a volatile equity market,a debt-ridden real estate sector,and falling real return on bank deposits,households did what was most prudent: seek the safety of gold.

All this is familiar ground and a widely accepted narrative. So it is quite surprising that we continue to treat this as a current account problem instead of what it really is: a portfolio reallocation problem. In other words,the rise in gold imports for investment purposes should be excluded from the headline CAD for any meaningful analysis. Doing that would lower the rise of the CAD. But it would also mean that,effectively,Indian households took out,so to speak,savings of around 1.5 per cent of the GDP from domestic assets. This is not a good thing either,but it is a different diagnosis that requires a different policy response than what we saw from the authorities last quarter.

Most things do not change much just because gold imports were analytically miscategorised in the current account. For example,it did not and does not matter for rupee dynamics. But some things do change. By treating gold as a consumption good,the government sought to stop its import by raising duties and eventually imposing quantity restrictions. But it wasn’t being used for consumption. It wasn’t typical capital outflow either. Households could have easily bought Google stocks instead of gold. Remember that till a few months ago an individual could take out up to $200,000 each year without approval. For a family of five that would be $1 million a year. But they didn’t. Instead,households turned to the safety of gold to protect their balance sheets.


However,with restrictions on gold investment,households may now be pushed into investing in riskier equities and real estate. This is may be great for equities and the housing market in the short run,but it could also easily end up impairing the only balance sheet in the economy that had withstood the economic mayhem over the last three years. Gold may appear to be “unproductive” investment,as is often lamented,but it does help to protect households against shocks. Over the last few years,banks have lazily stuffed themselves with government securities that arguably finance many “unproductive” activities. We call it good risk management because it preserves the banks’ balance sheets during a cyclical downturn. Inexplicably,the same logic isn’t applied to households.

But even excluding gold,the CAD rose 2.5 percentage points of the GDP,which is still disconcerting. Take a look at oil imports. Excluding crude oil imported for re-exports,India’s petroleum imports rose from an average of 4 per cent of the GDP over 2005-7 to nearly 6 per cent of the GDP last year. One would expect oil demand to outstrip income growth,given that Indian consumers are moving up the value-added ladder (for example,from two-wheelers to cars). But even the government would concede that a sizeable part of the increase took place because continued subsidies to domestic retail users prevented any meaningful demand contraction in response to the rise in world prices. Add to that the court-ordered ban on iron ore exports,the rise in coal imports because of delays in granting new domestic mining concessions as well as the continuing large subsidies for urea,and one can easily see another $35 billion (2 per cent of the GDP) being added to the CAD.

Put differently,as global uncertainty rose and growth slowed,households and firms did what they were supposed to do: protect their balance sheets and constrain spending. This should have narrowed the CAD. But misdiagnosis and poor policy choices ended up blowing it up.


Correcting these policy errors is the right way to address the current account (non) problem. Heartening shifts are taking place in India’s policymaking framework. Accepting lower near-term growth in the policy framework,focusing on curbing inflation,allowing greater pass-through of international prices to the domestic economy,actively searching for new sources of capital inflow and liberalising the banking system are the right things to do. Their collective impact will take time to materialise. But their results will be much better than artificially boosting growth through a high fiscal deficit and low interest rates. We did that in 2010 and 2011. See where it got us in 2012 and 2013.

The writer is head,emerging markets Asia economic research,JP Morgan Chase. Views are personal

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First published on: 29-10-2013 at 04:55:26 am
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