Can gold ETFs reduce Current Account Deficit?
India imported gold worth over US$ 46 billion in the last financial year. Most of the physical gold imported into the country is converted into jewelry. Gold jewelry is often bought at festivals or joyful occasions. While at the time of buying, no one thinks about selling or mortgaging it anytime in the future; however, with gold, there is always a comfort that, if needed, gold in any form can be converted into cash.
One of the reasons why India and Indians weather global economic crises better than their global peers is due to their significant holdings. Gold tends to do well or at least offers a store of value during economic calamities. Whether it was the Great Financial Crisis of 2007-08 or the COVID-19 catastrophe, if you had gold in your portfolio, you would have weathered the storm a lot better than most.Socioeconomic Issues Locking Household GoldIndia imported gold worth over US$ 46 billion in the last financial year. Most of the physical gold imported into the country is converted into jewelry. Gold jewelry is often bought at festivals or joyful occasions. While at the time of buying, no one thinks about selling or mortgaging it anytime in the future; however, with gold, there is always a comfort that, if needed, gold in any form can be converted into cash.
But then there lies an impediment too. There is a social stigma attached to pawning or mortgaging family jewelry. Moreover, gold jewelry is part of the personal wealth of the woman or women of the house, putting them in a precarious position if taken away. Conversely, even if gold prices skyrocket, the women of the house may not like to part with their jewelry to book gains.
Wealth Destruction in Selling, Pawning, or Mortgaging Old Gold Jewelry
Gold jewelry gets converted into cash with a significant haircut and time-lapse. It is estimated that the haircut can be as high as 20-40% on account of making charges, melting losses, etc. This is a key reason for the gold jewelry to be locked away in personal vaults. Thus, only 8-9% of the gold supply comes through gold jewelry scrap, albeit at a sizable wealth destruction equivalent to billions of dollars.
Tax Avoidance and Money Laundering Risks
Anecdotal evidence suggests that the physical gold trade is susceptible to tax avoidance and money laundering risks. The problem may be even more acute for jewelry scrap recycling, especially as the jewelry market remains fragmented and unorganized.
How gold ETFs can solve the problems
There is a solution.
If part of the gold holdings of every family is in the form of Gold ETFs, then in times of economic distress, they can convert their units into cash with the click of a button, with limited impact cost, and with full anonymity. And when the good times roll back again, the said family can rebuild their corpus of Gold ETFs. Also, when gold prices skyrocket, the said family can encash the gains.
This works in favor of the country too. At times of economic distress, the country would like to keep the (CAD) under check, and outflows from Gold ETFs, on account of distress selling, will free up physical gold almost immediately with limited impact costs and reduce imports. This is in contrast to jewelry that gets converted into cash with a significant haircut and time-lapse.
Also, when gold prices are higher, it has a detrimental effect on the CAD, and profit booking in Gold ETFs will free up physical gold and have a positive impact on the CAD.
There is no possibility of money laundering and tax avoidance while investing in gold through Gold ETFs.
It is estimated that Indian households hold roughly US$ 1.5 trillion worth of gold. Most of it is in the form of gold jewelry. Assuming just 5% of that is exchanged with Gold ETFs, we would have roughly US$ 75 billion worth of gold with high liquidity that can flow into the domestic market in a very short span of time with limited impact costs and settlement lead times. Especially in times of economic distress and skyrocketing gold prices, both instances where CAD tends to widen, reduction in gold imports on account of flows out of Gold ETFs shall conserve precious foreign exchange and relieve downward pressure on the Rupee.
However, to make the process smooth and efficient for the Gold ETF holder, certain regulatory and statutory revisions may be essential to ensure wide participation.
Suggested Regulatory and Statutory Changes
1. Gold ETFs and Fund of Funds (FoF), which invest 90 percent or more of their corpus in units of Gold ETFs, should be subjected to long-term capital gains tax of 10 percent or 20 percent with indexation benefit.
2. The holding period to avail long-term capital gains taxation in respect of Gold ETFs should be one year.
3. Incentivize Jewelers and Bullion Dealers to swap units of Gold ETFs and Gold Fund of Funds for physical gold or gold jewelry. This will enhance direct and indirect taxation compliance.
(Vikram Dhawan is Head of Commodities & Fund Manager at Nippon India Mutual Fund)
Wealth Destruction in Selling, Pawning, or Mortgaging Old Gold Jewelry
Gold jewelry gets converted into cash with a significant haircut and time-lapse. It is estimated that the haircut can be as high as 20-40% on account of making charges, melting losses, etc. This is a key reason for the gold jewelry to be locked away in personal vaults. Thus, only 8-9% of the gold supply comes through gold jewelry scrap, albeit at a sizable wealth destruction equivalent to billions of dollars.
Tax Avoidance and Money Laundering Risks
Anecdotal evidence suggests that the physical gold trade is susceptible to tax avoidance and money laundering risks. The problem may be even more acute for jewelry scrap recycling, especially as the jewelry market remains fragmented and unorganized.
How gold ETFs can solve the problems
There is a solution.
If part of the gold holdings of every family is in the form of Gold ETFs, then in times of economic distress, they can convert their units into cash with the click of a button, with limited impact cost, and with full anonymity. And when the good times roll back again, the said family can rebuild their corpus of Gold ETFs. Also, when gold prices skyrocket, the said family can encash the gains.
This works in favor of the country too. At times of economic distress, the country would like to keep the (CAD) under check, and outflows from Gold ETFs, on account of distress selling, will free up physical gold almost immediately with limited impact costs and reduce imports. This is in contrast to jewelry that gets converted into cash with a significant haircut and time-lapse.
Also, when gold prices are higher, it has a detrimental effect on the CAD, and profit booking in Gold ETFs will free up physical gold and have a positive impact on the CAD.
There is no possibility of money laundering and tax avoidance while investing in gold through Gold ETFs.
It is estimated that Indian households hold roughly US$ 1.5 trillion worth of gold. Most of it is in the form of gold jewelry. Assuming just 5% of that is exchanged with Gold ETFs, we would have roughly US$ 75 billion worth of gold with high liquidity that can flow into the domestic market in a very short span of time with limited impact costs and settlement lead times. Especially in times of economic distress and skyrocketing gold prices, both instances where CAD tends to widen, reduction in gold imports on account of flows out of Gold ETFs shall conserve precious foreign exchange and relieve downward pressure on the Rupee.
However, to make the process smooth and efficient for the Gold ETF holder, certain regulatory and statutory revisions may be essential to ensure wide participation.
Suggested Regulatory and Statutory Changes
1. Gold ETFs and Fund of Funds (FoF), which invest 90 percent or more of their corpus in units of Gold ETFs, should be subjected to long-term capital gains tax of 10 percent or 20 percent with indexation benefit.
2. The holding period to avail long-term capital gains taxation in respect of Gold ETFs should be one year.
3. Incentivize Jewelers and Bullion Dealers to swap units of Gold ETFs and Gold Fund of Funds for physical gold or gold jewelry. This will enhance direct and indirect taxation compliance.
(Vikram Dhawan is Head of Commodities & Fund Manager at Nippon India Mutual Fund)
