India’s Gold Dilemma

November 25, 2013 Posted by India Briefing Reading Time: 3 minutes

By Kavita Patel

Nov. 25 – India’s voracious appetite for gold may be an obstacle to its economic growth. The subcontinent is the world’s leading consumer of gold but has almost no domestic supply. As rising income boosts demand, gold imports jumped from about 471 tons in 2001 to around 1,017 tons in 2012. Demand is inelastic as this precious metal plays an integral role in Indian culture; almost half of all purchases are used during weddings. Unfortunately, gold is an unproductive store of wealth. It deepens the current account deficit and slows capital investment, weakening the economy.

Inflows of the yellow metal have weighed on the country. In the past, almost 40 percent of India’s gold imports were processed by its skilled and inexpensive labor for subsequent export. This number has decreased to just 29 percent, and gold imports helped push the current account deficit to the US$87.8 billion it reached last financial year, an unmanageable 4.8 percent of GDP.

This left India even more vulnerable during fears of the U.S. Federal Reserve taper, sending investors out of emerging markets such as India and back to the U.S. This caused the rupee to fall around 15 percent.

Following the country’s worst financial environment in more than two decades, Finance Minister Palaniappan Chidambaram resolved to take action. This past July the central bank moved to require 20 percent of imported gold to be earmarked for export. Additionally, customs duties have increased gradually from four to 15 percent.

The government’s adjustments have not been easy for jewelers, who have had to grapple with an 85 percent decrease in gold supply and an increasing amount of gold being smuggled for illegal sale. Indian jewelers typically import raw gold and turn them into value-added products for both domestic and foreign consumption. During the 2012 fiscal year, the jewelry industry made up 14 percent of total merchandise exports. Recently, companies have begun increasing their gold exports, and have shifted more of their focus onto jewels.

The gold policy seems to be working, at least temporarily, as imports decreased 74 percent year-on-year in August. In addition to implementing other policies such as new restrictions on outward direct investment by Indian entities, India has made strides in decreasing the current account deficit and recovering the ailing rupee. However, foreign investors have started to question the Reserve Bank of India (RBI), whose efforts to promote stability are hurt by ever-changing policies at a time when the currency needs credibility and predictability.

Another centuries-old role of gold in India is its use as savings and investment. Indians are storing their wealth in 20,000 tons of gold worth US$1.1 trillion rather than using it as capital investment. Indeed, 40 percent of people in India do not have a bank account.

Policy makers hope to change this behavior, and move investment into financial instruments. Finance Minister Chidambaram Palaniappan said in June, “if I have one wish which the people of India can fulfill, it is don’t buy gold.”

This has been difficult, as returns on gold in the past five years have far surpassed comparable investments such as bank deposits, and India’s financial system still has weaknesses.

The RBI has considered gold-backed financial products to cater to the entrenched gold culture while furthering the country’s financial development. If gold deposit schemes were established, gold owners could earn interest depositing their supply into banks, which could then be injected into the domestic market. This would reduce the demand for imports and stimulate investment flows.

Rising income and cultural norms have fueled India’s insatiable demand for gold, causing many of its financial woes. Asia’s third largest economy must find a way to change its people’s investment behavior to continue on its road of development.

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