11 July 2014

No Indian gold import policy change explains RBI gold swap

After a lot of speculation about what changes the 2014 Indian budget would bring for gold import policies, we got zip. That now supports my speculation on why the Reserve Bank of India (RBI) announced, ahead of the budget, a combined quality and loco swap of its gold: it was a temporary political fix to the problem of:

1. Making promises to the gold industry during the election campaign that it would wind back gold import restrictions.
2. Reality, once in office, that such relief on gold imports would negatively affect India's current account deficit.

Standard political MO: "Oh, it is a lot worse than we thought, we can't honour our promises, it is the previous Government's fault". Interestingly, on the eve of the budget the Indian gold industry hadn't read the warning signs and thought there would be relief, with Bachhraj Bamalwa, of All India Gems and Jewellery Trade Federation, speculating that the duty would be cut to 6% and even that "the government might remove the 80:20 rule in a gradual, 'phased' manner". This view was probably helped along by statements from the Government like "any action on gold should take into account the interests of the public and traders, not just economics and policy". Well it is clear they sided with economics and policy.

There were some warning signs, with this Reuters article quoting commentators noting that the Government was "moving back and dithering on their decisions, and in a sense playing politics". Another sign was this Report that "India risks losing its investment-grade sovereign rating if it fails to get its finances into shape" with S&P warning "there was a one-third chance of a downgrade [of India] to "junk" without a big improvement in the fiscal deficit and in implementing reforms."

For me, the strongest sign the new Indian government was going to back away from its promises was the RBI gold swap announcement and the local gold industry should have paid more attention to it, because its timing was very unusual: just before the election about gold which had been sitting in RBI's vaults in India for decades. Why was this non-standard gold suddenly an issue?

I think it is a reasonable speculation that the RBI knew in advance that the new Government could not open up the import restrictions and have a flood of gold imports affecting the current account deficit and the country's rating. This gold swap was then a planned action to placate the industry by releasing supply into the local market in a way that would not affect the current account deficit.

The RBI is aware of the local gold supply issues, have loosened the 80:20 rule a little in March by allowing some banks without three years worth of exports to import gold, but only on the basis that they had current customers to export gold to (see this Reuters article).

Sidebar: the clear message from the Indian session at the recent Singapore Gold Forum was that it was the 80:20 rule that halted gold imports and not the duty hikes. On that basis I was expecting some duty cut as that would have made it look like the Government had done something while not making any difference to how much gold could be imported.

So how does this gold swap work and not impact the current account deficit? Firstly, a swap involves two legs, as explained here, in this case being:

1. Sell non-LBMA standard gold loco India
2. Buy LBMA standard gold loco UK

No doubt the RBI had some interest in upgrading its non-standard gold (as it makes it easier in the future to mobilise it in a financial crisis, like it did in 1991) but it could have just sent it to a local refinery. However, this would not have had any impact on local supplies as the gold would have just went straight back into the RBI's vault.

The key is that the swap results in a net supply of gold into the local Indian market, but the replacement gold is supplied from London (or Switzerland, as we will see shortly). The net supply in India will result in a reduction of the local premium (which the public will welcome) but more importantly, it will give the local gold industry material to work with (of which they are starved) and this should increase employment. The reason this swap will not affect the current account deficit is because the cash legs of a swap are netted, so the RBI will only be paying a few dollars per ounce out of its offshore USD reserves.

Regarding the swap, I had a debate with twitter based precious metals analyst Silver Watchdog who thinks the RBI swap would also involve leasing. I see this as unnecessarily complex, which his diagram indicates. The leasing angle only makes sense if you believe that there is a shortage of gold in London (as the second leg of the swap pulls physical out of the London market), so only if the RBI subsequently leases their newly acquired London gold will this take pressure off the London market. Apart from there being no indication that the RBI was intending to do this, Perth Mint does not see any such shortages in London at this time.

