Benign inflation key to curbing gold demand

It seems there is no easy way to tackle the country’s fixation with gold. Large-scale investment in gold by individuals is the result of a confluence of diverse factors. One of the long-term solutions to this problem is to have a “benign inflation regime”, which needs to supplemented with both demand reduction and supply management measures, in addition to promoting alternative asset class of similar returns. This was the key message of the Reserve Bank of India’s (RBI) working group appointed to look into the issues of gold import and gold loan NBFCs (non-banking finance companies).

“Indians’ obsession for large investment in physical gold is the outcome of the confluence of numerous and divergent factors. A holistic strategy that deploys a combination of demand reduction measures, supply management measures and measures to increase monetisation of idle gold stocks needs to be put in place,” said the working group’s report, released by RBI on Wednesday.

“A necessary pre-condition for reducing the demand for the precious metal is to ensure a benign inflationary environment along with achieving and maintaining macroeconomic stability,” the report said.

With inflation staying stubbornly high for the past three years, contribution of gold imports to trade deficit has gone up to 30 per cent between FY10 and FY12 from 20 per cent recorded in the previous three years.

“The situation is not different during 2012-13. While capital flows into the economy are volatile and uncertain, large payments for gold imports inflict a drag on our foreign exchange reserves and would impact the volume of external debt,” the report said.

Commenting on supply side measures, the panel has recommended several options to reduce the role of the banks in gold deals such as prohibiting import of gold coins and differential pricing of banking services and finance for gold imports. The panel is of the view that limits on volume and value of gold imported by banks may be considered, if required, but only under extreme situation.

One of the key steps to rein in gold import, the panel said, is that the import duties on gold need to be reviewed from time to time to dissuade gold imports as warranted by evolving a balance of payments (BoP) situation.

“While a sharp increase in import duties is counterproductive, a well-modulated increase in import duty may reduce the demand,” said the report.

The working group has also noted that the restrictions on bringing gold and gold jewellery by incoming Indian community from abroad may also have to be reviewed to make bringing gold into the country less attractive.

Another reason why gold is a preferred investment vehicle is the fact that gold investments have neither tax nor documentation-related hassles. With jewellery shops often flouting the current stipulations that the permanent account number (PAN)-card number needs to be furnished for ornament purchases beyond the limit of Rs 5 lakhs, there is a need to plug these loopholes.

The report also noted the need for alternative financial investment avenues that can give gold-like returns, the demand for yellow metal could be diverted. Products such as inflation indexed bonds may be considered as alternatives. In addition, introduction of gold-backed financial products, such as gold deposit schemes, are required to reduce the demand for physical gold.

The RBI working group has found merit in the request made by Indian Banks Association for allowing banks to use the futures markets to hedge bulk purchases. It recommended RBI to examine this proposal, which will minimise risks for banks while dealing in gold transactions.