The Fallacy of Composition: Selling Equity, Buying Gold


Gold has done well in the recent past. Over the last six months it has given a return of around 14% (in dollar terms) and is currently quoting at $1250 per ounce (one troy ounce equals 31.1 grams).  With these returns gold is coming back on the investment radar, though over the last five years the yellow metal has given a negative return of 12%.

Indians have always been fascinated with the idea of buying gold. As per the World Gold Council the consumer demand for gold in 2015 stood at 848.9 tonnes. Of this 654.3 tonnes was gold that went towards making jewellery and 194.6 tonnes was gold that went towards making bars and coins.

Interestingly, India now lags behind China when it comes to gold consumption. In 2015, Chinese consumer demand for gold stood at 984.5 tonnes, around 16% more than Indian demand. The Chinese consumed more gold than India both when it comes to jewellery as well as gold in the form of bars and coins.

The trouble in the Indian case is that the country produces very little gold of its own. In 2015, the domestic supply of gold in India, as per estimates made by the World Gold Council stood at 9.2 tonnes or a little over 1% of total consumer demand. This supply came from local mine production, recovery from imported copper concentrates and disinvestment.

What this means is that India imports a bulk of its gold demand. As Akhilesh Tilotia of Kotak Institutional Equities who is also the author of The Making of India writes in a recent research note titled Selling Equity for Gold: “On net basis, i.e. accounting for the gold which is imported for re-export, Indians bought US$267 billion of gold over the past decade.”

The gold that is imported into India needs to be paid for in dollars. India’s stock of dollars comes in from various things including foreign direct investment(FDI) made into companies and projects and foreign portfolio investment(FPI) made into stocks and bonds.

As Tilotia writes: “According to our calculations, FPIs own a quarter of the outstanding stock of the BSE-200 stocks as of 2QFY16. Over the past decade, India received net equity FII flows of US$119 bn; the net FDI inflow is US$185 billion.”

If we add the FPI and FDI numbers for the last decade it comes to $304 billion. As mentioned earlier India net-imported gold worth $267 billion over the last decade. This essentially means that a bulk of the dollars that came into India through the FDI and the FPI route where used to buy up gold.

As Tilotia writes: “Indians have, over the last decade, traded equity in their private and public companies for gold. Of the US$304 billion that came in as net FDI and FII inflows over the last decade (FY2007-16E), Indians bought gold worth US$267 billion.”

To put it simply, over the years, India has sold stocks to earn dollars and in turn used these dollars to buy gold. While this wasn’t planned, this is how things have turned out. In the process, the country has become a victim of the fallacy of composition.

As Greg IP writes Foolproof—Why Safety Can Be Dangerous and How Danger Makes Us Safe: “This fallacy occurs when what benefits an individual is wrongly assumed to benefit an entire group. For example, if one moviegoer stands, he can see the show better. But if everyone in the audience stands, no one sees better, and everyone is uncomfortable.”

Indians buying gold is a tad like that. When an individual Indian buys gold either as jewellery or as an investment or as a hedge against inflation, it makes sense for him at individual level. But when the same thing happens at a societal level, it creates problems for the country.

Buying gold needs dollars, which can’t be created out of thin air. Further, it can also lead to the value of the rupee against the dollar falling as had happened between May and August 2013, when the dollars coming into India dried up, but Indians still continued to buy gold. As Tilotia writes: “when foreign fund flows dried up, Indians continued to buy gold thereby precipitating worries of large slippages on the current account deficit.”

It also led to the demand for dollars going up leading to the rupee depreciating against the dollar. This led to the value one dollar nearly touching Rs 70. This became a huge problem given that oil imports suddenly became very expensive as Indian oil marketing companies had to pay more in rupees in order to buy dollars they required to buy oil. The demand of oil companies for dollars led to further depreciation of the rupee against the dollar.

Further, these were the days when diesel was subsidised by the government. The government in turn compensated the oil marketing companies for the under-recoveries they occurred. This pushed up the government expenditure as well as the fiscal deficit. The fiscal deficit is the difference between what a government earns and what it spends.

Of course, every time someone buys gold, it takes away money from another productive investment. Gold essentially is useful because it is useless.

All this was an impact of the fallacy of composition which came with Indians buying gold. The government is now trying to address this fascination that we have for gold through the gold monetisation scheme and the sovereign gold bonds. Let’s see how successful they are with it.

The column originally appeared on Vivek Kaul’s Diary on March 11, 2016

Sovereign Gold Bonds are a great idea that won’t work in India

On November 5, 2015, the Prime Minister Narendra Modi launched the sovereign gold bonds. On the occasion Modi said: “India has no reason to be described as a poor country, as it has 20,000 tonnes of gold. He said the gold available with the country should be put to productive use, and these schemes show us the way to achieve this goal.”

Our fascination for gold has led to a situation where we have managed to accumulate 20,000 tonnes of gold over the years. To understand how big this number is, consider the following point made by the World Gold Council. As it points out: “At the end of 2014, there were 183,600 tonnes of stocks in existence above ground. If every single ounce of this gold were placed next to each other, the resulting cube of pure gold would only measure 21 metres in any direction.”

