Gold Monetization Scheme – Will it impact the imports of gold?
During the announcement of the Budget of 2015-16, Finance Minister Arun Jaitley announced a new scheme, the Gold Monetization Scheme, to replace the Gold Deposit and Gold Metal Loan scheme. This new scheme allows the depositors of gold to earn interest on their ‘metal accounts’ and jewellers to get loans on these accounts.
Along with this, a new financial asset, called as Sovereign Gold Bonds were announced as an alternative to purchasing metal gold. These bonds carry a fixed interest rate (2.75%), and are redeemable at the face value of the gold (at the time of redemption).
The objectives of this scheme are to mobilize the gold stored in households and institutions across the country, allow jewellers to borrow gold as raw material easily, and allow for less import requirements of gold.
How it works?
In the first step, the customer approaches a
Purity Testing Centre, a BIS (Bureau of Indian Standards) certified centre located in most states across the country and submits the gold in form of bullion or jewellery (Minimum – 30gms of gold required). A preliminary XRF machine test (45 min) is carried out to estimate the amount of pure gold.
If the customer agrees, he will fill up a form for allowing the
melting of gold. Next comes the ‘Fire Assay Test’ (3-4 hours), in which the ornaments are cleaned of studs, meena etc. and are handed over to the customer directly. From a viewing gallery, the customer will be able to observe the melting process. Finally the results of the fire assay will be given to the customer and he can either choose to accept the gold in form of gold bars and pay a small fee, or can choose to open a ‘Gold Savings Account’. In case he chooses to deposit the gold, he will be given a certificate pertaining to the amount of gold.
Next, he approaches a bank which opens the account for him, in exchange of the given certificate. The bank credits the
quantity in his account. The interest rates can be decided by the bank and the interest is credit every 60 days in form of gold quantity. For example, 1% interest on 100gms of gold will have a maturity of 101gms of gold.
The deposit accounts will have a tenure of minimum 1 year (multiple of years) and like fixed deposits, the breaking of lock-in period will be allowed.
What is done with the deposited gold?
The banks may be allowed to use the mobilized gold for CRR/SLR requirements with RBI (still under consideration). They can also sell the gold to generate foreign currency, convert gold into coins for sale, buy/sell gold on commodity exchanges and lend the gold to jewellers who will use it as raw material.
Jewellers
They benefit from GMS in the form of ‘Gold Loan Accounts’ that they can open with banks. Once a loan is sanctioned, they receive physical gold from refiners (who are contracted with banks). The banks will make an entry in that jeweller’s Gold Loan Account. The interest rate charged by the bank will cover – the interest rate paid to depositors, the fees paid to refiners and Purity Verification Centres and keep a profit margin.
Coordination
The banks will enter into a tripartite MoU with refiners and purity testing centres that are selected by them to be their partners in the scheme. It will clearly lay down the details regarding payment of fee, services to be provided, standards of service and the details of the arrangements between the banks, refiners and purity testing centres.
Benefits
This scheme will allow households to use their unused gold for earning interest and benefiting from investments in physical gold simultaneously. Banks may be able to cover their CRR/SLR requirements from mobilized gold, thus having more currency to lend out, as well as give gold as loans and earn interest at profits. With the supply of gold increasing, the demand for imports will decrease, thus benefiting the current account of the country. Jewellers can earn by keeping their stock of gold with banks and getting loans of raw material of gold, which they can process and sell, and then repay the bank with their profits.
One benefit to the consumer is that they can avail tax exemption in Gold Deposit Scheme (1999) under Capital Gains Tax, Wealth Tax and Income Tax.
Limitations
There are a variety of problems that can hamper the effects of the scheme. For one, consumers may be trusting banks but not Purity Verification Centres even if they can see the processes happening, as they are essentially not run by the government. When the results of the fire assay tests are told, in case the customer is unsatisfied he had to accept gold bars as refund. Majority of gold in households is kept as jewellery to which sentimental and social status value is attached. Conversion of this gold to pure gold may not be appealing to household members.
The process is lengthy and complicated for the rural household consumer and awareness of the scheme is also a big issue. Consumers will also have to incur fees if they choose to break the lock-in period (the gold deposit account is very similar to a fixed deposit account).
Banks can also get gold from international market and lend it to jewellers using the Gold Loan Account. If they choose to do this, then the purpose of this scheme will be defeated.
Lastly, there are almost no Purity Verification Centres in the eastern part of India, so a consumer in states like Mizoram, Meghalaya, Tripura, etc. will not be able to make use of this scheme.
Implications for the Banks -
The banks are likely to pay about 2% interest on the gold they take as deposit from its depositors. (Source:
http://profit.ndtv.com/news/your-money/article-gold-monetisation-scheme-2-interest-likely-on-gold-deposits-1216318)
This creates a huge Net Interest Margin for banks as the average lending rate for the banks is about 12-13%. This comes as a cost for risking their position for the increase in the value of the gold over the lock-in period.
For example, if banks take deposits of Rs. 1 crore at the current price of Rs. 1000 per unit of gold. This amounts to 10,000 units of gold deposited into the banks. Now at an agreed lock-in period of 1 year at 2% interest rate, banks will have to return 10,200 units of gold to its depositors.
Now suppose the price of gold is Rs. 1100 per unit of gold. The bank will have to repay Rs. 1.122 crore (10,200 units @ Rs. 1100 per unit) worth of gold after one year, virtually earning nothing as the lending rate of loans that the bank gives is 12%. They instead made a nominal loss of 0.2% over one year if the average lending rate is about 12%. The real loss in terms of goods will be greater.
In the same way, the price of gold can reduce to Rs. 900 per unit. Now the banks will have to repay only Rs. 91.8 lacs (10,200 units @ Rs. 900 per unit) worth of gold after one year, hence earning an effective annual return of Rs. 12 lacs on the loan they give out at 12% interest rate and Rs. 8.2 lacs due to fall in price of gold. This is about 20.8% which is huge.
So the higher NIM may be justified for the higher risks that the bank assumes due to the fluctuating prices of gold, which are generally in the upper direction. But generally, the price of gold is not so fluctuating, hence letting the banks earn more in the long run.
Implications for the Jewellers –
Now instead of keeping gold in physical form, jewellers would prefer to keep their gold in bank (if it is not going to be used in the short term). Considering the same 2 situations above,
If the price is Rs. 1100 after 1 year, they earned 2.2% above the return on gold; and
If the price is Rs. 900 after 1 year, they lost 8.2% instead of 10% fall in price of gold.
Hence the jewellers are going to be better off in any way the direction of price of gold is in. It is like inventory giving returns to a business without being converted to sale, rather as being kept in a bank account.
Implications for the Indian economy –
Gold, which is generally considered an assets that sucks money out of the economic system (if the investment in gold is for the long run), will now be able to generate money flow in the economy without RBI intervening by its monetary policy. This would have a direct implication on the IS-LM model.
Due to a current boom being experienced by India, there is a need to increase the money supply to reduce the crowding out effect with only IS curve shifting to the right. Gold Monetization Scheme would increase the Money Supply without affecting the actual monetary base or changing the money multiplier.
Implications for Financial & Capital Market –
Indian financial & capital markets are considered to be under-developed. Gold Monetization Scheme would enhance the availability of funds with banks which can be given out as a loan or invested as private equity in start-ups, which is a big leap towards development of the financial & capital market of the country.
This article has been contributed by Voyage Capital @IIM-I.