Financing revival through household gold

The expansion of base money through household gold will have a negative wealth effect on households, besides attracting a hidden tax or seigniorage

According to available information, the government is contemplating “a series of measures, including using household gold and foreign exchange reserves as collateral to print more currency, to finance the proposed expenditure to revive the economy”. Quite an exciting proposal, which essentially has two parts — purchase of gold and using foreign exchange reserves as collateral.

Households in India hold roughly 25,000 tonne of gold on their balance sheet although the exact amount has never been estimated. Thus the proposal to purchase gold under some arrangement — either through banks or the RBI directly— would put in motion the KUB Rao committee’s recommendation of creating a market for gold where banks are free to give both bid/offer prices. Currently a bank is allowed to sell to a retail customer only with buy side of the transaction covered from the gold importer on a consignment basis.

The proposal is good and must be al­lowed as it creates one of the most transparent mechanisms in household purchase of gold. It brings some element of competition, which checks behaviour of other sellers who have a dominant share in the physical gold market. It is propelled by the freewill of the household, which either wants to buy or discharge gold in its possession. The only pressure point is that 75 per cent of the household gold is in the form of jewellery.

However, the proposal is to primarily finance consumption and not to generate income, which is the basis of demand in an Atmanirbhar Bharat. As a result, this measure will not kick-start the growth process as money created will be expended immediately with a zero income-multiplier effect. The expansion of base money via this route will also have a negative wealth effect on households, besides attracting the additional burden of seigniorage, which is a hidden tax. The household will lose valuable liquid collateral thus limiting the possibility of secondary credit creation via the banking system through gold loans.

There is a misconception that gold is a dead asset in India. Around 30 per cent of the agriculture loans are collateralised by gold. The gold NBFCs also lend for personal consumption and other purposes using gold as collateral. However, in this arrangement the jewellery is not melted, which explains the preference for monetising gold through this arrangement. 

Also, if the purpose is to finance current consumption, why not explore the possibility of, say, reverse mortgaging of gold with banks? If the purpose is to create a self-sufficient India, why not increase the LTV ratio for gold loans as the price of the collateral is not expected to fall soon? Households may not even desire to liquidate their gold holdings as explained above. Parting with gold is a sign of poverty and no economy has flourished by impoverishing its own people through the psychological channel of a wealth effect. The size of the package to revive the economy is really large and past experience shows relying on gold to raise finance can never be the mainstay of the resource mobilisation strategy.

Coming to the second proposal — using foreign exchange reserves as a collateral to increase money supply. The first question is collateral with whom. That apart, the proposal utterly disregards the basis of the RBI balance sheet. Since FX reserves form the asset side of the RBI, assuming there is no sterilisation, an equivalent amount of rupee liquidity is already in circulation and creating more does not make sense unless there is significant credit de­mand. Unless we run a current account surplus, the current FX holding in India is just future claims of the rest of the world on India. Given that, collateralising FX is tantamount to pledging US treasury holdings of the RBI. But with whom? How will this impact external debt servicing and payment for imports?

The problems with the second proposal are many. The expansion of the monetary base without increasing the sovereign debt reeks of ignorance of monetary economics. In a debt-based monetary system, the government debt forms the asset side of the Reserve Bank of India (RBI) balance sheet. With FII outflow and no exports, the only way to expand the money supply is by issuing debt or by increasing the gold holding or by tying the money supply to the market price of the gold holdings. One way of doing that is buy-sell swaps of banks with the RBI whereby the gold holdings are pledged with the former. But that involves a definite price risk. Since the RBI’s last major purchase of gold happened in 2009, the objective of increasing the base money without increasing public debt is futile.

India has a sovereign debt to GDP ratio of 72 per cent while most European countries and the US have over 100 per cent. Those with debt to GDP ratio of greater than 100 per cent never face downgrade but marginal increase from 72 per cent is always considered credit negative.

The main issue in such proposals is that while the blueprint to revive the economy is well thought-out there is no clear strategy on how resources would be mobilised to generate Rs 20 trillion worth of demand. This is further compounded by erroneous thinking that money supply can be expanded without incurring debt.

The best way to finance the fiscal stimulus will be to either issue long-dated sovereign zero-coupon bonds with 20-year maturity or a sovereign perpetuity bond bearing a nominal coupon of, say, 4 per cent. This will not create pressure of redemption or debt servicing. The funds may be used for a wide range of purposes such as providing equity to NIIF, capitalising banks if warranted, creating FOF for SMEs, VC funding for start-ups and so on. 

Once the economic cycle is set in motion, the government can exit by listing these and retiring some of the existing debt at that point in time. This is what the US did to stabilise its banking industry and in the process the US treasury made billions of dollars in profit.

For some reason, what is “right” for another economy is deemed “wrong” for India. There must be more detailed discussion on the financing strategy of the Atmanirbhar Bharat package. The PM has laid out a vision; let us take it forward with a well considered strategy.

Ghosh is group chief economic advisor & Hishikar is an economist with State Bank of India. Views are personal