What does this mean? India has 20,000 tonnes or around 10.9% of the 1,83,000 tonnes of gold in existence. The tragedy is that India doesn’t produce almost any gold. In fact, in 2013-2014, we produced 1.4 tonnes of gold.

And how much did we import? The minister of state for commerce Nirmala Sitharaman(independent charge) in a written reply in the Lok Sabha had pointed out that Indian import of gold in 2013-2014 had stood at 638 tonnes.

So India produced 1.4 tonnes of gold and imported 638 tonnes of gold. Interestingly, the import of gold in 2013-2014 fell by around 25% from 845 tonnes in 2011-2012. In 2011-2012, India had produced 1.59 tonnes of gold. Hence, we practically import all the gold that we consume.

And this creates major macroeconomic imbalances. Gold is sold internationally in dollars. When India imports gold it needs dollars, which need to be earned through exports. When India imports gold, it pushes up the demand for dollars in comparison to the rupee and the value of the rupee starts to fall. A depreciating rupee is good for the exporters because they earn more. But given that our imports are more than our exports it hurts.

Other than practically importing all the gold that it consumes, India also imports 80% of the oil that it consumes. A depreciating rupee means that the oil marketing companies which import oil have to pay more for oil in rupee terms. In the past, the government did not allow the oil marketing companies to pass on this increase in cost to the consumers totally.

Only recently diesel prices have been freed and are determined by the price at which oil marketing companies are able to buy oil internationally. Oil marketing companies still suffer under-recoveries every time they sell kerosene and domestic cooking gas.

The government has to compensate the oil marketing companies for these under-recoveries. Up until last year, the oil prices were very high. And when gold demand went up, the rupee depreciated and this pushed up the total amount of money oil marketing companies had to pay for oil. Since they were not allowed to totally pass on this increase in price to the end consumer on the oil products they sold, the government had to compensate them.

When the government compensated them, the expenditure of the government went up and so did its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. This meant higher borrowing by the government.  A higher borrowing led to crowding out, where the increased government borrowing did not leave enough on the table for the other borrowers. This, in turn, pushed up interest rates. And so the cycle worked.

Let’s look at this in another way. In 2013-2014, the gold and silver India imported, formed around 7.1% of the total commodity imports. In 2012-2013 and 2011-2012, the number was higher at 11.3% and 12.5%. For a commodity which is pretty much useless from an industrial point of view that is a huge proportion.

In 2013-2014, gold worth $28.7 billion had been imported. Now compare this to India’s IT and IT enabled services exports which during the same period stood at $86.4 billion. So, one way of looking at it is that one-third of dollars earned through IT and IT enabled services exports were used up to buy gold.

In fact, the situation was even worse in 2012-2013, when the gold imports were at $53.7 billion. The IT and IT enabled services exports were at $76.5 billion dollars. Hence, more than 70% of dollars earned through IT and IT enabled services exports were used up in buying gold. For 2011-2012, the proportion was even higher at 81%.

Once all these factors are taken into account the sovereign gold bonds sound like a fantastic idea. As a RBI notification dated October 30, 2015, points out: “The Bonds shall be denominated in units of one gram of gold and multiples thereof. Minimum investment in the Bonds shall be 2 grams with a maximum subscription of 500 grams per person per fiscal year (April – March).” The bonds shall also pay an interest of 2.75% per annum.

So anyone looking to buy gold instead of buying actual physical gold can buy these bonds. The value of these bonds will be linked to the price of gold. As the RBI notification points out: “The redemption price shall be fixed in Indian Rupees on the basis of the previous week’s (Monday – Friday) simple average closing price for gold of 999 purity, published by IBJA [Indian Bullion and Jewellers Association].” The bonds can be held on paper as well as demat form.

When an investor invests in these bonds he will not buy physical gold. This will help in reducing gold imports and the entire cycle, which I have explained above, will not play out or play out to a lesser extent. The RBI and the government will not get a macroeconomic headache because of our fascination for buying gold. At least, that’s the idea.

Of course I am assuming here that investors will move from buying physical gold to investing in sovereign gold bonds. Nevertheless, will that happen? Paper and demat gold has already around in the form of gold mutual funds and gold exchange traded funds(gold ETFs). Gold mutual funds invest the money that they collect into Gold ETFs.

These funds haven’t really taken off. This tells us that the Indian investor has an aversion to paper and demat gold and likes to hold real gold.

The advantage in case of sovereign gold bonds is that the investor along with getting gold returns also gets 2.75% as interest on the initial amount he invests. Is that lucrative enough to get him to move from physical gold to paper/demat gold? I don’t think so.

And that’s basically because there are other factors at play. Investing in gold is a lot about touch and feel. Indians are emotionally and culturally attached to the gold that they buy. Further, as I mentioned in the Friday edition of The Daily Reckoning, many Indians buy gold to store their black money. A lot of money can be held by buying a small amount of gold. These individuals are likely to continue to buy gold in physical form. The reason is straightforward. They are not going to buy paper/demat gold because it would be establish an audit trail and lead to problems for these individuals.

Also, those interested in getting gold jewellery made will get gold jewellery made and not buy sovereign gold bonds instead.

Due to all these reasons, I think the sovereign gold bonds are unlikely to take off. Indians will continue to buy gold in physical form. But that shouldn’t stop the government from trying.

The column originally appeared on The Daily Reckoning on November 10, 2015