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The Return of the Gold Carriers

Analysis
Feb 17, 2013 3:58 AM   By Dilipp S Nag
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RAPAPORT... India’s decision to increase the gold import duty for the third time in about a year has made the local gems and jewelry industry nervous, and not without reason. They are not as worried about the possible impact on demand as they are about an increase in gold smuggling in India, which is the world’s largest gold consumer market. They fear that higher duties will make gold smugglers, or gold carriers, very active due to the lucrative profit margin available now and willing to take the risk to carry the yellow metal.

The government knew that the smuggling was bound to increase if there were a further rise in the gold import duty. So what prompted India to take such a drastic step? The current account deficit (CAD), which occurs when a country’s total imports of goods, services and transfers are greater than its exports. The CAD hit a record high of 5.4 percent of the gross domestic product (GDP) in the second fiscal quarter that ended in September 2012. Since gold is the second largest import item after crude oil, the government imposed additional tax as an immediate step to check the CAD. In January this year, the gold import duty was increased to 6 percent from 4 percent.

“The starting point has been the current account deficit that came to 5.4 percent, so that is the time the government started to see what [could] be controlled,” notes Madan Sabnavis, the chief economist at CARE Ratings. “You cannot control oil because you require it. The other one was gold that accounts for around 12 percent of our imports. So they decided to control the gold, not physically but through additional tariff.”

There was already growing dissidence among local jewelers due to the 4 percent import tax on gold and the industry requested that the government reduce the tax by 2 percent. However, encouraged by the results of increased duty on the country’s gold imports, the government instead decided to hike the tax to 6 percent. From April to September of the fiscal year 2013, India's imports of gold and silver dropped to $21.3 billion, approximately a 33 percent year-on-year decline.

BACK IN ACTION

The industry is concerned that the government may further increase the import duty on gold by another 2 percent when it makes its federal budget announcement for fiscal year 2014, due on February 28. If that happens, it will certainly be a bonus for gold smugglers, who were the major force fulfilling local demand prior to 1990.

According to a paper from the Associated Chambers of Commerce and Industry of India (ASSOCHAM), the government’s gold policy until the economic reforms of the early 1990s centered on the major objectives of discouraging people from purchasing gold, reducing domestic demand and regulating the gold supply of gold. But in the early 1990s, when the Indian economy faced a severe Balance of Payment (BOP) crisis, there was a shift in the government's approach to gold policy.

The gold smugglers' dominance started declining in the early 1990s with the liberalization of India’s economy and after the government abolished the Gold Control Act in 1992, allowing gold import at low duties. Smuggling was further reduced after 1997, when the Reserve Bank of India (RBI) authorized commercial banks to import gold for sale or loan to jewelers and exporters.

But industry officials say that with recent increase in the gold import duty, smugglers have become active again. “Now with 6 percent import duty and 1 percent value added tax (VAT), the total comes to 7 percent and that is an extraordinarily good margin for the parallel economy,” says Pankaj Parekh, the vice chairman of the Gem & Jewelry Export Promotion Council (GJEPC).

The Directorate of Revenue Intelligence (DRI) – the agency responsible for checking smuggling and evasion of customs duty – has seized gold worth $11.2 million (INR 601.7 million) and cracked 36 cases of smuggling in the first 10 months of fiscal 2013, The Mint newspaper reports. To compare, in the corresponding period in 2012, DRI had seized gold worth $1.4 million (INR 74.2 million) and cracked 15 cases, it adds.

Sonal Varma and Aman Mohunta, economists at the brokerage firm Nomura, say that demand for gold demand as a hedge against inflation has risen. “We think import duties will lead to a reduction in gold imports [only] through the official channel and result in a simultaneous rise in gold imports through unofficial channels,” they observe.

MODUS OPERANDI

“Gold is such a small bulk and such a high value item that sea route does not apply. It [smuggling] is done mostly through [the] air route or land route,” Parekh says.

