Will You Feel the Pinch of the New Custom Duty? - Outside View by Chirag Mehta

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Will You Feel the Pinch of the New Custom Duty?
Jan 25, 2012

Halfway through January 2012, the government unexpectedly announced a change in the structure of gold's import duties. In the midst of one of the coldest winters in India, we're letting you in on how this new revision will affect your gold investments: Will it bring warmth to your gold holding? Or will you have to burrow your hands deeper into your pockets?

The Call of Duty

In a bid to match the import duty with rising prices, the government trebled the customs duty on import of gold by increasing the duty twice by Rs. 100 each time, during the Fiscal Year 2009-10.

On 17th January 2012 the government again changed the import duty and it has been set at 2% of value from the earlier import duty of flat Rs 300 per 10 grams. This means, at current price of Rs. 27,700 (rounded-off current gold price) for 10 grams of gold, while you used to pay Rs. 300 as customs duty, it will now increase to Rs.560 (approximately) per 10 grams. In other words, customs duty which amounted to 1.08% at current prices has increased to 2% of value; nearly double of the tariff.

What made the government raise the import duty on gold again? Here are a few probable reasons...

One, India is the world's largest consumer of gold and most of the gold demand is satisfied through imports. As consumption of gold increased, the value of gold imports also saw a rise. We know that higher imports require higher foreign exchange to pay for the import bill, causing a strain on the country's trade balances. Higher imports and rising gold prices worsened the rising trade deficit issue. As per December 2011 data, gold and silver imports grew at 53.8% to $45.5 billion. (Source: Cybex.in)

Many blamed gold imports for rising deficit and the resultant sharp depreciation of the Rupee compelling the government to take immediate measures concerning gold import. However, they simply tend to ignore that this allocation to gold helped the investor's portfolio during the year (2011) when most of the other assets lost heavily.

On the other hand, the increase in duty becomes an additional revenue source for the government. Everyone is aware that the government is struggling to keep deficit under control and is unlikely to meet its deficit targets. This may prove to be a useful contribution for government finances at the expense of gold buyers. According to estimates of the World Gold Council, the Indian government earned around Rs 2,836.6 Crore from import duty on gold after the Budget decision in 2010.

This move will probably ease the pressure that the Rupee has been facing and help increase revenue collection from duties.

The Impact on the Investor

Existing investors of gold will benefit from the hike in import duty as the value of the gold owned by them has increased by approximately 1% (other things being equal). On the other hand, prospective investors who wish to buy gold will probably have to purchase it at a higher rate to the extent of increase in the duty.

The import duty adds an additional levy of approximately 1% of the current market value. As mentioned in the table below, if you add this with existing duties and levies, the price difference between internationally sourced gold and Indian domestic gold widens to nearly 3%. This indicates that the Indian consumer is paying 3% more than the price of gold in the international markets.

The increase in duty is unlikely to impact the demand for gold in any meaningful way. After each of the previous episodes of duty hikes, duties/taxes as a percentage of gold's price would increase to nearly 3% of gold's price. This time, the increase has moved up close to 3% but it is not likely to affect the demand for gold as seen after the previous tariff hikes.

Post this increase as well, we have seen the duties/taxes total to 3.3% of gold price and hence should not influence gold's demand in any manner; atleast beyond the short term. Also, the sharp increases in price has not really made much difference in the demand suggesting that a 1% increase in duty should not impact the sentiment of purchasing gold.

Table: Events where customs duty have undergone change in the recent past, comparing the price of gold on the day of hike with price of the day before.

DatesCustoms Duty (incl cess Rs. Per 10 gms)Gold Price before taxes and dutiesGold Price after taxes and dutiesTaxes and duties as a % of gold price
3-Jul-0910314,34114,6181.90%
6-Jul-0920614,24014,6202.70%
     
25-Feb-1020616,23216,6362.50%
26-Feb-1030916,47916,9893.10%
     
16-Jan-1230927,18227,8222.40%
16-Jan-122% (approx 560)27,17428,0683.30%
Source: CBEC, Bloomberg. Data Compiled by Quantumamc.com

The unusual move by the government will not have a major impact on gold's consumption pattern in India since consumers maintain a positive outlook towards the precious metal.

The expectations of change in gold prices and price volatility are the two big factors that impact demand, and not the level of duties or even the gold price level.

Is the rise justified?

Many argue that this was a much needed measure to protect the India growth story and to stop the depreciation of the currency. The two reasons- Rupee depreciation and increasing imports are not related in any way. The India growth story revolves largely around the Indian consumption pattern and the Rupee depreciation was partly on account of global risk aversion and the resulting lack of capital flows owing to fiscal / trade deficits.

In order to confirm if the custom duty is justified, let's first understand why the customs came into existence.

