Should we (not) invest in gold?

Import duty on gold was increased by 2% couple of days back. That got me thinking whether it is really that bad to invest in gold. I jumped out of my seat when I read comment from Uday Kotak saying that "equities should be made more attractive to wean away gold demand".

Indians do have lot of attraction towards the yellow metal - most of it part of our ingrained culture and (rich) history. However, since we don't manufacture enough gold, we end up importing almost 2/3rd of the required gold. The usual numbers that are thrown are that gold imports account for 12% of the total imports, next only to crude oil, thus impacting adversely our balance of payment, currency reserve and so on. There is a school of thought which says that gold is an unproductive asset and hence it should not be owned.

I have a slightly different take on this. Gold is an accepted store of value over centuries, as against the relatively newer paper currency standard. So fundamentally owning gold is tried and tested phenomenon. It is even more important if the paper currency is being devalued by constant and sharp increase in money supply. It is because more paper currency is available for consumption of goods which increase by a smaller amount. Right now, there is a global competition for currency devaluation where all major countries are rapidly printing money to debase their currencies in a bid to improve their economies. In a coordinated global move of debasing paper currencies, owning gold would be a very good strategy indeed.

Let's take the issue of productivity. There are lot of assets which are not productive, but still contribute to GDP growth. My favourite example is real estate purchased for investment purpose. If a person invests in a house but doesn't stay there or even rent the property the asset itself is non-productive. But it is still counts when calculating the GDP. Best example would be China, which has built "Ghost cities" (completely non-occupied) only to boost its GDP.

Let me give another argument for investing in gold. India's inflation (as measured by CPI-IW) is constantly above (see here) 8%+ over the past few years. Risk free interest rate is ~8% on pre-tax basis. Subtract the tax and you are left with negative interest rate. Savings rate is a measly 4%, where people park significant part of their investible surplus to get instant liquidity. I would again think that not investing in gold which has given superb returns in the past and is very much a liquid asset would be counter-intuitive.

My only limited point is that, let people make their own investment choices to people in a free economy (if we can India that). And in the process if the currency devalues then it is a collective decision. Our imports would be costlier, there would be higher budget deficits. But the "golden" lining is that our government would be forced to control its wasteful expenses.

PS: Another news on Gold ETFs can invest in Gold deposit schemes. This is shear non-sense. I would not even want to comment on this. But if this actually happens, I would surely pull my money out of ETF and buy that shining yellow thing.

Problems of credit allocation

I have earlier written here about problems of inflation caused by agriculture sector. Actually high and persistent food inflation in India is due to mis-allocation of credit towards agriculture sector. So I ran a regression between Agriculture GDP and credit to Agriculture sector

Regression between Agri Credit and Agri GDP for FY01-12

The table above shows that Agri-Credit and Agri-GDP are correlated with high R-square, low p-value and so on. What is more interesting is that Agriculture credit is correlated with a factor of 0.29x with Agri GDP. In simple terms, every 1 Rupee increase in Agri credit results in 29 paise increase in Agri-GDP. This clearly shows mis-allocation to the sector. How does this happen? RBI's mandate for say a 15% credit growth and fixed priority sector lending norms for agri and allied sector result in agriculture credit growing by the same amount. Over the past 12 years, agri credit has grown 10-fold, i.e. CAGR of 21%. This is much higher growth rate than the sector can absorb.

Let us explore where this money (loan or equity) goes. A farmer uses various inputs seeds, fertilizers, tractors, etc. Most of these are purchased on loan. After 6-8 months, farmer is able to sell his product and repay the loan (or revolve it for the next farming cycle). Now we are increasingly stuffing more loan  into this shrinking (in terms of farm sizes, area cultivated and so on) segment. The input companies figure out availability of cheaper loans and aggressive lending by banks and hence have incentive to increase the prices at will. This is precisely what has happened in India. Look at prices of tractors, fertilizers, seeds over last 10 years and you would know.

In a free market system, rampant increase in input prices would result in shrinking margins of the producer and he would restrict the usage of these inputs or look for cheaper alternative. But in India Government decides minimum support prices (MSP), which basically compensates for increase in input prices. So, who benefits? Banks, input companies. And who pays? Every citizen - he borrows at higher cost to compensate for incentives to agri sector and occasionally absorbs the losses due to defaults.

Are we consumers or products??

If you are not paying for it, YOU are the product

Current interest rate spectrum in India

With interest rate increasing and banks tightening on loan disbursement, lot of companies are hitting the retail markets to raise money. Following chart captures Cumulative Annualized yields across various maturities offered in various NCD schemes as of now. Hope this helps you in making meaningful financial planning decisions.

Source: ICICI Direct, Google Docs

Some comments -

1. DHFL is offering the highest rate for all maturities, mostly due to lower credit rating. But spread with HDFC, which is in the same industry, is widening with time. I would be careful in investing for longer duration in this company.
2. ICICI Housing finance rates are the worst. Why would anyone would invest in this NCD when industry leader HDFC (presumably more stable in terms of future performance) is offering higher rates at all the maturities.

