The Attack On Gold Is Not Limited To Rhetoric

In his annual budget speech, Finance Minister Palaniappan Chidambaram stated that a “Passion for Gold” is responsible for India’s high current account deficit. He proposed offering inflation-indexed government bonds to discourage people from using gold as a hedge against expectations of a 10 percent annual rise in consumer prices.

The minister’s argument is arithmetically correct: Remove the $60 billion that the country, the world’s largest Gold Bullion importer, spends annually on buying gold, and it would wipe out most of the $75 billion in overseas capital that India needs to cover its current account shortfall. This would put upward pressure on the Rupee, helping the country draw in even more foreign capital. India could then join the credit-fuelled investment boom that is currently in full swing in smaller Asian economies like Thailand and the Philippines.

The attack on Gold is not limited to rhetoric.

The government has slapped higher import duties on gold two years in a row. But the case does not stand up to logical scrutiny.

Granted, the country’s CAD - Current Account Deficit - is very high, at about 5 percent of GDP. A sustainable rate that does not raise risks of a currency crisis is about half that level, according to India’s central bank. But lowering the deficit requires influencing the saving and investment decisions not only of households, but also of companies and the government. A clampdown on just one of the three groups is a futile game of whack-a-mole.

Households everywhere have a desire to improve their balance sheets. They do so by acquiring financial assets, which are supplied by the corporate sector, the state or by the rest of the world. Dealing with the rest of the world requires foreign currency, which has to be earned by exporting goods and services.

India has a sixth of the world’s population, but does not yet have an industrial base to sell many useful things other than computer software to the remaining five-sixths.

That leads to a current account deficit, which means that households have to lean harder on domestic sources to accumulate wealth. But individuals can only buy local corporate bonds and equity if they are being supplied. If companies don’t make new investments and even cancel existing ones, the stock of private domestic financial assets held by households will shrink. This, at the present, is the case in India; investment demand has slumped and a cyclical recovery is taking longer than expected.

Demand for corporate liabilities is also constrained. The government-controlled pension industry, the intermediary for a large chunk of household savings, does not own corporate equity and has a very limited exposure to private debt. Banks, an even more important source for channelling savings to investments, are required by law to invest 23 percent of their deposits in government securities.

That’s why the government has taken it upon itself to satisfy household demand for wealth by issuing bonds. This makes sense in Japan, where the private corporate sector has not increased its borrowings for two decades. But it is highly inappropriate in India, where the sovereign has yet to firmly establish its right to tax incomes. Fewer than 43,000 Indians report a taxable income of more than $200,000 a year to the tax authorities, and the figure could easily be lower.

Without a developed tax system, the government’s debt is supported simply by the central bank’s printing press. Households intuitively know this. Fearing money-printing and inflation, they turn to gold to retain their wealth in a form that cannot be devalued by the government’s whim.

The government needs to solve the problem. It should do so by drawing up a blueprint for increasing the tax-to-GDP ratio from about 10 percent now to 20 percent – similar to countries such as Mexico and Chile – by 2025. An even longer-term objective should be to aspire to tax revenue of between 25 percent and 30 percent of GDP, as is the case in South Korea, Australia, Japan and the United States.

A credible strategy for raising the tax take would allow the government to stop forcing banks to buy its debt. Government bonds, inflation-linked or not, would be willingly bought as fears of money-printing ease; once that happens, the investment demand for gold, an asset that offers no income, will wane.

Increasing the tax-to-GDP ratio doesn’t mean raising tax rates: it’s the tax net that needs to widen. Perhaps the only sensible economic idea India’s communist parties have unsuccessfully championed is a tax on agricultural incomes. The Indian government gave up this right after achieving independence from Britain, as farmers suffered predatory taxation during the colonial era. A current government cannot muster the political courage to tax the incomes of even very large farmers.
There’s a strong case for public investment in rural India, especially in irrigation, health and education. Boosting productivity of land and labour can help bring down the rate of inflation in the long run, which will also dim the allure of gold. The government should commit itself to transparent spending of much more money in villages than it collects from them.