Should Gold Loans be Banned?

November 30, 2012 at 07:37

truthing

The fact that gold gave an annual return of about 36% in 2011-12 only consolidates gold’s position both as an inflation hedge as well as an investment asset. However, nobody is going to argue that rising imports of gold (in 2011-12, it was 72% of India’s current account deficit) is not a cause for worry.

There is also a case for squeezing India’s appetite for gold as there is precious little that can be done in the short term to squeeze the demand for the other major import—oil. There are other statistics that are worrying. Gold loans have grown by a CAGR of around 40% in the last decade when non-food credit of banks has seen a CAGR of 24%. Not to mention the fact that gold stocks in the country have grown by 20% CAGR in this period with more than 60% of the stocks being held in rural India. Investment in gold does not create jobs in the economy, and that is worrisome.

Therefore, the latest move by RBI, of prohibiting bank financing of gold (especially buying gold at auctions or for speculative reasons), does not come as a surprise. Especially coming as it does on the heels of the move in March this year by the central bank to cap the loan-to-value ratio of gold loans extended by NBFCs. The question is how effective will this latest move be? For example, is there a mechanism in place by which banks can identify the speculator category of borrowers from those with genuine need for money against gold? The circular prohibits banks from making advances against gold/bullion if such advances, according to the concerned commercial bank, ‘are likely to be utilised for purposes of financing gold purchase at auctions and/or speculative holding of stocks and bullion’.

It is well-known that, in financial markets, speculators are a category of market participants who merely have a view on the prices and don’t really have exposure in the physical market. Their main contribution to the market is liquidity. Thus, even without holding an ounce of gold, it is entirely possible to speculate on gold prices and non-availability of bank-finance need not necessarily restrain such speculation on gold. Unless the circular is aimed at discouraging hoarding of gold and the banks are equipped to identify such hoarders who depend on banks to finance their hoarding activities. Then this would be a step in the right direction. Else, it might not achieve the intended objectives and might have unintended consequences.

For example, some banks offer gold loans (against gold coins and jewellery) to firms for meeting their working capital requirements (especially in the SME sector) and this circular by any manner of interpretation or implementation should not add to the woes of the SME sector by choking a source of finance. And then of course, there is the familiar problem of circumvention of law using illicit channels for bringing in gold into the country. That would be harking back to the pre-liberalisation days when gold smuggling was rampant and a menace.

A crisis must not be wasted and neither should extreme behaviour. If RBI is able to come up with a ‘gold-like’ alternative instrument and make a dent in the investment psyche of an average Indian, it would take care of this problem of obsession with gold for all time to come. And that would be no mean feat. After all, what would be simpler to understand than gold?

In a capital-scarce economy, where access to credit is limited, though growing, gold loans look like a good option provided the ground rules are put in place. Also, since we are talking a lot about financial inclusion, this particular mode of lending is effective for a number of low-income households who buy and hoard ornaments as part of tradition.

Gold loans are typically structured as secured loans where the holder gives gold or ornaments as a security and a gets a proportion of value of the same as a loan. The interest rate varies across banks and NBFCs who finance through this mode. Also, this is a quicker process relative to other personal loans and often is considered to be more dignified as the borrower need not give references, thus revealing his monetary status to others known to them.

Prima facie, this is analogous to the pawn system that exists in unorganised markets with a transparent face. It is a win-win situation for both the lender and borrower. The lender has collateral that can be easily converted to cash and since the loan given is a fixed percentage of value, the downside risk is limited unless the price of gold falls sharply. But given that these loans are normally for a shorter tenure, such a sharp decline in value would be an exception. Therefore, for the borrower, it is a good source of finance as it eschews the elaborate processes that would otherwise be involved in personal loans.

Also, since this security is provided upfront, the borrower need not have any major worry of having other property attached as the transaction involves only the ornaments or gold that is given to the lender.

In the light of the need for financial inclusion, this is useful for both individuals as well as the SME segment, where the small entrepreneur can obtain loans easily. In the case of SMEs, very often the owner has to pledge personal effects, which is limited when gold loans are taken. Therefore, such loans should be encouraged and there is no case for banning or restricting the proliferation of these loans.

From the regulatory standpoint, the safeguards have to be put in place as this business expands. Typically, there are three risks involved, of which two can be addressed. The price volatility in gold should be hedged by the lender simultaneously. Given that the FCRA Bill is likely to be passed, options trading would most probably be available, and hedging would be even more effective. Second, based on past price movements, RBI should fix the margin-lending norms, with a buffer so that any sudden decline in value of the collateral should still be above the threshold level. The lender should also have the right to call for additional collateral when such triggers are reached.

The third risk relates to the higher demand for gold, which has macro-economic implications for the country. But in a free market economy where one can buy imported cheese and motor vehicles, logically there can be no physical restriction on the purchase of gold.