The three ‘Rs': Against this backdrop, we think that the global macro debate in 2011 will revolve around three ‘Rs' - rebalancing, reflation and reconciliation - which encapsulate our key themes above. Further progress from the pre-crisis unbalanced global economy to a more balanced one is a pre-requisite for making this recovery sustainable over the next several years. During the rebalancing process, central banks will likely keep policy very expansionary, which should support the ongoing reflation of the global economy and financial markets. However, debt-laden governments are facing the huge challenge of reconciling conflicting claims by their creditors (private and public bondholders) and stakeholders (pensioners and other recipients of public transfers, users of the public infrastructure, taxpayers and public servants) on their limited resources. Which choices governments will be making between the various options - default, engineer strong growth, fiscal austerity, monetisation and/or force lenders to fund them at low interest rates - will likely be key for economic and market outcomes in 2011 and beyond.
Rebalancing: Our country economists forecast some good progress on the road to rebalancing in the upcoming year. In China, consumer spending will become the biggest contributor to GDP growth, contributing more than half of the 9% GDP growth we forecast for 2011, and the current account surplus should shrink by a full point to 3.6% of GDP. In the US, conversely, net exports are expected to make a positive contribution to GDP growth, reversing this year's drag on growth. More broadly, external imbalances are likely to shrink in most countries, largely reflecting the rebalancing from consumption to exports in the countries with current account deficits and vice versa in surplus countries.
This ongoing process of rebalancing from export-led to domestic demand-led growth and vice versa has two important implications. First, it requires a shift of resources (capital and labour) from the external to the domestic goods-producing sectors or vice versa, which takes time and thus weighs on growth in the meantime. This is especially true in high-income economies where workers' skills and the capital stock are often sector-specific. Hence, the ongoing rebalancing is contributing to the ‘BBB' nature of the recovery in mature economies. Second, as capital is often sector-specific, the sectoral shift in the drivers of growth requires new investment in the expanding sectors and should thus support capex globally, despite the fact that there is still considerable spare capacity in the (relatively) shrinking sectors.
Reflation: The combination of undesirably low inflation in the US, deflation in Japan, the ongoing sovereign debt crisis in Europe and a BBB recovery in virtually all of the mature economies implies that G10 central banks will keep their foot on the monetary accelerator for much or all of 2011. With official interest rates near zero in major economies and quantitative easing in various disguises continuing at least in the G3, monetary policy looks set to remain super-expansionary and will support the ongoing reflation of the global economy, in our view. True, we see many EM central banks, including the People's Bank of China, raising interest rates in the upcoming year. However, in most cases we think the tightening will be moderate in order to prevent a sharp deceleration of economic growth and/or excessive exchange rate appreciation.
Given these constraints on EM monetary policies, the AAA global liquidity cycle should remain intact. Yet, these constraints also imply that the risks to our relatively benign inflation outlook for EM economies are tilted to the upside.
Reconciliation: While rebalancing and reflation should provide support for the global economy and markets in 2011, the reconciliation of the many claims on debt-laden governments remains a gargantuan task for governments and a major source of downside risk to the outlook. In principle, governments have five options to deal with unsustainable debt trajectories: they can default, engineer strong growth, tighten fiscal policy, monetise and/or force lenders to finance them at low interest rates. Of these, default or restructuring is likely to be avoided at all costs in 2011, given the severe systemic consequences - but that doesn't mean markets won't be nervous about potential defaults in the future, especially in euro area member states that are not true sovereigns any more. Engineering strong growth is virtually impossible for any length of time, given the BBB recovery. And a massive tightening of fiscal policy also looks unlikely in most countries outside of the European periphery, as many governments lack the public support to implement draconian measures à la Greece or Ireland.
This leaves most governments with only two options - monetise (if your central bank agrees) and/or take measures to ensure continued access to cheap funding from other sources. As our colleague Arnaud Marès has argued, the latter is inherent in financial regulation that requires banks, insurance companies and pension funds, explicitly or implicitly, to increase their holdings of government bonds for financial stability purposes. Alternatively, cheap funding could come from the IMF and/or other governments as in the recent cases of Greece or (less cheaply) Ireland. And the former option - monetisation - is inherent in quantitative easing, which raises longer-term inflation risks if the banks' excess reserves that are created in the process are not withdrawn in a timely fashion once banks start to use them to lend and create deposits.
Gold Consumption Is Rising Sharply Again
After a short weak trend in 2009 due to the global credit crisis, India's spending on gold has bounced back sharply in 2010. India's gold consumption (in USD terms) has risen by almost 100%Y during the first three quarters ending September 2010 after declining 12%Y in 2009. Cumulatively, India now holds over 18,000 tonnes of above-ground gold stocks worth approximately US$800 billion at the current gold price - nearly 50% of the country's GDP. This represents 11% of the world's stock, according to World Gold Council1 (WGC) estimates. On an annual basis, India is the world's largest consumer of gold in tonnage terms, followed by China. During the four quarters ending September 2010, India's gold demand accounted for 21% of global gold demand.
