Put India's Gold to Work

This article was first published in the Financial Times, Beyond Brics, on May 1st 2013

http://blogs.ft.com/beyond-brics/2013/05/01/guest-post-put-indias-gold-to-work/#ixzz2S7f5RUMg

Co-Author: Saumya Rastogi

When gold prices fell below $1400 in mid-April, investors across the globe panicked and tried to exit their gold-based investments. Yet the scene was quite different driving through the Somajiguda area of Hyderabad, in India.

Both sides of the road, which is lined with jewellery shops, were overflowing with customers. As a valet at one of the largest shops put it: “People have been buying like gold is being distributed for free.”

The scene is testimony to the craze for gold among Indians. This craze is often blamed for India’s burgeoning current account deficit, and for a failure of household savings to reach the financial markets.

With cultural values that laud fiscal sagacity and shun profligacy, Indians traditionally save more than they spend. The household savings rate in India has always been above the global rate of 20 per cent. It was close to 30 per cent in 2012, making the year’s savings around $400bn.

But a very small part of these savings gets invested in stock markets (just 2 to 5 per cent). A large portion goes into fixed deposits (45 per cent) and a significant amount finds its way into buying the yellow metal (8 to 10 per cent).

Reduced real rates on bank deposits and small savings funds coupled with a volatile stock market have made gold even more popular among Indians. The risk-averse Indian considers gold a hedge against inflation and a safe asset with high investment potential – and rightly so.

Source: Authors

Let’s look at the normalised prices of gold and the Sensex equities index of the top 30 companies listed on the Bombay Stock Exchange. A person who invested in the Sensex in 1997 and held his investment until today would have earned as much as a person who had invested in gold. However, it is also evident from the graph that while gold prices have risen steadily in the last 15 years, the Sensex has been very volatile since 2007. Since it is very difficult to time the market, a lot of investors might have ended up losing money if they had invested in the Sensex in 2006-2007 and then tried to exit. However, gold continued its steady rise even during those tumultuous years.

It is ironical that people buy gold and hoard it for years, but people buy stocks and sell at the first opportunity. If they held onto stocks as they do gold, their stocks might give them the same or maybe better returns. The difference in behaviour may be attributed to an emotional attachment to gold.

Another point worth noting is that aversion to risk is inversely proportionate to the level of education. According to a study by the National Council for Applied Economic Research, supported by the Securities and Exchange Board of India, risk-taking ability is highest among individuals with 15 years of schooling. Investment in mutual funds is much higher in villages close to urban centres, than in villages in remote areas.

There is a lack of financial awareness and innovation in India. Only 55 per cent of the country’s population has bank deposits, 9 per cent has bank credit accounts, less than 20 per cent has life insurance coverage and only 10 per cent has access to other kinds of insurance.

Clearly, financial services in India are under-penetrated and there is a need for inclusion of financial products and services to channel household savings into the financial markets. It is essential that people are educated about the existence of investment options and their associated risks and possible returns. The Indian market is up for grabs but more financial players will have to be encouraged to develop products and services aligned with the risk-averse nature of Indian households.

It would be wrong to expect that investment in gold can be quickly replaced with investment in financial instruments in India. However, measures that integrate gold and financial markets can provide a solution. Instrument like gold-backed deposit schemes, where households can deposit their surplus gold, in any form, in a bank and earn interest on it, gold exchange-traded funds, and so on, could facilitate the penetration of financial products in India. Better penetration and participation of households in the financial markets would definitely stoke the country’s economic engine.