Asia's Gold Investing Support, Part 2: India Goes AWOL

'Sink of the world' for 2,000 years, India faces an outright attack on its gold demand...

In CONTRAST to China, the Indian government's attacks on gold investing are well known and increasingly well-practised, writes Adrian Ash at BullionVault in the second part of this story (read the first here).

New Delhi's latest action is even having an effect, short term at last, amid the collapse in cash transactions following the shock demonetisation of 500 and 1000 Rupee notes last month.

How did the world's second biggest private gold consumer get here? To recap...

With next-to-no domestic mine output, and after two millenia or more as the "sink of the world" for precious metals, India today holds perhaps 50% of its $2 trillion of private household wealth in physical gold. That has required an awful lot of gold imports over the years, requiring in turn an awful lot of cash outflows.

That's why Indian citizens were banned from investing and trading in gold amid the balance of payments and currency crisis building after 1947's independence from Britain. Almost 30 years of smuggling followed, with mafia networks and everyday law-breaking growing to match, as people continued buying gold to sidestep the Rupee's continued and steady devaluation.

A fit of commonsense led the government to repeal that Gold Control Act in 1990, and more deregulation came after the balance-of-payments crisis which hit a year later, due to a deadly mix of Soviet Russia's collapse (a key export market) and Gulf War I's surging oil prices (India's biggest import, ahead then as now of gold).

So although exports of bullion were still banned by a raft of complex rules and regulations (bureaucratic habits die hard), India's gold private demand was allowed to waft and wane pretty much as investors and householders chose during the long bull market peaking 2011. The drop in prices through 2012 started to spook India's politicians however, while the Reserve Bank's deputy governor moaned that "90% of India's gold demand is jewelry or to offer to God... Both have to stop."

Then came the 2013 gold crash.

The authorities had already hiked India's import duties that January, but it didn't touch the sides as gold sank through $1600...then $1500...then $1400 per ounce. Even with the Rupee falling too, buoying domestic gold prices, consumer demand leapt, sucking in record-high monthly inflows of gold and costing record-high outflows of cash. That only worsened India's Current Account Deficit with the rest of the world, dragging the Rupee down to new record lows on the currency markets. That only worsened the flight to gold, and so worsened the CAD in turn.

So the Congress Party government raised import duty on gold again, and again – sparking a boom in the old smuggling trade – and then it imposed a series of import rules so novel, and so complex, the secure airfreight industry which ships gold into Mumbai and Ahmedabad froze in fear. Imports to India fell to zero – or rather, legal inflows did.

The BJP government taking power in 2014 has since abandoned that dreaded 80:20 rule. Narendra Modi had, after all, campaigned on a platform of being wise to unintended consequences, leading many dealers and jewelers to expect a gold-friendly government when he took power.  Yet even as Modi left a fat profit margin wide open to smugglers – by leaving the 10% duty on legal imports unchanged – his administration sought other ways to cut gold inflows, by trying to cut gold investment demand itself.

First it tried cash incentives, offering to match the move in gold prices plus a rate of interest on top through the Gold Monetisation Scheme and Sovereign Gold Bonds. Then it turned on the jewelry trade directly, lowering the value at which any cash transaction or purchase must be reported to the tax authorities via the customer's PAN card (personal account number) while imposing a new 1% tax at the point of sale. The industry squealed, shutting up shop and striking for well over a month, all to no avail but further denting India's imports.

Rising prices didn't help (because of how the gold market works, as per Part I here), dampening legal demand so badly (the import tariff continued to offer that 10% margin for smugglers and ask-no-questions consumers to share) that domestic prices sank to a record discount to London quotes of $100 per ounce as metal piled up, unsold, in midsummer. Because with India still banning the (legal) export of bullion, there's no other easy way for over-supply to get fixed.

By July 2016's three-year high in the global Dollar gold price following the UK's Brexit vote, the secure airfreight industry was sucking wind yet again as legal inflows to India dried up. One industry estimate guessed that some 7/10th of all imports were coming via the black market, only confirming the Indian gold business's shady reputation for policy makers – a confirmation their own actions helped bring about. 

And then, on the same day as the US election in November, New Delhi went nuclear on India's black-market economy and untaxed wealth. With just 4 hours' notice, Modi announced that India's highest denomination banknotes – worth some $7 and $15 each in an economy generating $5 per head per day in 2015 – would cease to be legal tender. This demonetisation killed 86% of currency in circulation, forcing pretty much everyone to cue at their bank to deposit the now useless paper, for full value, into their accounts before the end-December deadline.

