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Indian Gold deposit scheme http://www.gold-eagle.com/editorials_98/madhok101598a.gif The gold deposit scheme announced by the Indian Finance Minister aims to draw out a part of country's vast gold holding in private hands and thus reducing India's dependence on importation of gold. With approval from the Indian Central Bank, India's largest commercial bank ("SBI") plans to launch a gold deposit scheme (GDS) on November 15, 1999, whereby they will issue interest bearing certificates against gold collected from households, temples and trusts. This is a controversial development and merits an in-depth analysis. A lot can be said both in favor of this scheme and against it. The Indian Finance Minister, backed by the Central Bank, has, obviously, found value in this scheme. On the other side there are many who believe that by launching this scheme the government plans to speculate in the gold market from the short side. If the POG rises sharply or if the Indian rupee devalues sharply against the US$ then the cost of borrowing gold will have terrible consequences for the Indian financial system. The salient features of the SBI's gold deposit scheme are: 1. Interest bearing certificates will be issued against gold deposits. Interest rate is likely to be about 3.5 % per annum. 2. Certificates will be redeemable in gold or rupee equivalent on maturity, at the discretion of the depositor. 3. Minimum deposit - 200 grams of gold. 4. Certificates will be transferable by endorsement and delivery. 5. No capital gains tax, wealth tax or income tax on the deposits. 6. Maturity - 3 to 7 years 7. Premature redemption in gold will be permitted after the minimum lock-in of 1 year. 8. SBI will give rupee loans against the certificates. The State Bank of India (SBI) will sell the gold collected under the scheme in the local market and thereby reduce India's dependence on imported gold. The Central Bank will provide a forward cover to SBI at a cost. This cost plus the interest on the certificate will more or less equal the SBI's rupee borrowing rate. In other words this is an attempt by the government to convert physical gold into paper gold backed by the Indian Central Bank. Making or accepting a gold deposit is not as simple as it sounds. Nearly all the gold held by Indian households is in the form of jewelry. Jewelry deposited under the GDS would be melted down and refined to pure gold bars. Since jewelry is a value added product, its purchase price is 25% to 100% more than the value of gold content. Under the said scheme this value addition would be lost. At the time of accepting the deposit, the Bank will have to test the purity and issue the certificate based upon the exact gold content. Thereafter, the Bank will have to melt this jewelry and refine it to pure gold bars. In addition to losing the value addition, the depositor of jewelry will have to bear the cost of testing the purity and the cost of refining. This effectively means that only scrap jewelry would be available for deposit. This leads us to an important question, that is, what is the availability of scrap jewelry? Poor people do not scrap jewelry as they can get it polished very economically. After polishing, the jewelry recovers its lost shine and is as good as new. Very rich people do exchange their old-fashioned jewelry with the latest designs. I am unsure whether they will be willing to exchange their old jewelry for paper. In any case not many households will have 200 grams of scrap jewelry. Temples and religious trusts own a lot of gold in the form of jewelry. The majority Hindu population in India believes in idol worship. The jewelry owned by the temples and religious trusts have been gifted by the believers to decorate the idols of God. Government has a significant influence on the management of these temples and trusts. They may use this influence and persuade the management of these temples and trusts to deposit this gold with the Banks. At the same time there are many diehard believers who would lay down their lives if the "ornaments meant for God" are deposited with the banks in exchange for paper. History is a witness that a lot of lives have been lost in India because somebody made the mistake of shifting an idol from one place to another. If some religious leader shouts that the necklace of "Lord Rama" has been deposited with SBI and they have melted it down, then the Government could fall in New Delhi. In India, or for that matter anywhere else in the world, one cannot play with the religious sentiments of the people. I believe that unless the deposits are made secretly, there is no chance of this gold finding its way to the Bank. The government has announced that there will be no capital gains tax or income tax or wealth tax on these deposits. What they have not announced is whether the depositor will be asked to account for the gold. Most of the gold held privately in India is unaccounted. This means that it has been purchased with the money on which no income tax was paid. To make the scheme successful the government may amend the terms to "no