Old Tradition and Complex Set of Drivers Plus Investor Interest Underpin Gold Demand
Hoarding of gold is an old tradition deeply ingrained in Indian culture and society. Traditionally, apart from being an item of consumption in the form of jewellery, high demand for gold stemmed from low penetration of banking facilities, restricted laws of inheritance, hedging against inflation, and being a medium of hiding unaccounted income. Gold has also served as a hedge against rupee depreciation, as in the past laws prevented Indian households from investing in foreign assets or holding foreign currencies. Also, as the rupee is not fully convertible, gold is one of the limited ways in which Indian households can diversify their currency exposure.
Over the last few years, gold as an investment option has become increasingly popular. It is perceived as a safe and liquid investment even in the event of global risk-aversion and acts as a hedge against rising inflation expectations.
In fact, the share of net retail investment (comprising individuals' purchases of coins and bars) as a percentage of total Indian gold demand rose to 23% as of the 12 months ended September 2010 from 15% as of the 12 months ended September 2001. New ways of holding gold are being explored, like gold Exchange-Traded Funds (ETFs). According to the WGC, total holdings under gold ETFs amounted to 11 tonnes by the end of August 2010, up 77% from 6 tonnes as of the same period last year. Other products include gold saving schemes and microfinance gold link schemes.
The purchase of 200 tonnes of gold from the IMF by the Reserve Bank of India (RBI) in October 2009 has also boosted consumer confidence about gold as a safe asset class.
Gold Is One of the Key Assets in Household Balance Sheets
As mentioned earlier, according to WGC estimates, Indian households own about 18,000 tonnes of gold. Gold holdings among Indian households at current market value are about 2.5 times the current equity stock holding of US$315 billion. Bank deposits by households are currently valued at US$625 billion, according to our estimates. While the share of gold in household savings declined to 5.7% in F2008, we estimate that this has again risen back to 9-10% currently. On an annual basis, household savings in gold and bank deposits stood at US$29 billion and US$104 billion, respectively; in equities, it was -US$4 billion as of the four quarters ending September 2010. With its high rate of gold consumption, India accounts for 21% of annual global gold demand, while its share of global GDP in terms of nominal dollar GDP is only 2.1% (2009). India's share of global gold demand is about one-and-a-half times that of China, though its GDP is only about a quarter of China's.
Opportunity Cost of Gold Investments Is High
As Dr. Y. V. Reddy of the RBI mentioned in a past speech, "The total quantities of gold imported, legally and otherwise, have risen sharply after liberalisation, particularly in the recent past. This has been a ‘drain on savings'." We believe that if India were to invest its annual savings in more productive business assets rather than gold, its annual GDP growth would be higher by about 0.4%. The cumulative GDP value lost by parking US$800 billion worth of savings over the years in this not so productive asset would be huge. With no domestic gold mining, the purchase of gold is also resulting in inappropriate use of foreign exchange earnings. During F2010 (12 months ended March 2010), gold imports were 2.1% of GDP and about 13% of total non-oil imports. India's growing demand will be largely met from imports, apart from recycled gold as little supply comes from domestic production.
Share of Financial Savings Remains Low
After rising to an average of 60% in the mid-1990s, over the last ten years, the share of financial savings in total household savings has remained largely stagnant at an average of 47%. Indeed, low real interest rates have provided little incentive to increase allocation from physical savings (which include gold, property and household investments in small businesses). The share of financial savings in total has decreased to 46% in F2009 from 64% in F1997 as real interest rates have fallen to -0.5% from 9.1% over the same period. Indeed, this decline in real interest rates has only encouraged households to increase the allocation to physical savings (including gold, property and household investments in small businesses). Although the official statistics for F2010 are not available, from preliminary figures we believe that the share of financial savings has increased to 53% in F2010 as real interest rates increased to 3.6%. Yet, the penetration of financial savings in India still remains low. Apart from this, the incidence of unaccounted money (black money) is also a reason for the low share of financial savings. On the other hand, the share of gold in household savings appears to have risen again in F2010. Our analysis based on the stake holdings trend of around 1,200 NSE listed companies and purchases of mutual funds indicate that Indian households' allocation to equity has fallen sharply following the credit crisis. On the other hand, their investment in gold has been trending upwards.
Financial Sector Reforms Needed to Increase the Share of Financial Savings
To increase the share of financial savings, deepening of financial sector reforms would be the key. Apart from increased easy access to banking and financial services facilities, one of the most important areas that need attention in this context is reforms related to long-term savings schemes. Although the government has initiated some reforms recently, the desired results are still not reflected in the share of long-term savings. Currently, only about 10% of the workforce is covered by some form of pension scheme, including government-sponsored social security schemes. These schemes have also failed to be fully effective as contributors tend to withdraw a significant sum before retirement. About 90% of the workforce depend on family transfers and other informal systems for old-age security.
Bottom Line
A shift away from gold into financial savings is unlikely to happen in a hurry. We believe that there are a complex set of drivers behind Indian households' fetish for gold. While the government is continuing its effort to channel these savings into more productive financial assets, we believe that this shift is unlikely to materialize in the short term.
For full details, see India EcoView: Fetish for Gold, December 9, 2010.
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