Only half of Indian adults have a bank account. The other hundreds of millions who do have lost untold hours ( or worse) lining up to deposit their cash savings. That wall of money swelled the banks so fat, the central bank had to hike the cash reserve ratio kept back to limit a potential surge in new lending. Replacement notes still won't be ready for perhaps another 2 months, and the shock has caused such uncertainty, rural families receiving financial support apparently won't deposit new checks for fear of losing their 'below the poverty line' status, meaning they cannot spend the cash. With the trucking industry seizing up as drivers – like everyone else – runs out of cash, India's economic outlook has been downgraded by all major ratings agencies, and GDP may drop 1-2 percentage points from the world-beating 7.3% clocked in the third quarter.

Why so drastic? Hardly anyone pays income tax in India – as few as 1% on official data – and untaxed transactions might account for half of economic activity on some estimates. Corruption is endemic, and the Modi government – in line with Western authorities – thinks physical cash does more than simply enable it. So despite all this chaos, Modi's move is still mostly backed by the population, at least according to Indian media. Because corruption is a terrible drag on doing business and everyday life in general for the vast majority of voters.

Untracked and untraceable, banknotes are the lifeblood of backhanders and bungs. But New Delhi sees physical gold as the fat store, holding value – again untracked and untraceable – far from the Revenue Service's grasp until the ordinary householder's everyday criminal acts need to release it as cash. (Another such store is real estate, now next on Modi's list of tax evasion targets.) One senior bullion-market bank executive reckons that 10-30% of India's gold investing and jewelry demand is paid for using so-called 'black' money. That guess might jump higher still for any metal sold since demonetisation struck – again confirming the industry as crooked amid the impact of the government's own policies.

Jewelers can't even buy people's gold back from them legally, because there's no cash to pay them with and no hope of re-selling again because there's no cash for local buyers to pay with and bullion exports are banned. Many individual jewelers and dealers are meantime being pursued by the tax authorities for accepting the now banned banknotes after the 9 November deadline, with the giant Axis Bank freezing at least 50 gold business's accounts for suspicious deposits. And while last month's surge in (legal) gold imports fits the usual model for how India responds to a price drop, the media and Modi government are taking it as proof positive that the gold industry sold metal for illegal cash, helping people launder savings they would otherwise have had to declare to the tax man by putting it into the bank.

What next? A massive 80% of the $234 billion-worth of cancelled notes have already found their way into bank accounts, according to the Reserve Bank of India. But the long lines of savers wanting to deposit their otherwise worthless paper ahead of the New Year's deadline continue, as does a legal challenge to the whole demonetisation decision. The attack on gold has meantime created such fear amongst ordinary savers that New Delhi had to assure the nation it doesn't plan to impose a wealth tax on inherited jewelry.

All told then, the cash crunch and uncertainty show no sign of ending just yet, precisely while the global gold price looks for a floor amid the post-Trump sell-off by Western ETF shareholders and other professional investors. Alongside Beijing's restriction on gold imports to China, "We do not expect either situation to ease meaningfully before the next Indian budget and Chinese New Year," says precious metals strategist Tom Kendall at global bullion bank ICBC Standard, "both of which will fall around the end of January 2017."

Key to resolving the collapse in India's import demand will be the decision on GST – the General Sales Tax, currently under (heated) discussion by a government-appointed committee, and aimed at simplifying and unifying revenue raising across the world's second most populous nation from 1 April. It should be detailed in the Government's 1 February budget, and some people seem to think the net tax-take on gold purchases might go down. Maybe they have somehow missed the plain intent to reduce gold demand shown by Modi's BJP administration. 

Will that succeed long term? Banning imports failed between the 1960s and 1990's repeal, and hiking duty and tax rates only boosted black market inflows again over the last 5 years. Yes, the shock and awe of Modi's demonetisation bombshell is certainly worsening the 2016 plunge in demand – a fact which Western investors and traders hoping Indian buyers will stem any further price drop cannot ignore. But 2016's drop in Indian gold demand began alongside the first-half's strong price gains. November's surging imports show the underlying model working when prices turned lower as well. And India's deep love for gold has overcome everything government has thrown at it to date.

As for China, Beijing has by all accounts tapped the brakes in gold inflows by restricting the number of licenses it issues. But inflows to where? The international free-trade zone in Shanghai doesn't count as China, not for import purposes, not until bullion crosses the line into the Shanghai Gold Exchange's domestic section. All that gold leaving Western ETF accounts in London and also Comex warehouses in the US must be going somewhere.

Word is, Switzerland is seeing heavy shipments of .9999 fine gold, the high-grade kilobars loved by the Far Eastern markets. Just maybe the two are connected.