With the London Bullion Market Association Conference delegates preparing to descend on Mumbai next year, David Gornall discusses a gold market that is undergoing one of the most significant changes in consumption that the country has ever experienced.

India’s seemingly insatiable and unending appetite for gold has long fascinated market participants. Such is the importance of the country’s wedding season and its major religious festivals that all physical gold commentators refer to them when analysing the global market. The average Londoner may not have any idea when Diwali occurs, but many gold market participants do.

Statistics alone cannot convey the scale of the buying: to truly appreciate how massive it is, it must be witnessed firsthand, as delegates of the LBMA Conference will have the opportunity to do in November. In any jewellery emporium in one of the main gold centres (see map) during a time of peak demand, hundreds of customers are crammed onto four or five floors stocked solid with jewellery. On one auspicious day this past September, there were 30,000 weddings in the city of Delhi alone. Before days such as this, it may not be physically possible to even enter one of these large stores.

In order to cater to this unparalleled appetite for gold, India must import considerable volumes of metal, as very little is produced domestically (see sidebar for details about import procedures).

According to GFMS data, on a gross basis India imported over 800 metric tonnes in 2005 (excluding some trade-related exports), compared to 533 metric tonnes in 2003.This substantial increase came about despite a sharp rise in price. It can mainly be traced to the usance letter of credit scheme, which effectively allowed importers to purchase gold at a discount to the London price by giving them an opportunity to arbitrage, one year forward, rupee and US dollar interest rates. However, the opportunity proved short lived: the government became so concerned about the amount of business being transacted that it changed the law to allow only 90 days of credit on gold LCs. This action, together with rising US dollar interest rates, killed off the arbitrage.

Even without interest rate arbitrage, imports for 2006 will likely be strong. Prospects look good for 2007, although a rise in price above $650 would likely trigger a buyers’ strike, causing imports to dry up for as long as three to six months, until either prices fell back or buyers adjusted to the elevated levels.

Oval coin depicting Lakshmi, Hindu goddess of wealth and beauty

A Problem with Purity…

A look at a breakdown of the forms of Indian gold consumption shows that one type of investment has had a stronger rate of growth than the others: while overall imports have shown 50% yearly growth over the last two years, according to GFMS data, coin has consistently outperformed other forms of gold consumption recently. For example, GFMS data for the third quarter of 2006 shows that demand for coin grew by more than double the rate of hoarding and jewellery (measured on a quarter-on-quarter basis – see chart).Meanwhile, the figures for silver demand as an investment class – traditionally popular among the rural classes – have decreased dramatically over the last two years, as these communities are now turning to the smaller denominations of gold coins.

Gold trading centres are located across India

In order to understand the reasons for this development, it is worth remembering that India has one of the world’s youngest populations, coupled with one of the fastest growing economies. Consequently, the standard of education is improving, and the new middle class has gained an increasingly international perspective. As a result, Indians are becoming ever more aware of the existence and advantages of alternative asset classes. These increasingly sophisticated investors are still purchasing gold – but with a difference.

Poor and rich alike in India have bought gold for centuries, as a product for both adornment and investment purposes. The tradition of giving gold jewellery at weddings and other ceremonies, combined with a poorly performing national currency, have contributed to elevating gold to this dual role.

Unfortunately, there has been another strong tradition in India – the quality of local jewellery was never guaranteed due to the lack of hallmarking. Indeed, 88% of the jewellers tested in a recent survey are selling gold at poorer quality than they advertise.

This problem has been addressed by the Bureau of Indian Standards (BIS), which sets quality standards for all products in India. It introduced a hallmarking scheme in 1999 on a voluntary basis, pointing out to the public through advertising that quality cannot be assured unless the gold is hallmarked. However, acceptance of the scheme thus far has not been widespread: although many reputable companies have signed up in an effort to stamp out inferior quality, the majority of the country’s estimated 100,000 jewellers are still not using hallmarking. Acceptance of the scheme would be broadened by setting up more hallmarking centres, as the service is not easily accessible to all jewellers across the country, and the government is rumoured to be considering the introduction of mandatory hallmarking of gold by 2008.

Because all Indian jewellery is supposedly 22-carat, consumers have been paying a premium for a product whose quality is not guaranteed. In fact, those buying gold jewellery are well aware that the meltdown purity of their purchases could be as low as 14 to 18 carat. Ironically, for a country that is synonymous with high-carat jewellery, the actual purity of it is very similar to that on offer in Western markets, such as Europe and the United States.

One of New Delhi’s large jewellery stores. Photo courtesy PC Jewellers

…Is Not a Problem with Coins

Given the doubts as to the actual purity of gold jewellery, the shift to coins is entirely rational – savvy investors are increasingly buying gold coins and small bars, whose purity of 23 to 24 carat is guaranteed to be in line with that advertised.

The availability of gold coins in India is not a new phenomenon. The difference now is that coins can be bought in a range of weights, from as little as five grams, ranging up to as much as 100 grams. Small bars are available in similar weights, rising to as much as 1 kg – and ten-tola bars, the old standard of the Indian market, are also still available in a 100gram form, though less popular than they used to be. As with the ETFs in the West, this proliferation of products has served to expand and deepen the market for gold.