Compared to the trading it is exposed to at the moment, India was a self-sufficient, inward looking economy that was focused on reducing imports and avoided excessive foreign exchange. As testimony, the Customs Act was established in 1962 to protect local industries and prevent illegal trade of goods.

Over the years however, the Indian government decided to open its economy to foreign business and liberalisation reforms helped free the gold market through unrestricted movement of currency.

The trades were carried out smoothly until recently when the reforms were reversed and gold customs duty was increased. Ironically, India has been producing almost negligible quantities of gold in comparison to its consumption and hence there was no real need for such a duty to be levied, especially not by claiming protection for domestic industries.

The previous Indian Budgets too saw a reduction in customs duty. Here's a brief look at the justifications provided by the then Finance Ministers:

  1. 2001-2002:"In order to discourage smuggling I propose to reduce the duty on gold from Rs 400 per 10 grams to Rs 250 per 10 grams."- Yashwant Sinha

  2. 2003-2004:"As for gold, it is proposed to reduce the customs duty on imported gold to Rs.100 per 10 grams from the present level of Rs.250 per 10 grams, but only when it is brought in the form of serially numbered bars, or in the form of gold coins, not as 'tola' bars, please. It is my hope and expectation that this will become the first step in enabling India to shortly emerge as the gold-trading capital of the world."- Jaswant Singh
While these were their justifications, some questions remain unanswered...

What happened to the dream to make India the gold-trading capital of the world?

India has every reason to become a dominant player in the gold market because of its immense consumption power; individuals are holding huge gold stock reserves, and already has the exchanges and products required for the development of the gold market in place. However, instead of being a country that should be setting the price, we have been categorized as price takers.

The dream of making India the gold-trading capital has been sacrificed because the government is currently focused on filling it's deficit ridden coffers with the revenue it will earn from the customs duty. To earn custom duty, the government is burdening consumers who are already reeling under the pressure of rising prices. It seems the government has conveniently forgotten the main intention behind the introduction of such reforms, which was to make India the gold-trading capital of the world.

Our Appeal

Government policies play a big role in making or breaking the market, and hence the finance ministry should not be swayed by the short-term gains of the custom duty. Instead, they should pay attention to the overall development of the gold markets in India.

By introducing Gold ETFs in 2005-2006, the then Finance Minister took a step forward and enabled investors to purchase gold in a more efficient manner. The government should introduce more features like these to strengthen the gold markets.

As mentioned in an earlier Golden truth article, we reiterate a few other reforms that can be introduced to fulfill the dream of making India the gold-trading capital of the world:

  1. A gradual move towards a free market: Imports and exports of gold should be allowed with minimal restrictions if not freely. If the government opens up to a free market, there is a high chance that gold prices will trade better since domestic prices would be at par with international prices and will help lay down some basic rules in order to find the true price of that commodity or currency. For this to become suc-cessful, additional taxes, duties and levies need to be abolished. Getting domestic prices on level with international prices would thus serve as a stepping stone towards India being the center of the gold market.

  2. Mobilizing for productive purposes: The accumulated wealth of gold in India amounts to more than Rs. 30 Lakh crores. The government should try to use these savings for the development of the nation by mobilizing and channelizing the same to productive uses. One efficient use would be to mobilize these savings and efficiently utilize the same for managing trade deficit.

  3. Annual fee on foreign bullion players: The government could apply an annual fee on foreign bullion players trading in Indian markets and generate revenues through the fees charged on them.
The customs duty collected helps reduce the deficit by a negligible proportion. Hence, the government should focus on implementation of such reforms and look at the bigger picture. We all agree that it is not easy to implement these reforms overnight and it is a gradual process. However, if such steps are taken, we will definitely be strengthening our gold markets.

Until then, Investors...

Although the increased custom duty has made the purchasing gold in India a bit more expensive, investors should remember that they would recover the difference when they sell their gold holdings. Such small increases in duties was an expected phenomenon and will only marginally increase the purchasing price of gold. Investors should look at the long-term position, and invest in gold with the opportunity of benefiting from potential increase in its prices over the long term. They should also look at the diversification benefits that gold provides, as proved by the recent episodes of 2008 and 2011.

Afterall, the only thing constant is change - be it the weather or the government.

Chirag Mehta is Fund Manager, Commodities for Quantum Mutual Fund and manages the Quantum Gold Fund ETF and the Quantum Gold Savings Fund among others.

Disclaimer:

The views expressed in this Article are the personal views of the author Chirag Mehta and not views of Quantum Asset Management Company Private Limited(AMC), Quantum Trustee Company Private Limited (Trustee) and Quantum Mutual Fund (Fund). The AMC, Trustee and the Fund may or may not have the same view and DO not endorse this view.

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