Food inflation in India - a perspective

A lot of people have expressed their views on this topic. This article/post doesn’t do anything different. Focus of this article remains on how bad overall policies are leading to high food inflation in India. Over FY05-FY11, food articles prices have been increasing at 10.3%, which is considerably high for any country. The pace of price rise has increased in the past two years. 


What I am trying to show here is that inflation in India is a result of a) bad monetary policies, b) lot of money flowing in the economy and c) lack of improvement in productivity.

First factor is a large bank credit flowing into agricultural and allied sectors without generating adequate output growth. RBI mandates banks to disburse ~12-13% of incremental credit to agriculture or allied activities, as “Priority Sector lending”. In addition, regional & rural banks, cooperative banks, institutes like NABARD, provide credit to agricultural sectors. Total credit to agricultural sector has grown at 24% over FY05-09. In contrast, Agri sector at constant prices has grown at a measly rate of 3% and accounts for <15% of India's GDP. Clearly disproportionate amount of credit is flowing into the sector. This results in crowding out for private creditors and also at higher cost in order to compensate for low cost agri-credit.


One should wonder where this money would be flowing into. The credit is essentially used for purchase of agricultural inputs like seeds, fertilizers, irrigation, machinery and in agri-process industries. Increase in usage of farm inputs (to improve production yield) and their prices increase leads to exponential increase in total input cost for the farmers. This working capital is financed by banks and other institutions. Sadly, due to banks’ eagerness to fulfil priority sector lending quota, credit is easily available and at cheaper rates.   


Second factor is Government fixing MSPs of various agriculture produce. Here, Government tries to fix prices such that impact of increase in costs is absorbed in addition to some mark-up for the farmers. This has two unintended effects. One, there is less incentive for farmers to efficiently use the inputs. Two, agri input providing companies have incentives to increase prices to improve/maintain their profitability. A higher increase in MSPs would lead to larger amount of money flowing into hands of farmers. This money competes for consumption goods which are limited in number. It is no surprise that rural economy is growing.

Third factor is lack of improvement in agri productivity and is related to two earlier points. 13% incremental credit is flowing into agri sector. If one assumes that credit-to-capital ratio remained the same, this means agri-input cost is increasing at rate of ~20%+. However, output growth inclusive of productivity improvement is just 3%. Government tries to fix MSP breach this gap. But even MSPs of major crops have grown at 11-12% over the same time period. We can conclude that farmer's profitability has been declining over the years. 

What worries me that this is very similar to what happened in the US real estate sector. The agri sector growth in India is fueled by low cost credit. RBI’s policy makes sure that constant credit flow to the sector continues. Regular increase in MSP acts together with Government’s implicit agenda to support the farmer acts as “Bernanke’s Put” for the banks and all the players involved. And we are not seeing any real output growth. The problem would not surface as long as regular albeit smaller growth in agri output continues. But it would be growing in magnitude. Any external shock like natural calamity, irregular monsoon would create havoc. The impact would be first on farmers not being able to pay the loans they raised for various purposes. This would result in large scale defaults including social problems like large scale suicides, etc. In addition, Banks would large scale loan defaults. Results would be catastrophic and would soon spread to other sectors.

How can we avoid this problem? Free market. Either of the first two points mentioned here should be market determined. Either credit flowing into the system should be market driven or output prices should be liberalized. Both are difficult to implement and would result in series of social and economic issues. But this needs to be done, and sooner than later.

How do FIIs perceive Indian markets

Some time back, I was trying to look at FII holdings in the Indian companies. I used Nifty as a benchmark. The study threw some interesting facts. I am presenting them below and my comments on why this is possibly happening.

	Market Cap (bn)	FII (%)
Nifty - overall	29,584	17.8%
Nifty - ex-banks	25,057	15.3%
Nifty - banks	3,633	30.0%
Banks - overall	6,061	22.5%

As can be seen, foreign ownership in banks is significantly higher. One obvious reason is limited float in some of the large companies - a) Government owned entities like NTPC, ONGC and b) companies like TCS, Wipro where promoters have done limited dilution. There could be other reasons like limit on FDI in a particular sector like retail,insurance but would have limited impact. I think, India still has lot of regulatory and other operating risks. Much of the raw material usage is regulated; many of the utilities like power, telecom,transport have strong regulatory bodies. Agriculture, although large in size is very fragmented. In this scenario, banks are mostly likely to be perceived as aggregator of risk. Plus, there is an implicit assurance that Government would not let the bigger banks fail due to systemic threat to the economy.
This gets even more interesting if you look at FII holdings of real estate companies Vs that of housing finance companies.

	Market Cap (bn)	FII (%)
Real estate companies	977	20.5%
Real estate financiers	1,065	54.7%
Banks	6,061	22.5%

Real estate sector in India is attractive and has more FII holding than Nifty. However, real estate financiers are preferred a lot more. I think this is on two accounts. Real estate financers have two important loan assets - loans to real estate companies provide high yield, while loans to individual homeowner would provide stability in terms of low default (Indian consumers are very sensitive about loan default, especially on mortgaged house). This offers best risk-return profile.