Saturday, October 12, 2013

On Bank of Nova Scotia's new Indian gold deposit scheme

An interesting news item hit the wire over the past few days. Here's a link for you to read first:

Reuters - India's top bullion bank to work with jewellers to tease out gold hoards.

So basically, BNS is offering a gold deposit scheme that will pay out 2.5%-3% interest, in gold, and send that gold to the jewellers so they can melt it down to make and sell jewelry.

Because it's Indian gold to begin with, this eases the need for imports, so India's CAD drops.

Here's a quote from the Reuters article:
Scotiabank's plan aims to enlist jewellers to collect the gold, which could make it more accessible in a country where many people use family-run jewellers for generations and banks are few and far between in rural areas.

Other attractions of the scheme could include more flexibility in the duration of deposits plus tax-free interest.

Soni said he had proposed a lock-in period for the deposits with Scotiabank of two to seven years, compared with the three to five years in a similar scheme run by state-owned State Bank of India (SBI).

Indians often use gold as a ready source of liquidity in times of need, making longer-term deposits less attractive.

SBI offers interest rates of 0.75 percent to 1 percent on gold deposits, depending on the time period.
I've slept on this, and here's what I think:

First, let's get some background out of the way.

It's been noted elsewhere that the SBI's existing scheme has seen pretty much no participation. 2.5%-3% is a better yield than the 1% that the SBI offers, but remember that the Indian 10-year bond is at 8.48% as of this weekend.

(BTW, I consider any country's bond yield to be a function of the market-determined base risk for entering into any contract in that country. The market is saying "if you want me to give you money and take a piece of paper in return, this is the minimum interest I demand to make it worth my while to assume the risk of this contract.")

So anyway, offering 2.5%-3% for a gold loan when you're paying 8.48% for a rupee loan? Well, the only way that works is if most of the 8.48% is there because of perceived risk in the rupee. But given India's recent past, I'd have to think a big chunk of that risk premium actually comes from political and economic risk, not currency risk.

BTW, I don't see how a lot of jewelry would participate in this deposit scheme. Jewelry has a premium to melt, and also has heirloom or social value; the point of BNS taking in this gold is so that they can melt it down and sell it to the jewellers, so you won't get your granny's bangle back 5 years from now. So you probably won't deposit it, will you?

Now, next comes my opinion. Entirely honest, an attempt to be rational and empirical, not-goldbuggy.

I can understand the intent of this. As (I think) Raghuram Rajan has asserted, India has a tremendous amount of its total liquidatable (i.e. non-land) assets held in gold, and the gold is "just sitting there".

A modern financial system works by taking in liquid assets, paying "rent" in the form of interest, then leveraging against the assets to multiply money supply. Rajan thinks India is hamstrung in becoming financially modern because so much of its assets are hoarded gold, and thus not able to participate in this. So, let's take all India's gold, and treat it as money, leverage against it, and poof! We have a modern economic system where a large amount of new capital drives greater economic growth.

There's a sociological aspect to this, by the way. You need a society that's willing to participate in modern banking before you can have modern banking.

So sure, the sociologically-modern rich Indians in Bombay will possibly deposit some of their gold bullion in a gold account. After all, it is "just sitting there", and maybe 3% is better than nothing?

Although if you're a sociologically-modern rich Indian in Bombay, who no longer feels any imperative to own physical gold, then I'd have to wonder why you didn't sell all your gold ages ago for cash to buy shares in Wipro or Tata. Or even to buy Indian 10Y government debt at 8.48% yield.

But the point of this BNS scheme seems to be to draw gold out of the sociologically-archaic countryside. And that is problem number one.

If you're a peasant farmer with 10 grams of gold in his possession then you possess an unencumbered, fully-allocated asset that acts as a hedge against existential risk, and also acts as a hedge against currency weakness and inflation. What BNS wants to make you do is turn that asset into an encumbered, unallocated asset with counterparty risk.

If I have this right, you hand your gold to the local jeweller (who let's assume is considered completely trustworthy by your entire village, since his family has been selling you gold for generations); he forwards it to BNS, who put an IOU in a little box with your name on it, and BNS melts it down and passes it on to the jewellers to make new gold to sell to other people. Your gold is now gone and replaced with an IOU.

For all of this, BNS pays you interest with the promise of maybe getting your gold back after 2-7 years.

Firstly, I don't think the economic incentive is there. For a rural peasant who knows all about economic collapse and starvation, it must seem quite important to always physically possess an unencumbered, fully allocated asset that's instantly accessible and instantly liquidatable. Even the article above says this.

So imagine you're a rural Indian peasant: what premium would you want to be paid on a gold deposit? Even fully illiterate and uneducated, you can still understand that you're taking on an encumbrance risk, a de-allocation risk, and (if you're really smart) a currency risk (since once your gold is gone, the risk is there that the government changes the rules so you only have to be paid back in the rupee value of that gold when the deposit comes due).

The only reason Whiteys put up with idiotically low interest rates (like 2.6% on the UST10) is because our modern banking system is happy with these low interest rates. They leverage against the asset so that they see a larger return on their capital. But to a sociologically-archaic peasant, 3% is a joke.

The risks this peasant is taking on are very tangible. By "tangible", I mean he actually sees his gold go away, and is left holding piece of paper. Can't get more tangible than that.

Encumbrance, de-allocation and political/currency risk are probably worth more than 2.5%-3% for a 2-to-7-year deposit, as far as the average peasant is concerned. He'd probably want 10%.

After all, the Indian 10-year government bond is yielding 8.5%, and the yield on a government bond reflects internal political, economic and currency risk, no? Essentially India has to offer people 8.5% to lend the government money for 10 years. The peasant is essentially lending money to a bank; why should he only get 2.5%-3% for this loan? He doesn't know it, but he's expecting a premium to Indian government bonds, and with good reason - from his point of view, he's taking on more risk than someone buying bonds.

Really, when you look at it from the point of view of an Indian "goldbug", a fellow who owns physical gold for precisely the same reason that Ron Paul thinks you should own gold, then it doesn't seem likely there will be a lot of participation in this scheme.

From the point of Rajan, though, I guess any little bit helps.

But while it's awfully hard to figure out how much effect this new scheme by BNS can have on Indian gold imports - heck, they could drop by 20 tons a year if nobody participates, or by 1000 tons a year if everyone does - the above discussion should at least allow you to narrow the error bar.

I also wanted to talk about the effect this would have on the long-term gold demand side, but this post is already too long, so I'll leave that discussion for my next post.

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