TCA Srinivasa-Raghavan: How to manage gold demand?

OKONOMOS

"The demand for gold exhibits a significant inverse relationship with real interest rate on risk-free government bonds and a positive relationship with real income and equity prices"

The Indian passion for gold, mainly as a store of value, is well known. We consumed 720 tonnes in 2005 or 20 per cent of the world consumption. About 600 tonnes went into making jewelry, much of which would have turned up in private lockers.

At last count, the industry employed half a million people. The annual turnover was about Rs 25,000 crore. Next to oil, gold was the second most important import, because 95 per cent of the demand is met by imports.

In recent years, this has also helped sustain jewelry export growth. But it can be a problem also "" witness all the attempts to manage the gold market, both on the supply and the demand side. The former leads to smuggling; the latter has no effect at all.

And there is another aspect to it all which has not been noticed very much: gold demand has direct implications for monetary policy.

R Kannan, who is principal adviser in the department of economic analysis and policy at the RBI, and Sarat Dhal, who is an assistant adviser, have written a paper that examines the relationship of gold with India's macroeconomics.

Their main conclusion, after noting income elasticity is about half of the price elasticity of gold demand: "The demand for gold exhibits a significant inverse relationship with real interest rate on risk-free government bonds and a positive relationship with real income and equity prices." In other words, as incomes and stock prices increase, we will start buying even more gold.

This poses a special problem for the RBI, quite unlike any seen in by its counterparts in the rest of the world. As signal distorters go, it is hard to beat.

Hence, say the authors, "gold has critical implications for ... consumption, saving, investment, fiscal and monetary aggregates, external trade, balance of payments, reserves, exchange rate and the development of financial markets".

This last is important from the point of view of the long-term development of the financial markets. This is because "risk-free real yield on government bonds have inverse relationship with gold demand" and the real deposit rate of interest does not have a "statistically significant effect on gold demand." This, say the authors, is perhaps because of the alternatives such as mutual funds, equity market and so on. The effect of the exchange rate is two fold: inversely through gold prices in rupees and positively through the demand for it as a long-term asset.

From the RBI's point of view, the issue eventually boils down to how gold should be treated: as a commodity or an important variable in monetary policy. Therefore, say the authors, "it is possible to carve out a trajectory of long-run gold demand consistent with policy goals."

That is what they have done by estimating India's gold demand function. Since it is highly price elastic, and also very responsive to real income, interest rate, equity price, and exchange rates, one way of managing gold demand is to manage these variables in an internally consistent way. "The interest elasticity of gold demand revealed the implications of gold demand for saving and investment in the Indian context."

It turns out that tax policy also has a major impact on gold demand in India. To see if savings in gold are driven by tax considerations, the authors have estimated a gold demand function with the marginal tax rate as the explanatory variable.

They use the maximum tax rate for income groups that are able to save, that is, those who earn more than Rs 2 lakh annually. They find that by fiddling the tax rates for these income groups, you can influence the demand for gold, albeit perhaps only at the margin.

However, coming as it does from the RBI, one wonders how receptive the finance minister will be to the suggestion.

*Determinants of India's demand for gold: An empirical analysis. Available on request from the authors