The Indian government's gold folly

Aug 2, 2013·Alasdair Macleod

India has a history of gold ownership, spurred by long-term experience of a weak rupee. Only a fool leaves rupees on deposit, because they usually buy less and less every year. Alternative stores of value, such as equities, have only entered the mainstream on the back of the economic boom, and their performance on the whole has been nowhere as good or certain as gold.

Since independence gold has been the best store of family wealth by far. Today’s grandparents were buying it at 170 rupees to the ounce in 1965, and since then there have been festivals, children born, children married and grandchildren as well. The responsible family patriarch has saved for his family’s wellbeing and future, and gold has been central to his savings. And what a wise man he has been: gold today is about 75,000 rupees an ounce, having gone up 440 times in his lifetime measured in rupees.

He knows something Westerners do not: the rise in the gold price is due to the currency going down. And so long as the currency goes down, it makes sense to continue to accumulate gold to ensure family savings retain their value. Nothing else gives this protection, and the price paid today or tomorrow is a secondary consideration.

Governments don’t like this mainly for ideological reasons. They don’t like the idea of some people getting rich from doing nothing. Furthermore, they are in the business of transferring wealth from savers and workers to pay for political objectives and also to assist their favoured pressure groups. As well as getting its income legally through taxation, governments print money. Printing money devalues the purchasing power of people’s earnings and savings without them realising what is happening. The benefit of gold ownership is that it protects people from this hidden tax of monetary inflation, which leads over time to a lower and lower currency. And the lower the rupee goes, the greater the reasons to buy more gold.

Until recently the Indian government has allowed families to buy imported gold, having repealed the Gold Control Act in 1990. The lesson from this legislation was that it merely drove gold dealing onto the black market, and did nothing to stop individuals getting hold of gold if they wanted to.

However, the Indian government is not fully in favour of free markets and seeks to control many aspects of Indian life, including gold ownership. This is why the State and the financial sector (which is licensed by the State) are now encouraging ordinary people to buy Exchange Traded Funds and e-gold instead of physical bullion.

This amounts to an attempt to introduce western capital market practices into mainstream Indian life. However, it introduces new risks, which the vested interests of government and financial promoters do not tell you about. ETFs and e-gold do not require the backing of physical gold, only a promise to pay its value. Instead of being backed by gold, these financial substitutes need be no more than a book entry on a computer, so long as the issuer retains the confidence of the investor.

This is exploited to the full in western capital markets, where mountains of paper gold are transacted without delivery of any physical metal taking place. This is the world that ordinary Indian savers are being encouraged to join, where instead of actually holding physical gold they are being offered a paper entitlement. With physical possession of gold, it is yours and no one else’s. An ETF, or e-gold (whatever that is) depends entirely on the integrity of the financial intermediaries, and their integrity in turn depends on the rules provided by government.

The government’s agenda

So what is the government’s real agenda? There are three possible considerations. The most obvious and commonly cited of the three is that the government sees increasing imports of gold contributing to the trade deficit. Therefore, if it can discourage imports of gold, it believes the trade balance will correct.

This economic interpretation is uninformed and frankly naïve. Logically, the source of trade deficits is not the private sector, but always the result of government intervention. Put simply, if private persons or their businesses import something they pay for it, either out of earnings or savings. If they pay for it by borrowing the money, they always make arrangements to pay the money back so that any deficit is temporary. Governments do not have these constraints, being able to finance trade deficits through trade agreements at an inter-governmental level, by borrowing money they do not intend to repay, or by simply printing money. The imports of gold are therefore no more than an allocation of private sector savings, not additional spending. So the trade deficit argument is mistaken.

The second reason is that the government thinks that savings can be better deployed for the good of the nation by being spent on consumer goods, or invested in either government bonds or in businesses. The idea that government decides how much people should spend and how much they should save is economic intrusion into family life, and as we have seen, the returns on alternative investments have been unattractive compared with gold.

The third reason is less obvious but probably the most important. Demand for gold from Asian countries has resulted in a substantial shift of physical metal from the US and Europe to countries in the Asian continent such as India and China, and this shift has accelerated as more Asians have prospered. Therefore demand for gold from India and other Asian countries has led to gold shortages in western capital markets. For decades the western central banks have been supplying gold to the market to try to stop the price rising, a strategy that was always going to eventually fail.

We have no way of knowing how much gold the American and European central banks have left, but it is a fair bet that it is less than half the 19,000 tonnes they officially claim to have as part of their monetary reserves. They are simply running out of bullion to sell to keep the price down. So it is almost certain that the Reserve Bank of India has come under pressure from western central banks to limit Indian citizens’ imports of gold.

From the Reserve Bank’s point of view, it is a waste of time telling middle-class Indians to give up saving gold, so the answer is to persuade them to invest in paper alternatives. For this strategy to work, not only must they be encouraged to buy paper gold, but they must be discouraged from taking delivery of the physical metal. And this is precisely what is happening.

The irony is that while the Indian government is encouraging the development of paper gold markets, in the West these markets are now under significant stress. Bullion banks in London and New York geared up their paper gold trading in the 1990s, and have been unable to adjust to the rapidly increasing demand from India, China and elsewhere that has absorbed much of the available gold. The combination of large quantities of paper gold and very little physical bullion to underpin it threatens a liquidity crisis, which will also engulf paper gold products elsewhere, even in India.

At GoldMoney we have been observing these developments with increasing concern, and see attempts to encourage anyone to switch to synthetic gold as a trap. As the problems in the global economy and banking system multiply we expect western governments to continue to restrict their citizens’ freedom of choice. There is an increasing likelihood of taxes on gold or even outright confiscation in Europe and North America if this trend continues. In these circumstances it is also easier for any government to tax paper gold, such as ETFs or e-gold, than to track down anonymous bullion ownership.

By substituting paper gold for physical metal, the people of India are being asked to pay the price of the follies of the western banking system. This contrasts with the attitude taken by the Chinese authorities who are not so weak that they give in to western demands. The middle-class Indian may not be financially sophisticated, but he is more than likely to see through the ETF and e-gold promises.

After all, that is why he puts his trust in gold and not government paper. Attempts to establish various forms of paper gold should therefore fail.

This article was first published at


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