Why raising import duties on gold isn't enough

Given the extreme stress that India's current account is under, it came as a great relief when international gold prices declined sharply over the past several weeks.

Gold imports have been a huge contributor to the widening of the current account deficit. It was believed that lower prices would dampen the enthusiasm of buyers who were lured by the prospect of endless appreciation.

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But, unfortunately, this didn't happen; lower prices apparently induced even more buying, as people presumably felt that this was a temporary decline and it was a good time to build up holdings.

As a result, the total value of imports shot up. An extremely worried policy establishment has responded with several measures, essentially imposing quantitative restrictions on imports.

These come on the back of a series of increases in import duties on gold, taking them from 0 to 6 per cent over the past year -- and further up to 8 per cent on Wednesday.

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Unfortunately, while the government needs to be seen to be responding and has done so in some measure, its latest actions are virtually guaranteed to fail.

The compulsion to act may justify the steps taken, but it must be recognised that these will in no way address the fundamental reasons why people are flocking to gold.

India's long experience with quantitative restrictions on imports suggests that parallel channels will rapidly emerge -- indications are that this has already happened after the imposition of duties.

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The case is not helped by the fact that Bangladesh and Nepal, both with extremely porous borders with India, impose no duties on gold imports.

As more demand is satisfied through these channels, the visible current account deficit may narrow, but the true picture will be revealed by the hawala rate on foreign currencies, which will now begin to deviate from the rate in the organised market.

There are three components to a robust solution.

First, increase access and real returns on basic bank deposits.

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This implies both bringing down inflation and expanding the reach of banking services, not just in name but in substance.

Second, promote the development and offering of gold-linked financial products, which will give savers the financial returns from gold but not require physical ownership and, consequently, imports.

Several such products are available globally and have been proposed in a recent report by a working group set up by the Reserve Bank of India.

A significant move in this direction is the introduction of inflation-indexed bonds, which were launched this week.

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Although their linkage to the Wholesale Price Index dilutes their attraction as retail instruments somewhat, since these should logically be linked to the Consumer Price Index, this is a good beginning and should be reinforced with larger volumes and the resultant market liquidity.

Third, as also proposed by the working group, the very large stock of gold already in the hands of Indian households -- estimated at 20,000 tonnes (annual imports are around 1,000 tonnes) -- should be brought into the market by encouraging these households to convert them into financial products.

Both product design and marketing have important roles to play in this process. Absent these initiatives, it won't be very long before the gold smuggler as arch-villain makes a comeback in Bollywood.