The RBI Should Realise That Gold Does Not Always Glitter

The government has launched three schemes to reduce gold holdings with the public. So why does the RBI itself keep $17.24 billion worth of gold that it has no need to hold for monetary or financial reasons?

Reserve Bank of India office in New Delhi. Credit: Wikimedia

Reserve Bank of India office in New Delhi. Credit: Wikimedia

From 1801 to 2002, the average real appreciation in the price of gold in the United States has been 0.33% per annum. Over the period 1836 to 2011, the real appreciation rate is 1.1% per annum. Even this is a low return rate. So, the opportunity cost of holding gold is high – more so when its price has been very volatile over the past four decades.

Why then does the Reserve Bank of India hold more than $17 billion worth of gold reserves?

Weak economic rationale

Given that the RBI (and indeed central banks more generally) operate under a fiat money regime and not under gold standard, gold reserves are dispensable. Even from the viewpoint of exchange rate stability, there is a case for holding foreign exchange reserves but not gold.

In October 2009, the RBI bought an additional 200 metric tonnes of gold for $6.7 billion. On October 30, 2009, the price of gold in the international market was $1,045.80/oz. It was expected then that gold prices will rise and that the dollar and euro could fall due to economic weaknesses in the developed world and due to high inflation that may come about due to massive quantitative easing by the US Federal Reserve and the European Central Bank. This was an added rationale then for shifting somewhat from usual reserves to gold reserves. The gold price indeed rose and touched a maximum of $1,854.40/oz. on 8 September, 2011. However, it has been falling somewhat continuously or has been more or less stagnant ever since. On January 6, 2015, the price touched $1,085.16/oz. – just slightly above where it was in October 2009. In the meanwhile, hard currency values have not collapsed; in fact, the dollar has appreciated. So, ex-post, the decision of the RBI to shift from hard currency reserves to gold reserves was not sound – more so when there is an issue of setting an example.

It may be argued that ex-ante, the decision of the RBI was correct as it wanted to diversify, given the uncertain conditions prevailing then. However, the Fed and ECB were increasing only the base money and not the money in circulation with the public. So the fear of a jump in inflation and a collapse of the dollar and euro was highly exaggerated, if not outright wrong. In any case, the best time to diversify is before an eventuality and not after a financial crisis has occurred already in the US and in the global economy more generally. It is true that it is better late than never to make amends. However, even if a delayed diversification of reserves is important, is a shift to gold reserves the only way to diversify?

One alternative asset is ordinary securities (or better still, inflation-indexed securities) issued by AAA rated governments in countries like Canada, Singapore, and so on. The volatility in the price of the bundle of such securities can be much less than the volatility in the price of gold. When a number of countries are considered, there is little exchange rate risk. Also, a bundle of such securities can be used as collateral (just as gold reserves were used as collateral in the balance of payments crisis in early 1990s in India).

It is true that the suggested alternative reserves are not as liquid as US dollar reserves. However, nor are gold reserves. This may seem surprising but it is true. Though the market for gold is liquid for ordinary investors, it can be effectively illiquid for large holders such as central banks; this is due to the impact of transactions on market price when large holders offload their reserves. This again does not reflect well on gold reserves.

Also, one need not think in terms of an alternative asset with the RBI. One could think of an alternative safeguard. Consider international credit lines from the IMF or from elsewhere. The cost of a credit line can be much less than the opportunity cost of holding reserves, including that for gold reserves. It is interesting that India already has a credit line from the Bank of Japan to the tune of US$50 billion. But this can be increased. The increase can be from elsewhere; it need not be from Japan only.

The non-economic rationale

It appears that an important reason why central banks hold large amount of gold reserves is non-economic. It is related to power, status, and so on. In 2009, India’s finance minister told the Financial Times that the additional purchase of gold that year “reflected the power of an economy that laid claim to the fifth largest foreign reserves in the world.” But while gold reserves and foreign exchange reserves more generally can be one way to get status and recognition, they are not the only way. There can be other symbols of status and power, if one must think in these terms. One example can be prestigious, highly publicized and imposing institutes of learning and research. These can be national status symbols; these can also be useful as these are productive.

It is interesting that the IMF has decreased its gold holdings since the financial crisis. So while some central banks (like India) have increased their gold reserves, other international financial institutions have decreased theirs.

Not infallible

While the public has considerable faith in the intellectual capability of the US Federal Reserve, the hard empirical evidence is very different. This suggests that it is possible the RBI (and other central banks) too can make errors. The probability of such errors can be relatively high in matters related to gold. Why? Typically textbooks in economics at various levels are quite silent on the economics (and psychology) of gold holdings. This suggests that many trained economists in central banks may not be very clear in their understanding of the economics of gold even if they are outstanding in their knowledge of mainstream economics. So they are prone to making more errors with regard to gold as compared to other economic matters.

Setting an example

It is true that gold reserves are only about 5.5% of India’s foreign exchange reserves, which is arguably a small number. However, there are two issues. First, the total foreign exchange reserves may be more than is optimal, in which case the gold reserves too are high. Second and more important, it may be worthwhile including notions such as ‘moral authority’ and ‘setting an example’ in arriving at the optimal portfolio choice for RBI’s assets. From this standpoint too, a 5.5% weightage may be too large.

Because India’s gold import has been large, the government has introduced three schemes to induce people to hold less gold. However, the government has been finding it difficult to sell the idea of holding less gold to the public. In this context, it may help if the public authorities take a seemingly unusual step. Now as the RBI holds gold reserves of about US$ 17.24 billion. This is equivalent to about Rs.1,14,330 crores, which is a very large amount in relation to the value of gold that the GOI is expecting to mobilise under its gold monetisation scheme. A senior GOI official mentioned a hopeful figure of 50 tonnes of gold at a seminar at FICCI before the schemes were launched, forgetting perhaps that the RBI itself holds 557.7 tonnes of gold. It is important that the RBI (and the GOI) set an example, and reduce their own gold holdings. This will make it easier to convince the public to reduce their physical gold holdings.

Gurbachan Singh is an independent economist, and adjunct faculty member, Economics and Planning Unit, Indian Statistical Institute, Delhi Centre

  • S.Thiyagarajan

    The govt. will fail dismally in convincing the common man to part with his gold holdings. More than its economic worth and liquidity gold ornaments have got a emotional aspect. Ordinary rural families will not part with their gold holdings whatever assurance the govt. holds out. When the stock markets are having YO-yo ride, the interest rates going south all the time to facilitate cheap money to the industrialists, the real estates not looking up any sooner and the ponzi schemes are sponging public money periodically, holding on to the yellow metal is a smart and sureway to protect your money. It makes very good investment sense to keep part of your asset as gold.The so called high flying economists who are formulating these “brilliant’ schemes fail to take into consideration the emotional cultural and status aspect of gold to the common rural people. This is not the first time that the govt. is trying vainly to lay its hands on public gold holdings. Morarjee Desai as FM brought in 14 carat scheme which proved disastrous not only for millions of goldsmith families but also for congress party. Then HM Patel as FM vowed to bring the down the gold prices as though that was his main and only job as FM and failed miserably. The recent attempts are also failing miserably as can be seen from the dismal response from the public. Keep your hands off public gold and fulfill your promise of bringing back millions of crores of black money which will be more than enough for the fiscal needs of the govt.