questions asked". If that happens then a lot of gold will be deposited under this scheme. What will then happen is that people will buy gold with their unaccounted money and deposit it with the Bank. The stated purpose of the scheme would then be defeated as the quantity of gold deposited will more or less equal the increased demand. Indian rupee is not convertible on capital account. This means that people can not convert their rupee deposits with the Banks into foreign currency deposits. The GDS offers them a chance to convert their rupee deposits into gold deposits. A lot of people may opt to withdraw their Bank deposits and buy gold bars. They may then deposit these gold bars with SBI in exchange of interest bearing certificates. If people convert their rupee deposits to gold deposits then the scheme would be a miserable failure from the government's point of view for the following reasons: 1. The increase in gold demand would more or less match the quantity of gold deposited under the GDS. 2. The government would lose a lot of money if rupee devalues sharply against US$ or POG rises sharply during the tenure of deposit. 3. Interest earned on gold certificates is not taxable while interest income on rupee deposits is taxable. The Indian Central bank has gold reserves of about 350 tons. This gold is not earning anything for the Central Bank. Yet they have chosen to borrow gold from the people and pay an interest. If SBI manages to raise significant quantity of gold under the GDS and the Central Bank provides them with a forward cover then it means that Central bank has sold their reserves for a possible (probable) future delivery. What is the logic for not selling the gold reserves and choosing to launch the GDS? To get a possible answer to this question one would have to go back a bit in time. In 1991, when India had to pledge its gold for a short-term loan, there was a big hue and cry at home. It was as if the country had been sold off. It also became a political issue during the 1991 elections. In other words, Indians are very possessive about the country's gold. In September this year when gold was trading at record lows, S.S.Tarapore, former deputy Governor of the Indian Central bank gave an interview to Dow Jones Newswires. He said "Reserve Bank (Indian Central bank) mustn't jump on the bandwagon and sell because the time to sell is when you anticipate a fall in gold price, not after the gold price has fallen steeply and the next cycle of gold rise is going to come." He suggested that the Indian Central Bank should increase its gold reserves. How prophetic were his words! The relevance here is that there is a lot of opposition to selling of gold by the Indian Central bank. By coming out with a gold deposit scheme the people in-charge are trying to camouflage the gold sale by the Central Bank and making it look like a typical financial market product. The common man in India does not understand that this scheme is nothing but a forward sale of the reserves, thus, making it very difficult for people to criticize this scheme. There was a time when gold was money. Slowly it was replaced with paper currency fully backed by and redeemable in gold. Till 1971, any US dollars owned by foreigners were redeemable in gold. People who owned dollars as credits of balance of trade were shocked by the 1971 declaration (by the US) terminating the redemption of dollars for gold. Those who trusted were left with paper worth only as much as the market forces would allow it to buy. Today we have a financial system based only on trust. Although most Indians do not know about the 1971 declaration still, I believe, they are wise enough and will not part with their gold for interest bearing certificates. Aren't these certificates as good or as bad as the pre-1971 dollars? If a few years later, for any reason, the government of India finds that it can no longer honor its commitment to redeem these certificates with gold then they may offer rupees at a convenient rate on a "take it or get nothing basis". One more paragraph would then be written in the world's history of financial defaults. Sunil Madhok [email protected] United Arab Emirates 17 November 1999 Best Regards Millet Bobin Sales Manager ____________________________________________________________________________ ______________________________________________________________ Make investing a part of your daily routine start a Daily SIP in the Quantum Long Term Equity Fund Quantum Asset Management Company Private Limited ---------------------------------------------------------------------------- ------- Experience.Consistency.Credibility. Regent Chambers, #505, Nariman Point, Mumbai - 400 021, India. Office: +91-22-2283-0322 / 61447 800, Fax: +91-22-2285-4318 Mobile No: 9821528887 Toll Free: 1-800-22-3863 (FUND) http://www.quantumamc.com/images/stamp.gif Website: <http://www.quantumamc.com/> www.QuantumAMC.com Email: <mailto:[email protected]> [email protected] -- Disclaimer: The content of this e-mail is exclusively intended for addressee(s) and information purposes. 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