Prof. Joshy Jacob & Prof. Jayanth R. Varma
Although India is the world’s second largest gold consumer with an annual demand of nearly 1,000 tonnes, it lacks many key elements of an efficient gold ecosystem. The gold market here is plagued by fragmentation, with prices varying significantly across channels and locations. The quality of gold also varies widely. Jewellery rather than gold bars, gold coins, or gold-linked financial products, still dominates retail demand. Large jewellers and traders mostly import refined gold from international markets, such as Dubai, causing loss of economic value and jobs in India.
As the global gold market continues to shift from the West to the East, many Asian countries, such as Turkey, China, Singapore, and the UAE, have set up global-scale physical infrastructure for refining, storage, transport, trading and financing of gold to cater to the spurt in demand in the region. Gold exchanges and related infrastructure set up by these countries appear to have greatly enhanced the efficiency of their gold markets by way of efficient price discovery; quality assurance; active retail participation; use of gold bars and gold coins; and gold-linked financial products instead of jewellery for investment purposes; greater integration with financial markets through gold leasing and lending; and acting as a channel for gold recycling. Given the global scale market demand in India, we examined the viability of establishing a spot gold exchange for trading in gold for buying and selling standardized quality gold in India.
Our survey and interaction with a wide-range of participants in the gold value chain, conducted under the auspices of the India Gold Policy Center at IIM Ahmedabad, brings up a number of interesting findings. First, large players procure gold directly from miners and traders in overseas gold hubs, often at a discount to the benchmark London Bullion Market prices. Second, medium and small jewellers mostly depend on large players for supply of gold and face significant cost disadvantage. Third, resellers are a significant source of gold for jewellers and refiners; however, there is no transparency in the activities associated with reselling of gold into the market. Against this backdrop, participants largely felt that a national-level spot exchange would benefit stakeholders through transparency in pricing and standardization. Most of the small jewellers are keen to source gold through a gold exchange and, perhaps surprisingly, so are some large players.
Participants in the Indian gold market feel the need for a domestic and an international exchange (the Exchange) which would allow two-way trading in physical gold and also provide derivative products for hedging. The Exchange could also include gold vaulting facilities set up by experienced promoters, logistic arrangements to achieve next day (T+1) delivery across the 21 major locations in India, and mechanisms for quality assurance and standardization of gold. We believe the Exchange would be economically feasible if it drew a minimum trade quantity of about 100 tonnes a year, which appears quite feasible, given the annual demand of about 1,000 tonnes in India and that there are many segments of the gold market that are underserved by the existing market structure. Once the Exchange is set up, we expect activity levels to snowball as participation balloons and vibrant contracts in the Exchange become the dominant forum for price discovery and investment in physical gold.
The Exchange should offer a wide range of contracts to meet the needs of the gold industry, such as: (a) domestic spot gold contracts, (b) global spot gold contracts denominated in US dollars based on delivery outside the domestic tariff area; (c) dore swap contract; and (d) gold lending and borrowing mechanism (GLBM). Within the constraints of capital control regulations, both the domestic and global contracts on the Exchange must be open to the widest range of participants. All domestic entities and foreign portfolio investors could be allowed to trade in domestic contracts. Participation in global contracts would be open to all foreign participants and to domestic players that are allowed to trade or hedge in global markets in accordance with foreign exchange management act (FEMA) and resident individuals within the $250,000 limit under the Liberalized Remittance Scheme for investment outside India.
As in other Asian nations such as China, investment grade gold traded on the exchange should be exempt from indirect taxes such as VAT and GST, but should be subject to a Commodity Transaction Tax (CTT). This proposal to levy CTT in lieu of VAT/GST is likely to be broadly revenue neutral for the government. An Exchange located in an international financial services centre would have the ability to offer domestic and global gold contracts, provide gold vaults inside and outside the domestic tariff area and attract international participants. Based on our survey, exactly where the Exchange should be located in India is not critical to its efficacy.
High standard of governance is key if the Exchange is to aspire for leadership in Asian gold markets. These governance measures would include an India-responsible gold policy; world class gold quality assurance; risk management; high quality clearing and settlement; and regulation and supervision by a credible regulator such as Securities and Exchange Board of India. Ideally, the Exchange must be promoted by neutral players (e.g. existing commodity, stock and derivative exchanges; banks; and other financial entities) instead of participants in the gold industry (e.g. jewellers, refiners and traders) because of conflict of interest. Partnership with gold markets in Singapore, London and Shanghai; minority equity participation by multilateral financial institutions such as the Asian Development Bank and the BRICS bank; and technical collaboration with professional bodies such as the London Bullion Market Association would be valuable.
An Exchange in India would help much to create a vibrant gold ecosystem matching India’s large share of global gold consumption, leading to efficient price discovery, assurance in the quality of gold, active retail participation, greater integration with financial markets, and greater gold recycling. It would also boost the gold monetization efforts of the centre through transparency and standardization of the gold market.
Joshy Jacob’s research interests are in the fields of empirical asset pricing, corporate finance and behavioural finance at IIMA; Jayanth R. Varma’s teaching and research interests are in the fields of finance and accounting at IIMA.