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Wednesday, February 6, 2013

Gold Truth

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Physical gold is good for consumption, but don't bank on it as an investment vehicle

 Irrespective of rural or urban areas, few buy gold with the intention of selling it. No wonder, India's holdings are the highest globally.

According to World Gold Council figures, India held 18,000 tonnes of gold in 2011. The figures, according to experts, could be much higher if you take into account the dormant gold in temples and private lockers.

What makes the yellow metal so attractive to Indians? For one, it has a huge ornamental value. For most people, it is the family heirloom passed on over the generations. Whether it's marriage or any social event, a gift of gold - even if in small quantity - is preferred.

On the other hand, selling or mortgaging of gold is considered a shame – (mortgaged gold to educate). So, gold continues to thrive despite the physical gold market being marred with problems. If you are buying it for ornamental value, the cost of making jewellery comes into the picture.

In many cases, it is as high as 1015 per cent, which gets shaved off while selling it. While banks can sell gold, they are not allowed to buy it. Even if one buys coins from a bank or a particular  jeweller, it can seldom be sold back at the market rate to another jeweller. One will normally give 5- 10 per cent less.

In addition, one has to hold physical gold for three years to get long term capital gains tax benefits. If one invests in gold exchange- traded funds, the same benefits accrue after just one year.

In comparison, in the developed world, gold has always been an investment instrument. As the Reserve Bank of India's ( RBI) committee on gold chaired by U B Rao points out, The ornamental or jewellery forms of gold are relatively of lower caratage. Those who held gold for investment purposes were holding gold with higher caratage. With high inflation and falling rupee, gold has been a good hedge, especially for high net worth individuals ( HNIs) with incomes of over $ 1 million ( 5.4 crore). But inflation has started falling and, rupee is up from 58 levels to 53- 54 levels, so it makes little sense now.

Most investors were aggressive with gold because it has given great returns in the past nine years. Since 2000, Indian gold has returned almost 16 per cent, whereas the Sensex has returned 11 per cent. Over 20 and 30 years, the situation is the reverse.  But it barely gave 10 per cent last calendar year, whereas both equity and bank deposits have done relatively well.

Another issue, investment experts point out, is the low number of tax payers. " Only three- four per cent of people pay tax in India. They convert the black money into gold," says another investment expert.

No wonder, Finance Minister P Chidambaram's and RBI Governor Duvvuri Subbarao's job is already cut out. On the one hand, high imports of gold are one of the main culprits of the current account spiralling to a deficit at 5.4 per cent of the gross domestic product in the July- September quarter.

On the other, people are rushing to buy gold because other financial instruments are not giving substantial returns.

Both have already tried quite a few tricks. The finance ministry has increased gold import duty to six per cent – five times more from just the one percentage point importers paid last January. RBI has asked banks to reduce lending to gold loan companies. But imports, at 604 tonnes till September in the year, have continued.

More recently, the government has changed tack. Now it wants to limit imports by asking gold exchange traded funds ( ETFs) that hold 11,600 crore of gold ( around 35- 40 tonnes) to deposit part of it with banks. The banks, in turn, will lend it to jewellers. According to a government note, banks will pay a nominal fee to mutual fund houses to keep gold. This will improve the gold returns by 50- 100 basis points.

In other words, gold is being promoted as a financial instrument, much like the RBI committee recommended.

The committee recognised the need to convert both rural and urban demand for gold into investment in gold- backed financial instruments through dematerialisation of gold.

In the past five years, a lot of money has gone into debt, real estate and gold. Around 20- 30 per cent of the imported gold is for investment purposes.

There is a need to have financial products that will give comparable returns to divert investor's money There are some options such as gold ETFs, gold fund of funds, e- gold and others. Even banks have gold deposit schemes. However, promotion of these products has been limited. Mutual funds seldom advertise gold ETFs and banks complain of low storage capacities to accommodate gold deposits.

The committee has suggested introduction of products such as a modified gold deposit scheme, gold accumulation plan, gold- linked accounts, and gold pension products. The financial structuring of these products will be so done that entire investments need not be backed with physical gold. There are even suggestions to give incentives to investors who take cash delivery instead of physical gold. The proposal to increase the role of banks to help investors buy e- gold through their bank accounts will help attract more customers. At the moment, many customers do not prefer the route because they have to maintain a separate account with the commodity broker. So is the case with ETFs, where one has to use the demat account.

The most interesting recommendation is a gold pension plan, where households will deposit their idle gold with banks and get it back in instalments in the form of a monthly pension scheme over the next 20- 25 years.

This will work like an annuity scheme. In the foreseeable future, investors in the yellow metal would eventually move to financial instruments. It could happen if gold were to perform worse than other instruments.

This is much like land investment, which has a formidable physical presence. But as an investment ( not consumption), it could make little sense.

If inflation were to go below the bank rate in the next decade, the value of gold would come down very sharply. In fact, I would not even suggest too much of gold as a financial instrument.

The proposal to increase the role of banks to help investors buy e- gold via their bank accounts will help attract more customers

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