A fall in the gold price could boost India's financial system: Reserve Bank
Rather than drastically change or destabilise the Indian financial market, a correction in the price of gold could actually mitigate financial stress, a paper by India's central bank has noted.Author: Shivom Seth
Posted: Wednesday , 29 Feb 2012
MUMBAI (MINEWEB) -
A deep correction in the price of gold could nudge the financial stability of the Indian economy, according to a working paper on gold price by India's apex bank, the Reserve Bank of India. The paper has noted that any sharp fall in the price of gold is unlikely to have a destabilising effect on the Indian financial markets as was earlier envisaged and that instead a correction in gold prices may mitigate financial stress, if any.
Indians may be the biggest buyers of gold in the world with the country also holding the prime position as the largest importer of the precious metal. But when India purchased 200 tonnes of gold under the International Monetary Fund's limited gold sales programme, it was interpreted by experts that it may further inflate the gold price when the price was already ruling high. A new study in India has attempted to throw more light on this.
The report has indicated that there has been an almost unabated rise in the international gold prices in recent months. As gold is an integral part of savings of a large number of savers, the report has noted that it has raised apprehensions whether any correction in gold prices would have a destabilising effect on the financial markets.
"Even empirical analysis provides credence to the view that any deep correction in gold prices would not have any adverse implications for financial stability. In fact, the empirical results...provide support to a contrarian view that any correction in gold prices would cause stabilising impact on the financial indicators of the Indian financial system,'' notes the report, authored by members of the central bank's Financial Stability Unit.
Gold has been perceived as safe haven especially during periods of financial and economic stress. Stating that a safe haven can broadly be defined as an asset that protects investors' wealth against financial turmoil, the report notes that an asset with a stable real value or, at least a stable nominal value is an uncontroversial safe haven, as it allows its holder to resell it without loss at any time. "Viewed from this aspect, gold possess almost all characteristics essential to be classified as a safe haven,'' note the authors.
Gold rose to a 3-month high in India on Wednesday, as a low dollar lifted the precious commodity even higher. Analysts say more availability of cheaper loans by the ECB later this evening may help keeping the shine on the metal.
The research report states that the price of the precious metal is subject to two pre-conditions: whether gold is in a state of bubble and the nature and significance of gold in the overall financial architecture. "Asset bubbles burst and lead to contraction of the economy. But the impact of all types of bubbles has not been observed to be identical. Some asset price bubbles have devastating effect on the economy, whereas impact of others is minimal,'' notes the report.
The authors have noted that there is a lack of leverage in purchasing of gold. "Bubbles require large leverage and there is no evidence yet that investors (in India) are borrowing to invest in gold''.
The report has further noted that gold, unlike a financial asset, is not associated with cash inflows. "This makes it somewhat difficult to judge on a historical basis whether it is in a state of bubble or not and thus to predict the nature of correction in gold prices in the immediate future. Theoretically, severity of a correction in any asset prices (including gold) on the financial system would depend upon the nature of the ownership of the asset,'' notes the report - especially if those assets are held by banks and financial institutions, either directly or indirectly through collateral. The research note adds that in such cases, the severity of impact of the bursting of a bubble would be greater.
A gold price bubble, if at all, the authors note is likely to have a mild impact on economic activities. "Rather, gold price bust may have certain positive implications for economic activities. There is a general consensus that the present gold price spurt is taking place against the background of global uncertainties and gold is substituting for other risky assets like equities in asset portfolios. This in turn could lead to the fall in the entrepreneur's networth having adverse impact on the economic activities''.
The report notes that the fall in consumption expenditure by Indian household due to the wealth effect induced by a fall in the price of gold is likely to be minimal, as the usage of gold as a collateral for obtaining financial assistance from the banks and non-banks is still limited in nature.
The note says holding of gold among financial intermediaries is currently low, though rising. "It is bought mostly by the household sector as an alternative saving avenue and to meet social/cultural needs and not for speculative purposes.''
The authors have noted that it is important to note that the developments in the gold market in 2011-12 are taking place against the backdrop of global and economic uncertainties caused by the downgrading of sovereign debts and the debt crisis in many of the European countries. The crisis has quickly spread to the banking sector in Europe.
The authors are of the opinion that the scenario that would require gold to fall sharply would entail a turnaround in the global economy; subsiding of geopolitical tensions and a reversal of monetary accommodation.
"In that scenario, equity and other risky assets ought to recover as investors move money away from safe haven assets like gold and US treasuries. In other words, a sharp reversal in gold prices would in fact be reflective of improvement in global conditions, especially, those in the United States,'' the authors have said.
Any substitution of gold for equity and other riskier assets would thus offset the systemic impact of gold prices, if any. The report has examined the inter-linkages between domestic and international gold prices. The findings note that, presently, domestic gold prices and international gold prices are closely interlinked. Variations in the international gold prices find almost similar echo in the Indian domestic gold prices.
The Reserve Bank held 557.75 tonnes of gold as on September 30, 2011. This forms around 9.2% of the total foreign exchange reserves in value terms. Of these, 265.49 tonnes are held abroad in deposits and in safe custody with the Bank of England and the Bank for International Settlements.