I would note here that while bullion banks will probably quote on this swap, the advantage is with the refiners given the quality upgrade required. The one in the box seat is the local Indian refinery PAMP-MMTC who, through PAMP's parent MKS, is capable without bullion bank help to do "options, hedging and EFP’s; location, purity and quality swaps; forward leasing arrangements". PAMP would have no problem refining the gold locally and supplying 400oz bars into London out of its Switzerland operations.

While India has 557 tonnes of gold reserves, there is no indication of how much non-standard gold they hold or are looking to swap. This Reuters article notes that the RBI "would decide further in regard to quantity, swap-ratio [i.e. swap fee], timing etc. of the gold to be swapped". The reference to "timing" implies that the RBI is looking to supply their gold over a period of time, which would make sense if you want to alleviate local gold industry supply problems and help them out for as long as possible.

Whatever amount is involved it will only last for a limited time, in the order of months, not years, given India's appetite for gold. So this is just a short term fix to a political problem and ultimately shortages will resume due to the 80:20 rule.

Of course, it is entirely possible that the RBI's swap is solely about upgrading its gold reserves and the timing is purely coincidental. That would clearly be the case if the replacement gold was going back into the RBI's vaults in India, rather than with the Bank of England as reported by Reuters. However, as we are dealing with central banks, where transparency even on simple matters is rare to come by, we just don't know what the real motivation is and thus have to resort to speculation. I hope you got some value, in terms of how the industry works, out of my speculations even if they turn out to be wrong.


  1. The Reserve Bank has undertaken an exercise to swap old gold in its reserves with a new one with a view to standardize the yellow metal stock.

  2. "there is no indication of how much non-standard gold they hold or are looking to swap"

    We do know the RBI has 265 tonnes of their Gold abroad, so can assume no more than 292 tonnes will be swapped.

  3. Interesting. The RBI bought 200t from the IMF - that would be good delivery standard, surely?

  4. Hi Bron,

    This situation is very interesting and potentially instructive on several levels. A few quick observations:

    1. The 80:20 restrictions are analogous to capital controls for a currency and the duties are somewhat like seigniorage. This affects the de facto "exchange" rate between gold and rupee in India. It's interesting that the capital controls have the greatest impact (as opposed to exchange rate manipulation).

    2. There are several ways that the RBI can extract value from these transactions e.g. gold that is sold into the local market from the RBI vaults in India becomes non-monetary gold under IMF rules. No impact on the CAD except to potentially displace imports.

    3. Swaps/purchases by the RBI of good delivery bars in London become monetary gold under the IMF definition if they form part of India's official reserves. Perhaps a brilliant exploitation of a loop hole to assist their CAD position, provide some relief to the local fabrication market while collecting an arbitrage on the gold sales.


  5. Thanks BB, I knew there was something about the location of RBI's gold, but couldn't find it. With some imports under 80:20 and smuggling, the 292t could make up the demand gap and last for quite a while.

    Anon - the 200t would be good delivery and most likely overseas and be part of the 265t.

    costata, interesting way to view the 80:20 and duties. At the Forum one of the presenters said that the Govt really had no idea what they were doing, trying all sorts of measure to stop the imports until they hit on one which worked, being the 80:20.

    We will have to watch the premium in India to see if the RBI's gold is used to displace imports (premium will stay high) or to make up the demand gap (premium will fall).

    If they really want a loophole, just classify all gold imports as "monetary" which in reality is exactly how the local population views it.

  6. From James who is having problems commenting:

    Hi Bron,

    "If they really want a loophole, just classify all gold imports as "monetary" which in reality is exactly how the local population views it."

    One or two Indian economists have discussed this idea but it hasn't been taken seriously. It would contravene IMF, UN and World Bank national accounting rules and guidelines. It would also run up against US government policy toward gold that has been in place since the 1970s.

    If the IMF dropped the distinction between monetary gold and non-monetary gold (i.e. all gold is classed as monetary) we would be in a gold-based international monetary system immediately because gold imports and exports would be capital/monetary transactions rather than part of current account deficits or surpluses.