The Recent Surge in Gold Imports from South Korea: the History, the ‘Why’ and the ‘How’ explained in detail.

There’s been a recent, much reported surge in gold imports into India from South Korea since July 1st, when the Indian GST tax regime came into effect. Newspaper reports assert that gold imports from South Korea jumped to $339M during July 1-August 3 this year vs. imports of $470M in all of 2016-17. 

In this post, I'll explain in detail how and why this has happened, while giving the reader some historical context as well. 

The Backdrop

The Free Trade Agreement (FTA)

India has an FTA (Free Trade Agreement) with South Korea and other ASEAN nations due to which there is no basic customs duty on the import of gold from these countries. Note: A 10% basic customs duty is levied on gold imports into India from countries with which we do not have an FTA. The Indian government started levying this 10% import duty on gold in Aug 2013 when our Current Account Deficit (CAD) had reached sky-high levels and gold imports were soaring. The duty has stayed ever since. 

While the duty and other measures taken in 2013/2014 helped bring down the CAD and stabilize our currency, a new unanticipated problem relating to the gold trade emerged. 

Unintended Consequences of the FTA: Surging gold Imports taking advantage of the duty differential

The FTA with ASEAN meant that even after the imposition of the 10% import duty, gold imports from these nations were not subject to this basic customs duty. As a result, import of gold jewellery from these countries into India spiked due to the favourable duty differential vs. other nations. 

For instance, gold jewellery imports form Indonesia suddenly spiked in Apr-June 2015 to Rs. 2,896 crore from Rs. 620 crore in all of 2014-15! Obviously something fishy was going on. Indonesia is a gold producer and gold jewellery from Indonesia accounted for ~50% of the overall unstudded gold jewellery imports into India 2014-15, but the sudden dramatic surge obviously meant that a third country was likely routing its jewellery shipment through Indonesia in order to take advantage of the low import duties on gold shipped to India. (link to source article in Business Standard)

This was obviously concerning for the Indian government since higher gold jewellery imports not only have ramifications for the Current Account Balance but also hurt domestic producers. 

This is just one instance of misuse of an FTA leading to a surge of gold imports into India. There are many such instances from the past. The government needed a solution to plug such loophole. 

The Government’s Solution: Imposition of Excise duty on domestic gold jewellers so that Countervailing duties could be imposed on gold Imports 

In his 2015-16 budget, the Finance Minister levied a 1% excise duty on domestic gold jewellers with turnover over Rs. 12 crores. Note: This 1% excise duty was with Central VAT credit; without Central VAT credit, the duty would be 12.5%. Since these large jewellers would get credit for the VAT already paid on inputs etc., the effective excise duty for them would be just 1%. 

However, since an excise duty was now being levied on domestic jewellers, this meant the government could now impose a 12.5% Countervailing Duty (same as the excise duty on gold sales without Central VAT credit) on imported gold jewellery. Countervailing duties are levied on imports in order to ensure a level playing field between domestic and foreign producers. 

While the key reason the Finance Minister gave publicly for levying the excise duty was that gold is a luxury good and thus should come under excise duty purview (he also argued that this was a precursor to the GST), using this levy to protect domestic industry and a put a clamp on gold imports that utilized loopholes in FTAs was a key motive for the move as well. Gold traders/jewellers went on strike to oppose the levy but the government didn’t budge. 

The Current Problem 

The beginning of the GST regime meant Countervailing duty was no longer applicable

When GST became applicable from July 1, 2017, the 12.5% Countervailing duty levied on imports got subsumed under the GST. Per GST rates, gold imports now attract only 3% IGST (IGST = integrated GST which is shared between the central and the state government). 

As a result, gold imports from South Korea (one of the countries with which India has an FTA) have surged because of this sudden fall in tax rate from 12.5% to 3%. As I mentioned above, gold imports from South Korea jumped to $339M during July 1-August 3 this year vs. imports of $470M in all of 2016-17. In July alone, ~10 tonnes of gold mainly in the form of coins and medallions was imported from South Korea as compared to 0 tonnes imported in July 2016. Per industry sources, these coins are then melted in India/converted into gold bars and used for the manufacture of gold jewellery. 

