Warning: This article may contain jargon, so deal with it. Remember, you were warned.
Disclaimer: Mockery towards a political party or entity does not mean support for its immediate opponent(s).
I briefly mentioned in my previous post how adept we Indians are at the blame-game. I’m going to focus on one of the blame-games that we play: Ask any man why the economy is in dire straits, and (the odds are pretty high) he’ll say it’s because of the ruling Congress party. “They screwed it up bro, I’m going to vote for BJP next time”, is what you’ll hear. Ask people from the Congress party (Many thanks to Arnab Goswami there) and they will say the holy words ‘external factors’ or simply ‘back-blame’ Indians’ undying penchant for buying gold. Are these really the correct reasons? In this post I will focus on answering this question.
I’m sure there are two questions, broadly, that remain ambiguous in our minds: (1) Why should we not buy gold? (2) What are these external factors that are affecting us so? You’re right. In a free market economy, we should be allowed to buy whatever we want, no? And apart from that, we have a right to know what these holy external factors are, don’t we?
(1) Let’s start with gold.
The RBI commissioned a working group with an aim to study issues related to gold imports and gold loans in India. The broad and major conclusions (paraphrased) in the report were: (i) Gold is an obsession as an investment because it gives highest returns among other domestic assets (Figure 1), (ii) Demand reduction measures are called for; mainly, creating an asset class that is as alluring and convenient as gold, and providing a stable and less-inflationary macro environment, and lastly (iii) A variety of supply-side measures are to be taken up for consideration. Some of these reforms have already seen the light of day, the effects of which will be visible soon enough.
Why should we not buy gold? Simple. (Here is where the jargon comes.) Gold purchases add to the nation’s trade deficit and the current account deficit (CAD). We were the largest importer of gold in the world in the last quarter, closely followed by our dear friend, China. It is in fact the highest among items on the imports of principal commodities, even before oil. First, understand what the trade deficit and the CAD is, then go see Figure 2.
Trade Balance = Amt. received for EXPORT of goods and services (X) – Amt. received for IMPORT of goods and services (M)
If X < M, we have a trade deficit.
Current Account = Trade Balance + Net income received from stuff situated abroad, owned by Indians (like house rent on property situated in London etc.)
So the trade deficit impacts the current account, and can render a current account deficit (CAD).
Gold constituted nearly 30% of the trade deficit during 2009-10 to 2011-12, higher than 20% during 2006-07 to 2008-09. When we do not include gold, our trade deficit as a percentage of GDP would have been 2.1 percentage points lower, and the same applies for CAD as a percentage of GDP. Meaning, the trade deficit would have been 9.7 % instead of 10% – a significant change. Currently, CAD as a percentage of GDP stood at 4.8% for the year 2012-13, while the comfort level has been defined as being in the range of 2.5 to 3%. The Finance Minister has promised that it will be reduced to 3.7%, through a series of measures – still possible, if gold imports are reduced drastically; but then there’s also the Food Security Bill.
Another significant reason why gold purchases are not good for the economy at large is that most of the gold purchased remains locked up in peoples’ houses (as jewelry) or as donations in Hundis (in temples) – basically as an idle, lazy asset. Investment in more productive sectors of the economy could have much longer and deeper effects on the economy in the form of resulting in better goods and services. More on this in a later post.
But still, why do we Indians buy so much gold?! Many reasons. (1) Gold is considered the best hedge against inflation in the long-run (Figure 3), (2) Apart from inflation, for the poor man, it is really the best security against both macroeconomic and political uncertainty, (3) It is highly liquid (easy to exchange for cash) and one of the most efficient ‘store of value’, hence serving as a good form of intergenerational wealth transfers, and lastly, (4) Jewelry demand (Apparently, for Hindus alone, there are 24 days in a calendar year that are seen as auspicious to buy gold!)
(2) Moving on to External Factors: Why are we so affected by what goes on in the US?
Since the time the economy opened up, we are susceptible to external factors and hence, this calls for looking into developments abroad as well.
Some more jargon first. You must have seen this phrase somewhere in the recent newspapers (hopefully not in Bangalore Times!): Quantitative easing. To understand this, one must understand what we mean by the policy rate. So every central bank lends money to other commercial banks at a rate known as the ‘policy rate’ – more appropriately called the ‘cost of funds’. This rate goes on to further determine the rate at which these banks lend money to businesses and consumers (like us), at large. Fun fact: The RBI’s policy rate – Repo Rate – is currently 7.5%. There exists a similar policy rate for the US central bank – Federal Reserve (Fed, for short). Over time, their policy rate has reached a near-zero level and reducing it further does not make any sense. Hence, the Fed resorted to what was called ‘unconventional’ monetary policy, otherwise known as quantitative easing (QE). Since the Fed’s policy rate is too low, it needs to find other ways to inject money into the system. So how is that done? QE is the answer. QE is an outright purchase of bonds and other assets by the central bank, usually in the form of a committed fixed amount every month. Fun fact 2: Currently, the Fed is purchasing $85 billion of bonds/assets each month under the QE program. So money is injected in exchange for assets and bonds, and people build houses and invest in businesses – creating employment and GDP growth. Okay, enough about QE.
Investors have been getting higher rates in emerging markets like India and Brazil. Hence there was vast inflow of capital since the beginning of QE in the US. However, with the announcement of a possible tapering of the QE program by the Fed, investors have been withdrawing funds from emerging markets, which has resulted in a shortage of foreign currency in India. This is purely because of investor speculation. And THIS is what majorly caused the USD/INR exchange rate to fluctuate so much in the last month or so. (Someone actually told me the exchange rate incident was the work of the ruling Congress Party, because of the upcoming elections. So apparently they would bring back their funds from their Swiss bank accounts and gain more because of the new exchange rate, thereby leaving them with more money which they will use for campaigning! What bullshit.) Anyway, more recently, with the announcement of a new set of reforms from the RBI and the Fed’s clarification that tapering will not begin right away, the exchange rate has begun to stabilize – as you can see.
Open economy macroeconomics is always interesting. It throws us economists into a realm of new and unanswered questions on various matters. For instance, what is the correct exchange rate for the INR? What is ‘too much volatility’ in the exchange rate? Is there a specific number? How should the withdrawal of unconventional monetary policies, such as QE, be conducted? How do we check gold imports in India and will placing import restrictions fuel a gold black market economy?
Discussions on more pressing external factors, that I have not addressed, are welcome in the comments section.