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Thursday, December 10, 2009

India’s Love for Gold: A Rational Choice?

During the first week of November, a single, all-consuming news item grabbed the prime time screens of national TV channels and the editorial columns of newspapers—the selling of $6.7 bn by the Reserve Bank of India to buy 200 tons of what Keynes termed the “barbaric relic of human irrationality”—gold.
             With the purchase of 200 tons of bullion—which is 50% of what IMF had originally planned to offload or, 8% of the world’s annual gold mine supply—from the IMF, that too, when its price is at a record high of $1,080 per ounce, India has indeed caused an ‘earthquake’ in the bullion market.
             Our Finance Minister proudly announced: “We have money to buy gold. We have enough foreign exchange reserves.” If this statement of him is juxtaposed with his other observation about the weaknesses of economy elsewhere—“Europe collapsed and North America collapsed”—one tends to conclude the transaction as India’s attempt to diversify its risk of holding world’s fifth largest global foreign reserves. True, gold “makes sense as an element that contributes to the diversification of risk in a portfolio”. But for that to happen meaningfully, central banks have to necessarily purchase gold in vastly larger quantities. As against this theoretical requirement, our current acquisition of gold just raises the gold share to a mere 6% of the current reserves of $281 bn. This means, it hardly makes any dent as a risk management strategy.
             But the fundamental question is: At what price? Is it that even central banks too, like any other ordinary Indian investor in gold, cannot resist the temptation of buying gold when the prices are at an all-time high and selling when the prices fall (a decade back, UK sold gold at the then 23-year low of $250 per ounce)? To better understand the irrationality behind the deal, it is desirable to look at what Zhang Yuyan, head of the Institute of World Economics and Politics in Beijing, said: “From the point of view of diversifying foreign exchange reserves, you can spend part of your money on gold; but if you want to increase the share of gold significantly, especially when prices are so high—it’s unnecessary.” As he also said, gold has poor liquidity and pays no interest, while it costs a lot to store it safe.
             Having said that, let us examine what China is doing with its surging forex reserves that touched a staggering figure of $2,273 bn. China is the single largest investor in US treasuries, with a holding of around 23%. It started investing heavily in acquiring overseas oil fields, mines and such other assets globally as a hedge against falling dollar value. It is indeed building up an inventory of raw materials, even acquiring global brands and manufacturing assets as a strategy to keep its export market in good shape to reap benefits once the global economy bounces back to growth.
            There is yet another important question that merits our attention here: What constitutes our foreign exchange reserves? They are not our economy’s earnings, for our current account continues to be in the negative—the current account deficit being as high as 2.6% of our GDP. They are merely the result of capital flows in the form of remittances and FII investments in our equity market. That being the reality, our current investment in a dead asset like gold—that too, reversing its policy of steadily offloading gold since the 1990s—makes one wonder if it is not a mere ego-trip.
             Of course, a section of the press is arguing that such investment in gold is meant for strengthening our resources in the event of a crisis. And in support of their argument, they cite the act of our pledging gold in 1991 to borrow dollars from Bank of England to avert default on our international commitments, till the IMF loan came through. But the question is, if we had had then the equivalent of foreign exchange instead of gold, the very need for pledging gold would not have arisen at all. Indeed, the 1991 crisis was a result of our acute and unsustainable current account deficit, which we attempted to finance through capital inflows. No wonder, the same holds good for any future eventuality until we correct our current account deficit either by increasing our exports or decreasing imports.
            In any case, investing in gold amounts to hoarding, and hoarding, according to John Stuart Mill, means “savings laid out for future use” and not ever being consumed, which results in ‘opportunity costs’. And such opportunity costs are prohibitively high if the hoarding is in the form of precious metals, for they do not yield any interest but incur storage costs. And the impact of ‘opportunity cost’ will be high in a country that suffers from woeful infrastructure.
          So, where does all this argument lead us to? It simply tells that if India, as the Finance Minister felt, has to really soothe the  ‘outrage’ that Indians felt “when we had to pledge gold to the Bank of England just for borrowing dollars to support our imports,” it must: one, as a short-term measure diversify the reserves away from dollars—say into euro, yen or even renminbi; and two, as a long-term measure, use the reserves to strengthen the economy by investing in such activities that augment our productive base and in turn generate fresh wealth rather than investing in dead assets.

This obviously calls for tough but wise political choices.

- GRK Murty


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