FTA Violations 

Besides the fact that this modus operandi takes advantage of a loophole, it is also in violation of FTA rules. Under the FTA, gold imported from South Korea has to be manufactured/refined in South Korea, in order for it to be eligible for the zero basic customs duty. According to bullionstar.com (link here), South Korea’s gold refining capacity is 60 tonnes/year. Of this capacity, for ~10 tonnes of gold to come to India in just one month (July), points clearly to violations. 

Obviously, refined gold is being routed through South Korea from a third country in order to take advantage of the duty differential. It has been widely reported that per industry sources this refined gold is coming from Dubai. It is imported into South Korea in the form of gold bars or coins. If it is in the form of gold bars, then it is converted into gold coins in South Korea. Then it is incorrectly shown that the gold itself was manufactured (i.e. refined) in South Korea, and these gold coins get exported to India. These coins are then melted and used by gold traders/jewellers. 

The other FTA violation involved in this modus operandi is that under the FTA, any gold coins imported into India have to be meant for sale to final consumers. They cannot be converted into gold bars and/or used to manufacture jewellery, in the way that traders/jewellers are doing right now. 

What will the Indian Government do?

Good question. I wont speculate right now because the government will have to do something soon. I’ll dissect their action in a subsequent post.

Increased Gold Imports lead to Rupee Depreciation & Current Account Deficit

So I wrote the post Round Tripping and the Ban on 23 & 24 Carat Gold Exports just yesterday. In this post, I talk about the practice of “Round Tripping” and how the Indian government hopes that its recent order banning gold jewellery exports of 23 and 24-carat purity will curb it to some extent.

For anyone who’s been reading recent news articles about this gold export ban and surging gold imports from South Korea (read about this in my next post The Recent Surge in Gold Imports from South Korea: the History, the ‘Why’ and the ‘How’ explained in detail) which have alarmed our government, it is only logical to ask “why all this fuss about gold?”

Here’s why.

India is amongst the top gold importers in the world. Roughly a quarter of the world’s gold demand comes from India thanks to our penchant for investment in gold. On an average (rough average over the years), India imports ~800-900 tonnes of gold annually. 

Gold imports comprised ~10% of our total merchandise imports for FY17 (note: gold imports were down 24% y-y in FY17). 

Since gold is paid for in dollars (USD), high gold imports tend to deteriorate our Current Account Balance. When this happens i.e. our imports become much greater than our exports, the demand for dollars rises as compared to that for the Rupee and the Rupee depreciates. 

Sustained Rupee depreciation is not a good thing for India. It makes imports expensive (each dollar costs more rupees now) and leads to inflation. Also since it tends to happen in concert with our Current Account Balance deteriorating (India always runs a Current Account Deficit since we are a net importer), it is accompanied by a fall in forex reserves with the RBI. This means a drop in our reserve of dollars, which we need to pay for our imports. This is always troubling for any net importer. 

Depreciation also worries foreign investors who’ve invested money in India since now their investment returns are lower when converted to their own currency. This may spook them and lead to an exodus of foreign money out of the country (called “capital flight”). This can crash our stock market and spike our bond yields, and lead to further depreciation of our currency. This would mean country-rating downgrades for India and basically a full-blown economic crisis. 

OK. So I described the absolute worst scenario there, but you get the idea.

Bottom-line

Gold imports form a significant portion of our import bill and hence have direct ramifications for our Current Account Deficit (CAD) and Rupee strength. Since gold is not a necessity for our economic growth in the way oil is, excessive import of gold, which deteriorates our CAD, is not desirable for our nation. This is why government bodies and market watchers keep a close watch on gold imports and this is also why you have been reading about them in the paper recently.

Round Tripping and the Ban on 23 & 24 Carat Gold Exports

A few days ago (14th Aug), the Directorate General of Foreign Trade (DGFT), Ministry of Commerce, GOI, banned the export of gold jewellery, coins and medallions with purity above 22 carats. This means that Indian exporters can now only export gold products of purity of 22 carats or below.

Why did the Government do this? 

While the order did not give any official reason, most believe it is to help curb what is called “Round tripping”. In the context of gold, “Round tripping” refers to the practice where traders import gold, usually at low import duties/taxes and then subsequently export this gold without any value-addition or with minimal value addition (change packaging etc.). This is done mainly to avail of benefits such as cheap financing from banks by inflating trading volumes, higher import entitlements (this happens when import entitlements are linked to export volumes) or to simply profit from differences in tax rates/ interest rates/ exchange rates. 

Why is Round tripping undesirable? 

Round tripping is undesirable for a variety of reasons. First, it is against the law. Second, while traders indulging in this practice end up profiting and garnering bank finance at favourable rates, genuine traders suffer as these benefits are not available to them to the same extent. Three, Round tripping artificially inflates gold import and export figures for the nation in question. Since gold imports (India is one of the largest importers of gold in the world) require payment in dollars, high import volumes put a drain on our Current Account Balance and contribute to the depreciation of the Rupee. This is why in times when the Rupee has depreciated strongly due to deterioration in our Current Account Balance (when imports > exports, we need more dollars than foreigners need rupees, so the rupee depreciates vs. the dollar), the government has usually taken steps to discourage the import of gold and curb Round tripping. 

How much are Rounding tripping volumes for India?

While there are no official estimates, industry sources estimate gold Round tripping volumes at ~150-200 tonnes/year. For context, India imports roughly 800-900 tonnes of gold annually. 

Why is it hard for the government to prevent Round tripping?

It is hard for the government to prevent Round tripping because while it wants to clamp down on this practice, it doesn’t want to penalize genuine traders in the process. For example, in early 2015 the government tightened value addition norms in order to prevent Round tripping. As part of this exercise, for plain gold jewellery articles, value addition norms were raised from the earlier 3% to 4%. This meant that traders would have to add at least 4% value to imported gold in order to export it in the form of plain gold jewellery. 

Such a measure adds to the cost of exporting. Thus in theory, you cannot keep exporting gold without any value addition and keep importing it back multiple times if each time you export this gold, it is priced at least 4% higher. This will make Round tripping unviable. 

But at the same time when the government does something like this, it wants to ensure that the value addition norms aren’t so high that they discourage genuine exporters of gold jewellery and make their products uncompetitive in the world market. 

Will the current order Banning 23 and 24 Carat Exports curb Round tripping? 

This is a good question. Per Surendra Mehta, National Secretary, India Bullion and Jewellers Association (IBJA), the leading industry body representing gold jewellers and dealers in India, there isn’t much scope for value addition in 23 and 24 carat purity gold when it is converted to gold jewellery and medallions (link to the article in Business Standard where he is quoted). 

Experts tend to agree that it is difficult to make high quality jewellery out of 23 and 24 carat gold. 

Hence, the government’s logic is that those claiming to ship gold jewellery and medallions of 23 and 24 carat purity are likely indulging in Round tripping. This is why the government believes that banning these shipments will plug at least one channel of Round tripping.

The logical next question is how much gold jewellery / medallions of 23 and 24 carat purity are exported out of India? The same Business Standard article (link here) that I referenced above states that per an industry estimate, India exports ~170 tonnes of jewellery and medallions made of/ studded with gold. Ornaments made of 24-carat gold apparently form ~15% of this volume or ~25 tonnes. 

If we assume that all of these 25 tonnes of export comprised Round tripped gold (extreme assumption), then it follows that of the 150-200 tonnes per year of Round tripping, 25/175 or ~15% has been plugged.

Remember, there are a lot of assumptions and rough estimates here. This is just a back-of-the-envelope exercise. 

What about the recent surge in Gold Imports from South Korea?

Read my post The Recent Surge in Gold Imports from South Korea: the History, the ‘Why’ and the ‘How’ explained in detail for this discussion.

Real Interest Rates in India Amongst the Highest in the World Right Now

In the wake of yesterday’s Monetary Policy Review meeting, it’s important to talk about real interest rates in India. 

What is Real Interest Rate? 

Real interest rate = Nominal interest rate - Inflation 

For example, if you earn 10% (this is the nominal interest rate) on a deposit with a bank and inflation is running at 8%, the real interest rate you earn = 10% - 8% = 2%. 

What does it mean? 

If your deposit is worth Rs 100, the interest you earn is 10% * 100 = Rs 10. But inflation is running at 8% which means that whatever goods you were buying earlier with the deposit mount (Rs 100), now cost Rs 108. So, of the interest income of Rs 10 (or 10%), Rs 8 (or 8%) goes just in preserving the purchasing power of your deposit. Your “real interest income” is Rs 10 - Rs 8 = Rs 2 or 2%. This is the income with which you can buy extra goods over and above what you could buy with Rs 100 earlier. 

So the “Real interest rate” gives you (the lender), the true purchasing power of the interest income you earn. For the borrower (the bank in this case), the “real interest rate” is the return it gives to the lender in terms of real purchasing power. Naturally, it follows that....

....High Real Interest Rates are good for lenders and bad for borrowers 

Even after yesterday’s Repo rate cut, Real interest rates in India are amongst the highest in the world right now 

Let’s compare current Real interest rates in India vs. those in the US. For this purpose, we will compare the Real interest rate on 10-year government bonds of both countries. Government bonds give us the “risk free” real interest rate for a country because theoretically, governments do not default on their debt. At least that is the expectation. 

Real interest rates on corporate bonds are higher because over and above the risk-free real interest rate that is associated with government bonds of the same maturity, lenders add a risk premium to compensate for risk of default by the corporate entity. 

The 10-year government security (gsec) yield in India yesterday (2nd Aug) was 6.46%. The most recently reported CPI inflation number (for June) was 1.54%. This means that real yield or the “real interest rate” for the 10 year gsec is 6.46% - 1.54% = 4.93%.

In the US, 10 year g-sec real yield (on 2nd Aug) was 0.47%. 

As you can see, the positive differential between the 10-year Real interest rate in India vs. the US is a whopping 4.45% or 445 bps! India currently has one of the highest real interest rates in the world, making it a rather lucrative destination for foreign funds looking to pick up this extra yield. 

This is the reason that FII/FPI funds have been pouring into the Indian debt market 

Year to date, FII/FPIs have ploughed Rs 1.71 lakh crore ($27 Bn*) into the Indian equity and debt markets. Of this total amount, Rs 1.15 lakh crore ($18 Bn*) or 67% has been invested in the debt market and Rs 56 lakh crore ($9 Bn*) or 33% has been invested in equities. 

As one would expect, Indian debt has absorbed the lion’s share of foreign fund inflows YTD.

* I’ve converted FII/FPI INR inflow figures into USD at the 2nd Aug exchange rate of INR 63.635/USD.

While these high Real interest rates are favourable for FIIs/FPIs (foreign lenders), they are bad for Indian industry (borrowers) as explained above. That said, simply lowering rates isn’t a magic bullet. 

Especially in the current environment where demand is muted, corporate earnings aren’t strong, corporate balance sheets are over-leveraged and the NPA problem is rampant, corporates aren’t borrowing much anyway. High real interest rates on top of that, aren’t helping. This is one of the key reasons why market players wanted a lower Repo rate and applauded RBI’s rate cut yesterday. 

It’s important to remember however, that simply lowering rates is not going to revitalize India Inc. For that to happen, demand has to pick up, the investment cycle has to start in earnest, over-leveraged balance sheets have to be stabilized and the NPA issue has to be fully dealt with. 

Finally, let’s look at some historical data. 

Another way of calculating Real interest rates is looking at the spread between the Repo rate (the rate at which the RBI lends to commercial banks overnight) and CPI inflation. This gives us the “real interest rate” for overnight funds. 

