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India: Gold In The Sink

The latest views of Morgan Stanley Economists
Chetan Ahya (Mumbai)

"India, as we all know, already wastes far too high a proportion of her resources in the needless accumulation of the precious metals. It is interesting to reflect that India’s love of the precious metals, ruinous though it has been to her own economic development, has flourished in the past to the great advantage of Western nations. Every one knows (William Stanley) Jevons’s description of India as the sink of the precious metals, always ready to absorb the redundant bullion of the West".

John Maynard Keynes in his book titled "Indian Currency and Finance" published in 1913.

The recent sharp rise in India’s gold purchases reminds us of the above passage from Keynes on India’s love of precious metals during the 19th century and early 1900s. After rising by 63% in F2004, India’s gold consumption (excluding gold used for jewelry exports) rose by 57% in F2005. Indeed, during the quarter ended March 2005, gold consumption shot up 88%. Cumulatively, India now holds gold stock of about US$200 billion (29% of GDP), according to World Gold Council (WGC) estimates.

Old Tradition and Complex Set of Drivers Supporting Gold Demand
Hoarding of gold is an old tradition deeply embedded in the culture of the Indian society. Traditionally, apart from being an item of consumption in the form of jewelry, high gold demand was due to low penetration of banking facilities, restricted laws of inheritance, as a hedge against inflation, and as a medium of hiding unaccounted income. Gold has also served as a hedge against rupee depreciation, as laws prevented Indian households from investing in foreign assets or holding of foreign currency. However, the sharp rise in gold imports over the last three years is surprising, as the rupee has started appreciating, inflation is relatively low, banking facilities are improving and economic confidence has picked up.

Gold Is One of the Largest Assets of Indian Households
As per WGC estimates, Indian households own about 15,000 tones of gold, accounting for about 10% of the worldwide stock. At current market values, we estimate that gold accounts for about 10–15% of the Indian household balance sheet. Gold holdings among Indian households at current market value is about 2.5 times the current equity stock holding of US$80 billion. While the share of gold in household savings declined during 2001–03 to 5%, we estimate that this has risen again back to 6.5% during the quarter ended March 2005. With its high rate of gold consumption, India accounts for 18% of the annual global gold demand, while its share of global GDP on nominal dollar GDP is only 1.6%. India’s share of global gold demand is about one and a half times that of the US, though its GDP is only one twentieth that of the US.

Opportunity Cost of Gold Investments Is High
Instead of investing its annual savings in gold, if India were to invest this in more productive business assets, its annual GDP growth would be higher by about 0.3–0.4%. The cumulative GDP value lost by parking US$200 billion worth of savings over the years in this not so productive asset would be huge. With no domestic gold mining, the purchase of gold is also resulting in an inappropriate use of foreign exchange earnings. During the quarter ended March 2005, gold consumption (excluding gold used for jewelry exports) was 1.8% (annualized) of GDP and about 21% of the total non-oil imports.

Share of Financial Savings Has Declined Recently
Over the last 20 years, the share of financial savings has remained stagnant at an average of 50%. Indeed, the recent decline in real interest rates has only encouraged households to increase the allocation to physical savings (which includes gold, property and households investments in small businesses). The share of financial savings in the total has decreased to 47% in F2004 from 61% in F1997 as real deposit rates have fallen to -1.9% from 6.9% over the same period. Although, the official statistics for F2005 are not available, from preliminary figures for financial savings we believe that the share of financial savings is unlikely to have increased significantly. Over the last two years, the share of gold in household savings also appears to have risen again. Indeed, over the same period our approximate analysis based on the stake holdings trend for the top 200 companies (which account for 84% of the total market capitalization) and purchase of mutual funds indicate that over the last 24 months while Indian households’ investments in gold is rising, their allocation to equities has fallen, reflecting their risk aversion.

Need to Increase the Share of Financial Savings
We believe the preference of Indian households for gold specifically and physical savings in particular points towards gaps in the broader policy framework including the government’s expenditure mix. The government’s bias towards less efficient revenue expenditure has resulted in the inefficient allocation of resources. This is reflected in the fact that over the last five years, while the government debt increased by 16% points of GDP (65% of it being for funding revenue deficit), the corporate sector’s debt declined by 5.4% of GDP. High level pre-emption of savings for funding the government’s revenue expenditure has caused greater risk aversion amongst the corporate sector as well as households, in turn influencing their savings preferences.

As the government chooses to increase infrastructure spend resulting in a matching rise in corporate capex demand over the next few years, the country would need to not only increase aggregate savings and but also ensure a rise in the share of financial savings. To increase the share of financial savings, deepening the financial sector reforms would be the key. Apart from increased easy access to banking and financial services facilities, one of the most important areas that needs attention in this context is reforms related to long-term savings schemes. Although the government has initiated some reforms recently, the desired results are still not reflected in the share of long-term savings. Currently, only about 10% of the workforce is covered by some form of pension scheme, including government-sponsored social security schemes. These schemes have also failed to be fully effective as contributors tend to withdraw a significant sum before retirement. About 90% of the work force depends on family transfers and other informal systems for old-age security.