Gold Monetization Schemes in India1
The recently introduced gold monetization schemes seek to curb the Indian public’s high propensity to hold physical gold, release liquidity towards productive investments, and moderate demand for gold imports. Our estimates suggest that, if successful, the schemes can spur economic growth, including by reducing the dependence of the jewelry industry on imported gold. However, the viability of these schemes is linked to their ability to attract sufficient demand, an important hurdle to the success of previous similar schemes. Moreover, the Indian government and banks need to be mindful of valuation and exchange rate risks, which our simulations show to be nontrivial.
1. The proposed introduction of gold monetization schemes by the Indian government reflects a long-standing concern about the need to release the liquidity currently locked in gold holdings, and curb the high share of gold in imports. India is the world’s second-largest consumer of gold (about ¼ of world demand), and depends heavily on imported gold, which meets about 90 percent of domestic demand. Gold has accounted for an average of 10 percent of domestic imports since 2009, thus contributing significantly to India’s current account deficit (Figure). The sizable domestic demand reflects a long-standing deep cultural and religious affinity for gold and residents’ perception of gold as a “safe” asset. The perception of safety, coupled with limited availability of alternative investment opportunities, has contributed to a concentration of household savings in gold-related investments, with a recent survey of Federation of Indian Chambers of Commerce and Industries (FICCI) putting these at 22 percent of annual savings.2 Gold demand has been relatively inelastic relative to price movements, and gold purchases—particularly in the aftermath of the global financial crisis—continued to rise sharply despite the increase in global gold prices.
India: Gold Imports
Sources: Reserve Bank of India; and IMF staff estimates.
2. The schemes are intended to channel gold holdings into gold saving accounts and convert demand for gold into sovereign gold bond (SGB) holdings. Under the first scheme, banks are expected to mobilize pools of gold, currently held by the public, into deposits and extend these as gold loans to the jewelry sector (Figure). Under the second scheme, the Reserve Bank of India (RBI) is expected to issue SGBs on behalf of the government, with the redemption value of these bonds on maturity equivalent to the market value of gold over the preceding week. The schemes are motivated by the desire to increase the circulation of gold in the economy (the first scheme), and introduce a paper substitute for gold holdings (the second scheme). The proposed gold savings accounts are not dissimilar from existing gold savings deposit types. They entail a process of initial verification of gold quality prior to opening of the account, and have maturities of more than one year, interest payments in gold and principal redemption in gold or cash. The deposited gold can be lent to jewelers, converted to coins for sale, or sold at domestic commodity exchanges or to obtain foreign currency. The key difference to existing schemes is the smaller size of the permitted minimum investment, which is set at 30 grams per households, down from 200 grams previously. The SGBs will be issued in small gold denominations (in units of 1 gram, up to 500 grams per investor per year), at tenors of eightyears (with an exit option on interest payment dates after the fifth year), and at an interest rate of 2.75 percent.
Gold Monetization Scheme: Gold Savings Account
3. A key concern about the feasibility of the new schemes is that they may be unable to attract sufficient demand. Previous similar initiatives—including the gold deposit scheme (GDS) introduced in 1999 and the sovereign gold bonds issued in the 1960s and in the early 1990s—garnered limited demand.3 The conceivable reasons for the inadequate takeoff of these schemes appear linked to: (i) the public’s exclusive trust in the value of own physical gold holdings; (ii) perceptions of inadequate return on investment and/or high transaction costs; (iii) mismatches between contract maturities and ability to obtain liquidity; (iv) insufficient confidence in the gold assays or the need to prove the origin of gold acquisition; and (v) lack of sufficient distribution channels through the banking system. In this context, the contract design of the new schemes is critical for their potential success. Importantly, there are indications that the public attitude to alternative gold holdings may be changing. The FICCI survey indicates that roughly half of city-based Indian households may be willing to deposit gold coin / bullion with a bank, with 41 percent showing preference to cash settlement on maturity.4 However, the extent of such shift in sentiment is unclear, as the survey encompasses only city dwellers and does not capture attitudes towards melting of jewelry, which accounts for 63 percent of gold demand.
4. The ability to garner adequate demand hinges on establishing the needed infrastructure, providing acceptable investment returns, aligning maturities with investor preferences, and supporting sufficiently liquid secondary markets for SGBs. First, the attractiveness and payoffs of the gold savings scheme depend on participants’ trust in the quality of the exchanged gold. However, gold quality and pricing in India is still not sufficiently standardized, affecting adversely efficiency in the market and hindering broad-based monetization. Further expansion of existing infrastructure, including assaying and quality verification (BIS-approved hallmarking) of facilities would be critical in this regard. Second, gold monetization schemes should provide sufficiently liquid investment options, given that Indian households show a distinct preference for shorter-term instruments and ready availability of liquidity (40 percent of respondents in the FICCI survey liquidated gold to meet emergencies). A large share of households (36 percent) holds gold for less than 2 years and close to 90 percent for less than 5 years (Figure). The existence of a sufficiently liquid secondary market for SGBs (which have an envisaged maturity of 5 to 7 years) will allow investors to manage liquidity needs more easily and thus support stronger investor demand. Last but not least, the feasibility of the schemes would ultimately depend on the expected real payoffs, which by design are left to the issuers.
