Signup for our free newsletter:

India's Gold Purchase Plan

Written By Briton Ryle

Posted August 30, 2013

For a moment, there, it looked like the Indian government was one step ahead of the world in its decision to ride out the recent rout of its currency and not tinker too much with rates and bonds.

india goldBut now, India may be swinging the other way as it considers Trade Minister Anand Sharma’s suggestion to “monetize” gold to cover the nation’s $90 billion current account deficit.

As it turns out, this monetizing is more of a recycling of gold among India’s own citizenry in an attempt to reduce the import of gold and the outflow of money, thereby closing the deficit some.

But will this work? Or will it end up costing the Indian government more than it bargained for?

Passive At First

While emerging markets such as Turkey, Brazil, Indonesia, and a whole host of others have been raising interest rates and selling bonds to strengthen their reeling currencies, India last week decided it would do nothing further. It last raised interest rates in July, and it won’t go there anymore.

Why? Because raising rates impedes economic growth by sucking money out of businesses as they pay higher interest on their borrowed capital, triggering cuts to jobs and wages.

Another reason the Indian government had opted to do nothing to strengthen its currency is that the recent depreciation in the rupee and other emerging market currencies is believed to be temporary. Enormous speculation over an upcoming reduction of the U.S. Federal Reserve’s monthly bond purchases – likely to be announced September 18th – is believed to be behind the recent four-month slide in emerging currencies. The Indian government was willing to ride out the storm, confident the rupee will rebound on its own in a few weeks’ time.

Professor Bhanumurthy of India’s National Institute of Public Finance and Policy opined to USA Today, “My guess is that it’s speculative outflow, and the market will balance itself out in the next few months, maybe even weeks.”

Though many were taken by surprise by the Indian government’s “ride it out” approach, others praised it for looking one step further than everyone else. After all, if emerging market currencies are expected to stabilize on their own once U.S. Fed tapering is factored in, why take any drastic steps that would commit the Indian government to monetary tightening, which would only end up slowing the economy in the end?

Now Taking Action

But after all that, the Indian government seems to be having a change of heart, and now it wants to intervene.

Record imports of 860 tons of gold in 2012 and some 500 tons so far in 2013 have resulted in the removal of some U.S. $60 billion from the Indian economy, ballooning its current account deficit to a $90 billion annual shortfall. These gold imports have two adverse side-effects:

First, they reduce the value of the Indian rupee. As rupees are sold to buy gold, the value of gold rises relative to the rupee, and the value of the rupee falls. It’s bad enough that foreign investors are causing the rupee’s value to slide, but Indians are inadvertently exacerbating the problem through their imports.

Second, they reduce the currency’s liquidity, taking cash out of the system and parking it as gold in safety deposit boxes. Money which is no longer circulating through the economy cannot stimulate consumption and cannot generate incomes.

To remedy the deficit problem, the Indian government is considering buying gold from citizens wanting to sell, hiring refiners to melt it down for resale, and then selling that same gold to citizens wanting to buy. In this way, new Indian purchases of gold would not be imported, but would instead be recycled from gold already inside the country, and the rupees paid would remain in India.

The Indian government is also considering using the gold purchased from citizens as collateral against leveraged loans to finance the gaping budget deficit.

The Free Market Way

It seems like a sound plan on the surface. Buying gold from some citizens to sell back to others would reduce imports and lower the trade balance. But it does have risks.

Enticing Indians to sell their gold is no easy task, ultimately forcing the government to pay a premium to get the amount they want.

Another problem is that the government would not be reselling all of the gold purchased, but would be sending much of it abroad as collateral for loans. This would result in the pumping of rupees into the Indian economy without a means of extracting those rupees elsewhere. This would backfire for India, because the extra liquidity would weaken the rupee all the more.

To strengthen a weak currency, central banks don’t expand the money supply; they tighten it by either raising interest rates to make the money more expensive and less accessible, or by selling bonds to reduce liquidity as they take cash out of circulation and replace it with certificates.

Buying gold and pumping extra rupees into the system is the opposite of what the Indian government should be doing, even as Paul Hoffmeister, a senior analyst for Bretton Woods Research LLC in Mount Tabor, NJ, wrote in a note obtained by Forbes, “They should be selling bonds to extinguish excess rupees, but the RBI [Reserve Bank of India] is not doing so.”

Maybe the free market had it right all along. If the salvation of a cheap currency is removing liquidity, aren’t those record gold imports doing that job already? In a way, these gold imports are doing the government’s dirty work for it. If the government lets the free market dictate the trade, gold imports would themselves suck excess rupees out of the system, without the government having to sell bonds, which would save the government a lot of future interest payments and from having to raise interest rates, which would slow the economy.

As for the concern that gold imports weaken the rupee, this weakness comes relative to gold, not relative to other currencies.

Closing the Budget Gap

India’s current account deficit is a menacing problem that must be dealt with. But buying gold from its citizens won’t close the gap. Even if they managed to supply as much as half the annual gold purchases by recycling – which they can’t – the $20 billion saved from half the annual gold imports is far short of the $90 billion annual deficit.

Maximizing exports is always the preferred means of increasing revenues to close budget gaps. But with every other nation trying to maximize their exports, there’s no one left to do the buying.

So it all comes back to foreign investments. Yet emerging economies must find ways of drawing investments from abroad without resorting to interest rate hikes. Land leases to foreign manufacturers, for example, would generate billions a year from the leases, as well as creating jobs and reducing imports. Profit sharing on national projects from seaports to airports, from highways to railways, would also draw foreign investment on badly needed infrastructure.

Gold’s Future

It is quite likely gold will fall on a U.S. Fed tapering announcement on September 18th, possibly to retest the recent lows of $1,180 an ounce. If the level holds, gold’s bull-market may resume in October. Fed bond purchases may be on their way out, but ultra low interest rates will remain where they are until unemployment in the U.S. falls below 6.5% and inflation rises above 2.5% – and we’re nowhere near those levels.

And let’s not forget another round of debt ceiling battles, with the U.S. having to borrow yet again over the next few months. All of this hurts the USD and improves the case for gold.

But there is money to be made in gold’s volatility, buying on the dips and selling on the peaks. Just don’t stay out of the gold market too long if you decide to sell here. The crises are not over, with Europe still in turmoil and the U.S. Fed still not raising rates.

And you can add Iran into the mix, as it gets closer and closer to uranium enrichment – which the West will not allow to come to completion. Syria is merely a lure to draw Iran out. There will be war; maybe not tomorrow or next week, but it will happen.

Gold may have set its safe-haven status to “Away” for the moment, but at some point that status will change to “Online” once again. And the line it will be on points up.

Joseph Cafariello


If you liked this article, you may also enjoy: