Subsidies = inflation = gold problem

The government has a certain theory on gold as per which buying gold is harmful for the Indian economy. Allow me to elaborate starting with something that P Chidambaram, the Union finance minister, recently said “I...appeal to the people to moderate the demand for gold.”

India produces very little of the gold it consumes and hence imports almost all of it. Gold is bought and sold internationally in dollars. When someone from India buys gold internationally, Indian rupees are sold and dollars are bought. These dollars are then used to buy gold.

So buying gold pushes up demand for dollars. This leads to the dollar appreciating or the rupee depreciating. A depreciating rupee makes India’s other imports, including our biggest import i.e. oil, more expensive.

This pushes up the trade deficit (the difference between exports and imports) as well as our fiscal deficit (the difference between what the government earns and what it spends).
The fiscal deficit goes up because as the rupee depreciates the oil marketing companies (OMCs) pay more for the oil that they buy internationally. This increase is not totally passed onto the Indian consumer. The government in turn compensates the OMCs for selling kerosene, cooking gas and diesel, at a loss. Hence, the expenditure of the government goes up and so does the fiscal deficit.

A higher fiscal deficit means greater borrowing by the government, which crowds out private sector borrowing and pushes up interest rates. Higher interest rates in turn slow down the economy.

This is the government’s theory on gold and has been used in the recent past to hike the import duty on gold to 6%. But what the theory doesn’t tells us is why do Indians buy gold in the first place? The common answer is that Indians buy gold because we are fascinated by it. But that is really insulting our native wisdom.

World over, gold is bought as a hedge against inflation. The latest Economic Survey, authored by Raghuram Rajan, the chief economic advisor to the government, recognises this.

When inflation is high, the real returns on fixed income investments like fixed deposits and banks is low, pushing people to buy gold. So, people buy gold when inflation is high and the real return from fixed income investments is low, to protect themselves from high inflation.

That’s precisely what has happened in India. “High inflation may be causing anxious investors to shun fixed income investments such as deposits and even turn to gold as an inflation hedge,” the Survey points out.

High inflation in India has been the creation of all the subsidies that have been doled out by the government.

“The rising demand for gold is only a “symptom” of more fundamental problems in the economy. Curbing inflation, expanding financial inclusion, offering new products such as inflation indexed bonds, and improving saver access to financial products are all of paramount importance,” the Survey points out.

So, if Indians are buying gold despite its high price and imposition of import duty, they are not to be blamed for it.