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Rajan Says Interest Rates Must Be High and Gold Imports Could Be Investments

In a speech at Harvard Business School, RBI governor Raghuram Rajan tells us a story:

In part, India’s slowdown paradoxically reflects the substantial fiscal and monetary stimulus that its policymakers, like those in all major emerging markets, injected into its economy in the aftermath of the 2008 financial crisis. The resulting growth spurt led to inflation, especially because the world did not slide into a second Great Depression, as was originally feared. So monetary policy has had to be tight, with high interest rates contributing to slowing investment and consumption.

This is the first time I’ve heard of the RBI admitting to inflation through loose monetary policy. And I welcome the resulting tightness, though it would be strange to say it’s enough today.

And he makes an interesting point:

An increase in gold imports placed further pressure on the current-account balance. Newly rich consumers in rural areas increasingly put their savings in gold, a familiar store of value, while wealthy urban consumers, worried about inflation, also turned to buying gold. Ironically, had they bought Apple shares, rather than a commodity (no matter how fungible, liquid, and investible it is), their purchases would have been treated as a foreign investment rather than as adding to the external deficit.

This is important. The fact that Gold comes part of our current account deficit is because we categorize it that way. Gold is not used for things – it’s largely stored as an investment. If people bought Apple shares – or indeed anything like shares abroad – it would come into the capital account, not the current account.

Effectively when you invest abroad, you have a cash outflow but what you own can be sold in dollars, so that impact could be removed to see how much the real “consumed” imports are. However, gold muddies the waters. Gold isn’t sold back internationally – and if it is, the price will fall hugely, because Indians consume more than 50% of gold sold worldwide. And then, we don’t just import gold, we import jewellery, which will have a much lower buy-back price. So to just remove gold imports would be to deny reality that the reverse transaction is simply not going to happen, and the deficit will have to be bridged anyhow.

The accounting of gold, however, can bring the current account deficit down substantially. We have to follow world standards today, but it would be interesting to see what the “external deficit” would look like minus gold.

Still, there’s a whole lot of Gold in the country, and the only way to bring it out is related to the first point – I say bring down inflation to 3% or less, and watch people lose interest in Gold.

  • It may be possible to categorize gold into consumption and investment forms i.e. gold in form of bars/bricks etc can be classified as investment gold and value-added (actually value destroyed from an investor’s point of view) forms like coins, jewellery etc can be termed as consumption gold. But it’s going to be difficult to first classify different types and to track the flow of individual imported lot-whether it remained a gold bar or got converted into a gold necklace/gold tooth.
    My fear is that our FM will lap-up the idea to use it as a magic wand to ‘reduce’ CAD.

  • Rama Karupaiah says:

    I agree; the average Indian buys gold because instinctively he knows the govt. cannot be trusted. We have a history of devaluations and of rupee debasement. Then you cannot trust the stock market; there are crooks there. What about mutual funds? Well UTI was trusted once upon a time. You know how that ended! So what is the safest route? Gold!

  • Leo says:

    ok 2 things… i dont want to own gold but gold is not hedge against inflation.(it is hedge against worthless counterfeiting of currency notes or it is hedge against people stealing ur labour which u saved by doing UID and MNarega and all)
    second Inflation wont come down till u have defualts by some people.for inflation to come down u need rates 14 15% .Has he got the courage to do it.what happens to the govt debt.
    Lastly insane idea of CAd is cos of GOld.What about interest payment on the debt.U borrow then u realize u cant make money out of the borrowed money but u have to pay interest on it .U assume static rates when u borrow in panic.But when rates shoot up for some reason U sit and blame gold over population and all.
    Why borrow which u dont have ?
    Ps : why minus gold why would u give the gold to the govt to pay back what it has borrowed.>One should be nuts to think so .They will INFLATE till system crashes to freeze things.

  • v says:

    He is giving contradicting statements at home and away !
    To latha he said i will guard against inflation while having an eye on growth numbers,
    and now this … he is more confusing than Subba who did the exact opposite of what he said …
    Too complicated to call … lets see how he acts and what he says in the next policy meet

  • mangoman says:

    October policy will give full picture.
    He bought time by FCNR gamble hoping that he can fix things before time is up.
    He very well knew that once he allow OMC’s to buy currencies in market or FCNR scheme closes the INR is f***ed. If you want to take INR out of ventilator you have to fix the inflation. So October policy is key. If he raises 50 basis points of Repo and Keep MSF unchanged then we can say he is up to it.
    Otherwise ….hmmm

  • Anish says:

    Classic accounting versus cash flow issue. Will changing the accounting treatment of gold imports change the fact that we still need precious foreign exchange to acquire it? Definitely not.

  • Sanjeev B says:

    Since we have a managed currency anyway, let’s take advantage of that:
    1. Devalue the rupee by 30%.
    2. Do this in one shot so we don’t have to play tag with interest rates going up and then down, and wait for market economics to play out slowly
    3. Keep interest rates low to 5%. This will incentivize us to put our money to work productively, instead of putting it lazily in the bank hoping someone else will do all the work to make it productive.
    4. Split gold import accounting 70/30: 70% investment, 30% consumption. This will also account somewhat for gold devaluation in case all of us decide to sell.
    The result:
    – The Rupee value will be more honest
    – The CAD will be more honest
    – Most importantly our work ethic will be more honest

    • Leo says:

      I think you should read about hyperinflation…second no one is honest .
      You are not understanding why banks are there.It is not about lazy money.No one trusts the system of banking. REad about volcker he raised the rate to 20% .Now u think he knows better or what ? You have to stop this investment into real estate that is the cause of this problem.
      CAD is not coz of gold…sorry that is all crap.CAD is coz of the fii taking money home >industries selling stuff taking profits .The mint u raise rates all these guys who are in debt *real estate will defualt .Banks will feel the pinch short term but long term money will flood into the system .Stabilize the system.Imagine the rates are pushed down.It will get people into more debt and will collapse the system in the future.
      Rates always move up on 2 ocassions.
      The borrower not paying
      second people are optimistic and want to borrow to make life better
      We are going to see the former soon .This claim of Npas are low is total crap according to the PM
      If u really want to lear read Mises work on this.Austrian economics.
      Artha shastra was my favourite.(which said rates should not be below 15%)

    • Leo says:

      ur really crazy (sorry take it in the lighter note )
      Why should i keep money in the bank rather buy agri stuff and sell stuff..5% rates will create Hyperinflation instantly in India
      SEE THE GROWTH OF M3 .already mad guys US UK JAPAN are printing u want india to print too.Low rates = high assets ..when it collapses no one will be there to bail us out.Who will save us ? lord kirshna ? or NRIS….
      Insane thinking to lower rates.

  • jose says:

    as for as poor indian aam adhmis are concerned buying gold means amusing their wealth in swiss banks. after all they dont have much more to do with their hard earnings.