India: Time Horizon of Gold Investment
Source: Federation of Indian Chambers of Commerce and Industries (FICCI).
5. The monetization schemes also entail valuation risks, whose mitigation is contingent on the ability of domestic banks and the Indian government to hedge effectively their positions. For example, the gold savings account scheme exposes banks to potential asset-liabilities mismatches, given that interest payments to depositors are in gold, while interest to be received from jewelers is in cash. Banks also face valuation and exchange rate risks in case of cash redemptions of principal. Similarly, the guaranteed redemption price of gold under the SGB scheme can expose the government to potentially high fiscal costs in case of a large increase in global gold prices and/or a sharp rupee depreciation, if insufficiently hedged. The potential impact on government expenditures is assessed via simple simulations, assuming: (i) no hedging; (ii) an increase in global gold prices to 1,244 USD/oz and 1,380 USD/oz over a year, and an additional rupee depreciation of 22.5 percent; and (iii) formation of demand for gold-linked bonds in line with minimum, average and maximum annual demand for gold.5 Results of the simulation suggest that the SGB-related costs may account for 1.6 to 4.1 percentage point rise in fiscal expenditure as a result of a gold-price increase, and for 3.4 to 7.2 percentage points, in case of a concurrent sharp rupee depreciation (Figure).6 Thus, to contain potential costs, it is important to hedge against potential gold price volatility (both domestically and in international commodity exchanges), and increase the predictability of the import duty regime to support banks’ ability to hedge effectively.
India:Potential Fiscal Costs under Valuation and Exchange Rate Shocks
6. If successful, the gold monetization and SGB schemes can have a positive impact on the Indian economy. If sufficiently broad, the channeling of domestic gold deposits to jewelers under the gold savings scheme can provide a boost to economic growth by reducing the dependence of the jewelry fabrication industry on imported gold. IMF staff estimates suggest that a mobilization of 5 percent of the 22,000 tons of gold, currently believed to be held by the Indian public, can boost economic growth by 1 to 1.5 percentage points through an increase in jewelry production and reduction in imports.7
Federation of Indian Chambers of Commerce and Industries (FICCI) and World Gold Council2014 “Why India Needs a Gold Policy”. http://www.gold.org/download/file/3613/Why_India_Needs_a_Gold_Policy.pdf.
PricewaterhouseCoopers and World Gold Council2013 “The Direct Economic Impact of Gold”. http://www.gold.org/download/file/3208/PWCdirecteconomicimpactofgold.pdf.
ReddyY. V.2002 “Evolving Role of Gold – Recent Trends and Future Direction,” Address at a conference organized by the World Gold Council New Delhi 21 March 2002. http://www.gold.org/download/file/3208/PWCdirecteconomicimpactofgold.pdf.
Reserve Bank of India2015 “Gold Monetisation Scheme, 2015,” Master Direction No.DBR.IBD.No.45/23.67.003/2015-16. https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=10084&Mode=0
Prepared by Silvia Iorgova.
See FICCI and World Gold Council (2014).
The 1999 GDS was similar in design to the currently proposed deposit scheme, albeit with a higher minimum limit of 200 grams per deposit. Under the scheme, deposits had a maturity of 3 to 7 years and annual interest of 3–4 percent, and were exempted from taxes on interest and capital gains. India issued sovereign gold bonds on several occasions: three times in the early 1960s and once in 1993. Demand was limited, with GDS attracting about 8 tons of gold and the bond schemes—a maximum of 41 tons in 1993. For more on these schemes, see Reddy (2002).
The FICCI survey included 5,000 respondents in 33 cities across India. Seventy-three percent of respondents also indicated that they would be willing to deposit gold coin/bullion even if they were to obtain different coin/bullion on maturity.
The assumed increase in gold prices corresponds to the 75th and 90th percentiles of the distribution of annual price changes since 1995, with the later also identical to the average gold price between 2010 and 2014. The demand for gold-linked bonds is assumed to be equivalent to 3 to 5 percent of aggregate gold holdings. Gold holdings of Indian households are currently estimated to be at 22,000 tons (FICCI and World Gold Council, 2014).
The potential for fiscal costs in government-led schemes to expand considerably has precedents in other countries. For example, under a similar scheme in the late 1970s—known as “Giscard”—the French government faced a five-fold increase in redemption value after the introduction of the scheme. These mismatches may prove difficult to manage in the absence of effective hedging market for gold domestically.
The range reflects an assumption that between 50 to 75 percent of gold deposits would be channeled as loans to gold jewelers. The assessment is based estimates of gross-value added (GVA) that use mark-up values and turnover/GVA ratios from PricewaterhouseCoopers and World Gold Council (2013). Hence, it does not account for a change in mark-ups and turnover that may occur as a result of the lower cost base of the domestic jewelry industry due to the availability of cheaper gold loans.