The key element in the continuing growth in popularity of coins is distribution. The first two companies to start distributing in 2004 were the Indian bank ICICI and the Swiss refinery PAMP. By 2005 there were four banks offering the new products, and a total of 11 banks are currently producing their own coins– two of which have started up in the last three months. The advantage for the banks is that the coins carry their name, and so can enhance their image as a reliable institution. On the other hand, the banks have to be careful with the quality of the product they buy, as any defect will reflect badly on the bank, rather than the refinery that produced it.

Meanwhile, Indian banks are gaining the trust of the international markets, with double and triple B ratings now enjoyed by several state-owned banks – and as such they are winning the trust of the burgeoning number of Indian investors. If an Indian aim to accumulate units of gold for investment purposes, the banks are encouraging them to choose coins over jewellery as the cheapest and most efficient way to do this.

Furthermore, because gold is fungible with cash – it is used quite widely as security and can also be used in gold savings accounts for future purchase – and since gold jewellery is more difficult to use in this process because the purity is not validated, gold coins provide an obvious solution. While gold savings accounts are currently not very popular in India, having been run mostly by jewellers from a gimmick perspective, attitudes might change should they be offered by local banks, and be backed by the increasing liquidity of gold coins. (By far the strongest segment of this market is the ten-gram coin.)

Assuming the final quarter of 2006 continues the pattern seen in the first three, Indian coin demand could easily exceed 40 tonnes in 2006 (based on GFMS estimates for the first three quarters of the year). Remarkably, this would be double the size of the market in 2003.

From Smuggling to OGLs: Opening Imports of Gold

Imports of gold into India were not generally permitted in the 1990s. And on the occasions when it was permitted, a customs duty of 5% was levied, leading to a flourishing smuggling industry.

The first step towards liberalising imports was the introduction of the Special Import Licence (SIL) Scheme in 1995/96. Exporters of finished goods were issued with SIL licenses that enabled them to import gold up to the value of the licence. Once the finished product was exported, usually in the form of jewellery, the proceeds had to be placed in an Export Earnings Foreign Currency Account. From this account the holder could remit US dollars, and pay the customs duty of Rs250 per 10 grams. These licences were transferable and became freely traded, thus opening up the import of gold.

The introduction of the Open General License (OGL) agreement in 1998 enabled importers to dispense with the SIL and reduced import duty to Rs100 per 10 g. The government then authorised the Reserve Bank of India (the RBI) to nominate certain agencies that could negotiate consignment stocks with overseas suppliers, such as bullion houses and refineries. These agencies would also be responsible for the pricing and payment of the gold and charged their customers for the services accordingly.

Having a reduced number of entities was a benefit to the RBI, which only had to monitor a containable amount of agencies – rather than the thousands of separate private entities importing gold and remitting US dollars overseas. At one time, the number of agencies stood at more than 20, but through price competitiveness, the total was reduced to about 14, of which six are particularly active.

Photo courtesy of World Gold Council (www.gold.org)

Everyone’s Happy (Except, Perhaps, Jewellers)

Needless to say, many jewellers aren’t happy to see the shift to coins: they are losing business. Although jewellers are also often retailers of coin, the margin on coin is substantially lower than that on jewellery. Nonetheless, their future success may depend on how they adapt to this new trend, and whether an approved certification policy is more widely adopted.

In looking at the recent and forecasted success of gold coins, certain questions arise. Will ETFs succeed when they are introduced into India, or will investors shy away because they distrust paper gold? Although the market has traditionally been based on physical metal, the use of gold as collateral is widely accepted. ETF contracts will eliminate having to ship and store the metal, but investors will probably use a combination of the two, because taking delivery of physical coin has the benefit of anonymity.

Yet another driver of the investment phenomenon will be the issue of VAT uniformity, as states compete to offer the cheapest tax rates for storage. Significant progress has been made recently to impose uniform VAT across India, but there are still examples of tax competition.

The shift in investment towards coin is a permanent one, and one that carries many benefits for the Indian market. It brings gold into the reach of more consumers than ever before, thanks to the diversity of sizes, while giving consumers a form of gold that can be trusted to carry the stated purity. It also allows for more opportunities for gold to be used as collateral.

Over the long term, gold coinage should help to sustain or increase Indian demand for gold. Looking to the future, the Indian gold market will always remain extremely price sensitive, but whatever the ebb and flow of imports, it seems certain that coin’s position in the gold market will continue to grow.

David Gornall started his career in 1979, trading silver at Lonconex Limited, part of the Primary Industries/Golodetz commodity trading group. After a spell at Morgan Guaranty Trust of NewYork, he moved to Sogemin, trading in the LME ring and heading the bullion and FX desk. In 1992 he joined NM Rothschild to start their LME base metals operation, before returning to Sogemin – now Natexis Commodity Markets – where he is a main board director responsible for Bullion and FX trading.

David has been a member of the LBMA Management Committee since August 2005.