May 212015
 

The Indian Government has released its Draft Gold Monetization Scheme for comment, which builds on the earlier WGC & FICCI’s Why India needs a gold policy proposal. At this early stage it seems “likely fail in its current form as it does not address some key concerns for banks and consumers”, according to Reuters.

Whilst it may be news to Zero Hedge that gold pays interest (see In India, Gold Is Not Only Money But Now Pays Interest) this is not something new for India which has always had a gold borrowing and lending market although at the retail level it has not worked so well, with previous schemes obtaining less than 50 tonnes.

Positives for the current proposal are a low 30 gram (approx. 1 ounce) minimum deposit, a very transparent deposit and assaying process, and exemptions from Capital Gains Tax, Wealth Tax and Income Tax.

The main problem seems to be that banks will need to offer interest rates of 3% to 4% to make it attractive to investors but when those banks can import gold on consignment from western banks at rates lower than that, then “the government would have to give subsidies to encourage their [Indian banks] participation”.

Another issue is that “there is no guarantee that tax sleuths will not come calling hot on deposit, asking for the source” of funds that purchased the gold, as First Post notes. In addition, they note that the need to melt the jewellery “is abshagun, inauspicious and a strict no-no”.

The melting issue comes up a lot in the comments to the draft, but one helpful suggestion to “change the draft to deposit jewellery and get monthly interest on it” seems to miss the point of the whole scheme, which is for the gold to be used by jewellers. It also shows the difficultly in marketing this idea when people can’t see why it makes no commercial sense for a bank to pay interest on stored jewellery which it cannot use.

It is also a bit of a concern that the Government’s draft says that “banks may sell the gold to generate foreign currency. The foreign currency thus generated can then be used for onward lending to exporters / importers” which is basically saying the bank will go naked short gold (and no, they couldn’t hedge it as the cost of the hedge would eliminate the profit on lending cash – hence why the call for subsidies).

However, my main issue with this proposal is that it is a stop gap solution to the “problem” of gold imports. As Indians are net accumulators of gold any mobilisation of their existing gold into bank gold savings schemes does not mean that those people will not buy more gold. All they are doing is changing the way they hold their existing gold savings; they will still want to add to their existing savings (in aggregate). Any mobilised/recycled gold is just sold back to others who don’t want a bank gold savings scheme – the total amount of physical gold in the country stays the same, it is just that some are now holding bank gold savings schemes.

Consider that yearly Indian consumer demand is around 800t and estimated stocks within India in round numbers are (ignoring Temple Trusts who have about 2,000t):

Physical Gold held by Indians -> 18,000t
Physical Gold held by Jewellers -> 2,000t

In the banking system, this is the situation:

Bank gold asset (loans) to Indian Jewellers –  2,000t
Bank gold liabilities to Western Banks – 2,000t

If the scheme is so successful that they manage to mobilise 800t a year then Indian banks won’t have to import gold and can instead sell the mobilised gold to manufacturers who then transform it and sell it back to other Indians. After the first year this is what Indians will hold:

Physical Gold held by Indians -> 18,000t
Paper Gold held by Indians -> 800t
Physical Gold held by Jewellers -> 2,000t

In the banking system, this is the situation

Bank gold asset (loans) to Indian Jewellers –  2,000t
Bank gold liabilities to Western Banks – 1,200t
Bank gold liabilities to Indians – 800t

Effectively all that will happen is that the 800t is used to repay the consignment loans from Western Banks – the Indian Banks use the money from selling the 800t to the Jewellers to buy London gold which they then use to repay their Western bank gold loans. After the third year this would be the situation

Physical Gold held by Indians -> 18,000t
Paper Gold held by Indians -> 2,400t
Physical Gold held by Jewellers -> 2,000t

In the banking system, this is the situation

Bank gold asset (loans) to Indian Jewellers –  2,000t
Physical Gold held by Banks-> 400t
Bank gold liabilities to Indians – 2,400t

Now you may ask why does the bank have 400t of physical? By the end of the second year, the Indian Banks only have 400t worth of gold loans left, so when they sell the 800t to the Jewellers that year and buy 800t (which they have to otherwise they would be going naked short and thus pure speculating on the Indian gold price falling) it only has 400t of loans to repay, leaving it with 400t left over. Note that as Indians are not net sellers (in aggregate) the banks’ only option is to buy gold overseas, but in doing so they send currency out of the country, which is what the Government is trying to prevent.

In the 4th and subsequent years, there is no more demand to borrow the 800t of gold being deposited into the scheme – the jewellers only need 2,000t. Ultimately, if we remove the banks (who are just intermediaries) out of the picture what we have is that the gold that is being lent by some Indians is going to Indians who want to buy it – there is a mismatch here, one side wants to lend and still own it, whereas the other wants to own it outright. That cannot be squared with any fancy financial footwork – no Indian bank is going to go short gold in Indian dollars.

Indian Gold Price

So gold mobilisation is probably only good for a few years worth of gold import substitution and thereafter the Indian Government is back to its “problem”. All this work for a temporary solution. Easier to just talk to the main temple trusts and get them to fund the local jewellery industry IMO.