In the chart below, I have plotted CPI inflation, Repo rate and Real interest rate (Repo rate - CPI inflation). For July and Aug ’17, I’ve assumed CPI inflation of 1.07% and 1.45% (there’s a favourable base effect) respectively. This gives us estimated real interest rates of 5.18% for July and 4.55% for August.

As you can see from the chart below, besides Nov ’14 when the real interest rate rose to 4.73%, current real rates are the highest that we’ve seen since Jan ’12. 

Barring Nov ’14, current Real rates are the highest we’ve seen since Jan 2012.

Source: RBI, MOSPI data 

Why the RBI cut the Repo Rate Today

The Monetary Policy Committee (MPC) of the RBI cut the Repo rate today by 25 bps from 6.25% to 6%. A Repo rate cut was widely expected, and rightly so this time. 

Important to understand WHEN the RBI cuts rates

Sometimes market players/watchers predict rate cuts simply because growth slows, forgetting that RBI’s primary mandate is to keep CPI inflation within its target range of 4 +- 2% or 2-6% in the medium/long term. Simply because inflation is within this target range at the current moment doesn’t imply that the RBI will cut. The MPC usually looks at its projections for inflation 3-4 quarters out. If inflation looks close to its 4% (average) target or lower, without any significant risks to the upside, then it considers cutting rates. 

Market players always tend to advocate for a Rate cut

It’s important to remember that while the Central Bank will always tend to follow a cautious approach, market players (banks, research houses, financial institutions, corporates) will always tend to advocate for rate cuts. Why? Because lower interest rates are a positive driver for all of them. 

1) Banks can offer lower rates on deposits when the Repo rate falls and the RBI signals a low interest rate environment. This allows them to lend at lower rates to borrowers, which can help stimulate credit supply and expand banks’ loan books and profits.

2) Research houses are usually attached to the equities business. A Repo rate cut usually transmits through the banking/financial system and results in lower lending rates. This means that listed companies can borrow at lower interest rates, which is obviously a positive for them/equities in general. Also, for listed companies that have existing floating rate loans, a Repo rate cut usually translates into a fall in interest rate payments. Given this favourable impact on equities, research houses will usually tend to root for rate cuts.

3) Corporates (listed or unlisted) want rate cuts for the same reason listed in point no. 2 above.

CPI inflation has been consistently lower than RBI’s estimates over the last few months and some of the upside risks have receded. Hence the RBI felt comfortable cutting.

Even though CPI inflation has stayed below the mid-point of RBI’s target range (4%) since Nov ’16, RBI kept the Repo rate unchanged at 6.25% because it was unclear about the inflation trajectory going forward and there were risks to the upside - potentially weak monsoon, Fed rate hikes, GST implementation, global uncertainties (read Trump), oil price trajectory, fiscal slippages due to farm loan waivers, disbursement of allowances under the 7th pay commission etc. 

However, over the last few months, inflation has been consistently lower than the market’s and RBI’s estimates. Also, many of the upside risks to inflation have receded (monsoon has been normal, GST implementation has been smoother than expected, Fed hikes have been priced in, oil prices have been benign). 

The RBI now expects headline inflation (the total CPI inflation number reported by MOSPI) to be a little above 4% by Q4 excluding the impact of implementation of House Rent Allowance (HRA) recommendations under the 7th Pay Commission. This is lower than RBI’s June projections. As a result, the MPC felt comfortable lowering the Repo rate by 25 bps. 

Monetary policy stance is still neutral. Some disappointed, but this is in-line with RBI’s usual approach.

The RBI continued to keep its monetary policy stance as “neutral” since it believes that inflation is headed higher from current multi-year lows. It will watch how things shake out and look at more data before and if it makes any changes to its stance. This was disappointing for some market players who were hoping for the RBI to signal towards a more “accommodative” stance (i.e. intent to cut rates further). However, this was a naïve assumption in my view. Given RBI’s central mandate (keeping inflation in range) and its widely known (and appreciated) conservative approach, I expected the MPC to remain non-committal about future rate trajectory.