How do the smugglers operate? Are custom officials ready to tackle the surge in smuggling activity resulting from high import duty? Gold carriers continue to explore new ways to deliver the consignment. From using the services of air passengers and carriers by offering them money to carry gold with them to hiding gold in cabin baggage or on different parts of the body, smugglers exploit every option they can think of.

Officials note that most of the smuggled gold is brought into the country from Dubai and Thailand. Recently, customs has also detected cases of gold smuggling from countries that are not on the radar of intelligence agencies and the customs service.

Despite government vigilance, smugglers may not find it very difficult to walk into India from neighboring countries such as Bangladesh, Nepal and Pakistan, they note.

Sensing the increased smuggling activity, the government has already directed customs authorities and agencies to step up vigilance on international borders. But it is certain that government agencies will find it difficult to contain smuggling through sea and land routes, which – officials say – could revive significantly in the coming months if the gold duty remains high.

IMPACT ON GOLD DEMAND

Will the higher duty lead to lower gold demand? Or will Indian consumers continue their centuries-long love affair with gold? Jewelers do not seem to be worried about consumer demand as they are well aware that it is traditional in Indian families to purchase and gift gold and jewelry on wedding and festive occasions.

In addition, Parekh notes that international gold prices fluctuate by 4 percent to 5 percent in a span of about two months but demand remains constant. Therefore, there is unlikely to be any impact on jewelry demand due to the 2 percent duty increase. “Volatility in the price of gold is accepted,” Parekh says.

Gold prices rose to an all-time high in local currency to over $603 (INR 32,500) per 10 grams in 2012, driven by a pickup in consumer demand, a weak rupee against the U.S. dollar and the uncertain global economic environment. The precious metal is currently hovering around $561 (INR 30,200) in the local market.

“The government thinks that by increasing the import duty on gold it will be able to reduce the consumption in the country, but it is not true,” says Bachhraj Bamalwa, the chairman of the All India Gems and Jewelry Trade Federation (GJF).

Trade officials, however, say that jewelers may be tempted to buy gold in the grey market because it will be cheaper than buying gold from official sources.

“Two rates will apply in India and it will also become a source of doubt by the authorities whether this gold that is being used by jewelry establishments is bona-fide imported gold or smuggled gold. Everything will be under suspicion,” notes C. Vinod Hayagriv, the managing director of Bangalore-based jeweler C. Krishniah Chetty & Sons.

And what about investment demand? Will it sustain? Economists note that there will be a dip in the investment demand as investors’ effective return on gold will come down by 2 percent due to increased duty.

“It won’t affect the consumer’s consumption, but definitely the investor demand will be affected,” Sabnavis says.

CURRENT ACCOUNT DEFICIT

It is expected that the drop in gold imports as well as additional income from the higher gold duty will help improve the country’s CAD. Sabnavis projects India’s current account deficit to be around 4.5 percent of its GDP for the fiscal year 2013.

If RBI implements its working group’s recently announced proposals such as introducing new gold-backed financial products, designing inflation indexed bonds and prohibiting bank finance for purchases of gold bullion, this will further help curb gold demand and import.

Gold imports in fiscal 2012 amounted to $56.5 billion and in the current fiscal year, up to December 2012, gold imports were already estimated at $38 billion.

Nomura economists say that given the country’s penchant for gold at weddings and other religious ceremonies, a sharp fall in volume was unlikely. It expects India's gold imports to ease to $48.3 billion in fiscal year 2013.

“With exports likely to recover in 2013, we expect India’s current account deficit to improve but to remain around 4.3 percent  of GDP in fiscal year 2014, much above sustainable levels of 2.5 percent of GDP, due to high oil prices and continued domestic supply-side constraints boosting import demand,” they note.

Industry officials say that the government should keep the gold import duty for one or two years and gradually bring it to zero percent when the CAD improves. The government has said that it will review the duty if there is a moderation in the quantity of gold imported into the country.

It will take a while to see the desired results and in the mean time the industry will continue to bear the brunt of higher gold import duties. But the gold smugglers aren’t going to complain.  
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