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For centuries, buying gold has been a tradition in India.

Over the last 10-15 years there has also been a huge increase in buying of gold in the form of coins and bars. This has happened mainly for two reasons. First, gold is being accumulated for future use as parents use their current cash flows to accumulate gold for their children’s marriages. Second, gold as a lucrative investment option as a result of the secular uptrend in the value of gold over the last decade. Gold has shown low volatility (at least in rupee terms) and has been used as a hedge against inflation.

The fact that gold prices in rupee terms are just about 10%-15% lower than their peak values in the domestic market due to the depreciation of the rupee as well as the increase in import duties has reinforced the belief of Indians in gold.

It is officially estimated that the total stock of gold held by Indians will be in the region of 20,000 tonne. However the actual holding after taking into account unaccounted imports, ancestral holdings etc should actually be in the region of 25,000 to 30,000 tonne. The value of this gold at current prices will be $800 billion (roughly Rs 5,00,000 crore) for the official estimation and anywhere between $1-1.25 trillion (roughly Rs 6,50,000 crore) for the actual holding of gold.

Now, the idea of gold monetisation has been in the thought process of policy makers for years now. However, no workable idea has come up till now. In the current year’s Union Budget there was an announcement on the Gold Monetisation scheme which has undergone some changes since initially proposed.

This entire scheme is likely to be a big flop.

This is why:

In order to get gold out of peoples households and vaults it needs a huge incentive which the current proposal fails to address.

The issues which will lead this scheme to fail are as follows.

• An estimated 80% of the gold held by Indians is in the form of jewelry. Whoever has bought jewelry will know that on today’s day the making charges on gold jewelry are in the region of Rs 600 per 10 grams (tola) which comes to around 20-22% of the gold value. Who will be willing to give up jewelry to get a gold deposit form? Moreover, the interest rate on gold deposits is unlikely to be more than 3-4%. Therefore, just to recover the making charges on the gold, one will have to wait for over 6 years. On top of that, converting this gold back back into jewelry will entail another 20% cost as making charges.

• The scheme — as it is proposed — requires the depositor to show a receipt of purchase. This, frankly, is a ridiculous requirement. To begin with, the purpose of the entire exercise should be made clear. It seems like the purpose is to reduce imports and bring greater liquidity into the domestic economy which will in turn drive growth. Under these circumstances, asking for a receipt is difficult to fathom. Moreover, for any ancestoral jewelry there is unlikely to be any receipt.

• How are banks going to hedge their risks on gold price movements? There is not only a currency element involved here but also that of gold price movement. Handling and storing physical gold might involve costs which could make the overall costs unviable for banks.

The government might be successful in getting some temple trusts to put in their gold into this scheme but that will be a very small proportion of the entire gold in the country. I do not see the monetization efforts getting even 100-200 tonne under the current scheme of things — less than 10% of the total gold holding with Indians.

What is the solution?
The only way to get bigger quantities of gold to come into this scheme is to offer a ‘gold amnesty scheme’.

I believe that the best way to run this scheme will be as follows:

• As the first step the gold will be declared by the holders to the government and the government will in turn issue 10-year zero coupon bonds to people who declare gold. The yield on these bonds will be in the region of 3% and on redemption the amount that is paid will not be taxed. The post tax yield on ordinary 10-year bonds are in the region of 5% and 2% gap will take care of the tax that the declarer has possibly not paid on the money used to buy gold.

• At the second step the government will have to decide what to do with the gold that it has got. One option would be to sell it to the RBI which will then add this gold to the foreign exchange reserves and in turn given the equivalent money in INR to the government.

• The other option will be for the RBI to sell this gold in the international market, realize the money in USD and provide the equivalent INR amount to the government.

• The last option will be for the Government to open up the gold so bought for purchase by the Indian public. This will cut down imports of gold significantly.

Any of these options will boost the foreign exchange reserves, stabilize the rupee and build foreign exchange reserves. Now, the question is how much gold will the government need to get to make a meaningful impact?

At current prices one tonne of gold will be approximately $40 million. 25 tonnes will be required for $1 billion (Rs 6,400 crore). The government needs to target a quantity of 1000 tonne for an amount of $40 billion. This is 4-5% of the current holding of gold in India and should be easily possible.

This scheme  will kill three birds with one stone. Unproductive gold in the hands of Indian’s will be converted into a productive financial asset, the government will be able to raise cheap long term money and the foreign exchange reserves will get a strong leg up. Given that the government will be able to realize around Rs 2, 50,000 crore in 10 year money it will also remove crowding out from the economy.

[“source – dnaindia.com”]