Bear market a golden opportunity to shore up coffers

By Hartmut Issel
April 23, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

The recent run of the gold bears in financial markets has been positive for India’s current account balance. If this continues along with the persistent softness of oil prices, as many expect at least for the short term, it just might give the government the opportunity it needs to implement certain measures that have so far run against popular sentiment.

The plunge in the gold price since the start of the year, triggered by speculation and hints that the U.S. Federal Reserve may trim its bond-buying program sooner than markets had assumed, has helped the rupee hold up well against the dollar. This is good for India’s fiscal house, where the trade and current account deficits are more or less permanent fixtures.

Because gold accounts for just over 10 percent of India’s import bill — the second-largest import item after oil, which accounts for a little over 30 percent — a meaningful drop in the gold price, such as recently, eases the trade deficit. This is assuming the cheaper price does not trigger Indians to buy more gold. In the last two years, the steady rise of the already high gold price pared down local demand by roughly 10 percent a year in volume terms.

A lower trade deficit improves a country’s trade balance, and if it is achieved through lower imports, it also supports its currency and ultimately its current account balance. For India, this implies that it gets to keep more funds to finance domestic investments. However, commodity prices can be fickle, and gold is no exception. In fact, UBS expects the gold price to modestly recover in three to six months.

But even if that does not happen, the government would be ill-advised to use gold price relief as an excuse to let up on boosting its coffers through reform. The falling oil price, for example, could be used to phase out diesel subsidies without attracting too much attention from consumers, so the timing would be beneficial. The outcome of a lighter budget burden and better fiscal balance may then ease the government’s borrowing needs, reduce interest rates, relax inflation and ultimately stimulate investment.

The concerted fall in gold and oil prices therefore provides a window of opportunity to ease the pain of necessary reforms ahead of an election year. If the government is quick on its feet, it could even add a brick to the foundation that could put an end to years of meagre economic growth, make India even more attractive to foreign investors, and the rupee less sensitive to the swings in the price of the yellow metal.

For Indian stock markets, the falling gold price could also prove positive. Apart from its use for jewelry, gold is also bought as an investment instrument, and for this purpose, real interest rates — the difference between risk-free rates and inflation — matter to a large degree. As a general rule, low or falling real rates favour gold demand, and vice versa.

In the last 15 months, 10-year Indian government bond yields have receded from 9 percent to 7.8 percent. During this period, however, wholesale price inflation has fallen from 9.5 percent to 6 percent. In other words, real rates have almost tripled, from 1.2 percent to 3.5 percent. As a non-interest-bearing asset, gold has therefore lost some of its shine for Indian investors.

Interestingly, the only time in the last decade when Indian households invested as much in stocks as in gold was in early 2008, when the Sensex equity benchmark reached lofty levels. Since then, the difference between stock and gold investment returns has widened to unprecedented levels.

Given that real rates are expected to hold more or less steadily in India in the foreseeable future, we may soon witness a turning point in the gold-equity relationship. UBS’s outlook for the Indian stock market has recently turned bullish for fundamental reasons. If investors’ appetite for gold gets channelled to the share market, few equity investors will complain.

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