Why India’s Appetite for Gold Is Something to Worry About

Surging gold prices last year failed to dent India’s demand for the precious metal [XAU= 1667.90    0.46  (+0.03%)   ]. The country imported a record 969 tons in 2011, putting enormous pressure on its already ballooning trade and current account deficits.

“One of the primary drivers of the current account deficit has been the growth of almost 50 percent in imports of gold and other precious metals in the first three quarters of this year (2011-2012),” India’s finance minister Pranab Mukherjee said earlier this month.

The government has responded by doubling the import duty on gold, sparking a three-day strike by jewelers and gold dealers across the country.

India is the top importer of gold in the world and imported $58 billion worth of gold in the fiscal year ending March 31 2012, up from $38 billion in the previous fiscal, according to government estimates.

Prabhat Awasthi, Head of Equities for India at Nomura, says that oil imports are already a huge burden on India’s current account and the country cannot afford additional pressure from gold and silver.

Together oil and gold imports make up an estimated 70 percent of the country’s trade deficit.

India’s current account deficit is expected to be above $65 billion for the 2011-2012 fiscal year, while the trade deficit is expected to be around $175 billion, according to government forecasts.

This is worrying investors as the weakening rupee [INR=  50.87    -0.46  (-0.9%)   ]makes it more expensive for India to pay for its imports.

In a report published earlier this week, Morgan Stanley analysts wrote that gold has been a big source of stress on the current account deficit over the past two years.

The bank said India’s household gold consumption has gone up from $19 billion in 2009 to $45 billion in 2011.

According to Morgan Stanley, if you remove gold, India’s current account deficit would fall to just $12 billion and the current account deficit to GDP ratio would drop to less than 0.6 percent.

However, some economists argue that gold’s contribution to the current account deficit is overstated because, unlike oil, which is consumed, gold has tangible value and can be readily traded in global markets.

Rajeev Malik, Senior Economist at CLSA writes in a report, “Although it is technically correct to include gold imports and exports in the current account balance as per IMF guidelines, we peg the “overestimation” of the current account deficit due to net gold imports to be around 20-30 percent.”

The problem, he says, is that India still needs to pay for its gold imports, which puts pressure on the rupee.

“The close to $200 billion in imported gold over the past decade does not represent a drain on India’s resources, rather a diversification of India’s wealth into precious metals,” says Taimur Baig, Chief Economist, India, Indonesia and Philippines at Deutsche Bank.

But according to Nomura’s Awasthi, the funds used to buy gold are “misallocated capital” as they should be going into funding infrastructure growth, for example. “When the capital will be needed for investments, it will be difficult to find as it has already been invested in gold.”

The recent move by the government to increase import duty is thus a small step in the right direction, says Awasthi.

According to Baig, since gold demand in India appears to be inelastic, that is, demand isn’t as affected by higher prices, raising duties makes sense.

“If the duty does not change gold demand, then the government at least earns some revenue. If it ends up reducing gold demand, then the need for foreign currency eases along with imports,” he told CNBC.