01 April 2012

A war on gold? Whose interest will it serve anyway?

Existing gold investors to gain from duty hike-By CHIRAG MEHTA, QUANTUM MUTUAL FUND
The further hike in import duty by the finance minister will surely have an adverse effect on the development of gold market in India. The customs duty has been increased to 4 per cent (from 2 per cent prevailing previously) which is actually double of the previous levy and comes after nearly an equal hike that took place in January earlier this year. The duty increases have been on a spree since July 2009 when the reform process for gold markets was reversed. The duty increases currently total to a whopping increase of more than 10 times.

Will this serve the purpose?

Most probably not! It is doubtful whether these steps would have much impact on the buying behavior beyond the short term. The price sensitive Indian consumer may refrain from buying in the short term since there is a sentiment impact of a sudden increase in price owing to the duty added to already prevailing high prices.

Prices have been trending upwards over the past few years. However, even significant price rises over the past few years have not dithered consumers from purchasing more gold. Rather, there has been record consumption despite these price hikes. And hence a 2% increase in duty may not have much impact on consumption patterns.

The real story

Even in the past, policymakers have tried to discourage gold consumption but India’s affinity towards gold still holds strong. There have been a variety of measures adopted towards restricting gold consumption, right since our Independence. However, all these measure have met with little success. Thus, it is strange that the government should avoid addressing the underlying issues that drive gold consumption, and rather attempt to dissuade development of gold market in India in totality. The duty increases would probably help fill government coffers, but it’s unlikely that it would have any other significant impact on the demand of gold.

The side-effects

Going back to times when customs duty was significantly high, a major portion of gold consumed used to come by way of smuggled imports. There has been a continuous increase in duties during the last 3 years but it is still low as compared to what used to prevail when a large portion of gold requirement was obtained through unofficial channels.

Will the 5.3% incremental payment towards duties and taxes make history repeat itself? We don’t know as yet.

What the government should do ideally

Policymakers need to understand the reasons that drive people to gold. The most obvious is lack of banking / financing innovation / facilities in the rural areas where the major consumption happens. In these areas, it is gold that provides the needed liquidity. Also, inflation in India has been on a higher side often driving real interest rates in a negative territory. Owing to these reasons Indians have stayed loyal to their gold consumption habit.

Government should ideally work on measures such as promoting financial inclusion and understanding the financial needs and requirements of the rural masses, providing for social net that helps reduce uncertainty and aim at keeping inflation under control. Confidence through such measures can alter the saving habits and policymakers should ideally work towards that rather than move towards discouraging consumption.

Impact on investors

Existing gold investors will benefit from the hike in import duty as the value of the gold owned by them has increased by approximately 2% (other things being equal). On the other hand, prospective investors who wish to buy gold will probably have to purchase it at a higher rate (to the extent of increase in the duty).

Is the rise justified? Let's start with understanding why the customs came into existence.

In the past, India was a self-sufficient, inward looking economy that stayed focused on reducing imports and avoided excessive foreign exchange. In 1962, the Customs Act was established to protect local industries and prevent illegal trade of goods.

Over the years however, the Indian government decided to open its economy to foreign business and liberalisation reforms helped free the gold market through unrestricted movement of currency.

The trades were carried out smoothly until recently when the reforms were reversed and gold customs duty was increased. Ironically, India has been producing almost negligible quantities of gold in comparison to its consumption and hence there was no real need for such a duty to be levied, especially not by claiming protection for domestic industries.

The previous Indian Budgets too saw a reduction in customs duty. And then what happened to the dream to make India the gold-trading capital of the world?

India has every reason to become a dominant player in the gold market because of its immense consumption power; individuals are holding huge gold stock reserves, and the exchanges and products required for the development of the gold market are already in place. However, instead of being a country that should be setting the price, we have been categorized as price takers.The dream of making India the gold-trading capital has been sacrificed because the government is currently focused on filling its deficit ridden coffers with the revenue it will earn from the customs duty. To earn custom duty, the government is burdening consumers who are already reeling under the pressure of rising prices. It seems the government has conveniently forgotten the main intention behind the introduction of such reforms, which was to make India the gold-trading capital of the world.

Government policies play a big role in making or breaking the market, and hence the finance ministry should not be swayed by the short-term gains of the custom duty. Instead, they should pay attention to the overall development of the gold markets in India.

By introducing gold ETFs in 2005-2006, the then finance minister had taken a step forward and enabled investors to purchase gold in a more efficient manner. The government should introduce more features such as these to strengthen the gold market. Alas, the government for now has sacrificed our interest seen in the big picture and heeded advice of the naysayers of gold by increasing the levy. That’s become the norm for now.

source: http://www.moneyguruindia.com/article.php?cid=3318&id=6
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