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World Gold Council Stratstruck

Case Document


It was the shimmering glow of the decorations outside the Jewellery shops that brought Rajeevs
attention back to the meeting scheduled for the day after tomorrow. Passing through the markets
crowded with families on a shopping spree at the occasion of Dhanteras- the first day of the five day
long festival of Diwali, Rajeev was continuously trying to focus on the task at hand. As a principal
Finance Secretary to the Government of India, he had to present the strategic policy document to
the Cabinet to tackle the challenges faced by one of the most important segments of Indian
Economy the Gold Industry.

Introduction

An IAS from the batch of 1972, Mr. Rajeev belonged to a family running jewellery business in Indore
and was always interested in the Gold & Jewellery sector. He had undertaken the current
responsibility after performing a multitude of roles in Ministry of Commerce, Ministry of Finance,
RBI, and a brief stint as Ambassador & Permanent Representative of India to the WTO. Over this
varied experience he had overseen various government policy initiatives and observed various
industry segments in their growth phase during the late 90s.

It was an interesting coincidence that he was assigned the responsibility of developing the
government policy document for this sector in January 2013. He had met different industry
representatives in the past three months including World Gold Council, FICCI, CII, major organized
retailers and representatives of unorganized businesses in the past 3 months to understand the
issues and challenges faced by the industry.

The Gold Industry

In India, gems and jewellery had always inspired passion unlike any other object of desire. The
domestic gems and jewellery industry had a market size of INR 251,000 Cr in 2013, with a potential
to grow to INR 500,000530,000 Cr by 2018. The gems and jewellery industry had been crucial to
the Indian economy given its role in large-scale employment generation, foreign exchange earnings
through exports, and value addition. The industry was a source of direct employment to roughly 2.5
million people and was expected to generate employment of 0.71.5 million over 2014-2020. In
comparison to the 2.1 million jobs provided by IT services, it was one of the most important sectors
of Indian economy. The industry was to drive a value addition of more than INR 99,000 Cr, a figure
comparable to several large industries such as apparel manufacturing.

The domestic gold industry was considered the focal point with a market size of $46 Billion in 2012
and a growth rate of 75%(in Value terms) for the past 5 years. Gold, the precious shiny metal was
used in the preparation of jewellery and ornaments and as a mode of investment through bullions,
bars & coins. The estimated gold stock in India was more than 20,000 tonnes valued at more than
$1 Trillion. This was approximately 60% of Indias total GDP and 200% of Indias Infrastructure
investment in the 11
th
Five Year Plan.

However gold had been in focus due to almost complete dependence on imports for supply and an
expanding current account deficit (CAD). As a result of increasing pressures to bring CAD down,
regulatory action had been taken to limit gold imports. The CAD for India had increased to 4.8
percent of GDP in 20122013 from a positive current account balance of 1.2 percent of GDP in
20022003. It was worth noting that while imports had grown by a CAGR of 25 percent in this
period, exports, however, had not kept pace, with a CAGR of 20 percent between 20022003 and
20122013.

Gold had the second-highest share in imports, increasing from 6 percent in 20022003 to 11
percent in 20122013. The increase in gold imports had largely been driven by the spectacular
growth in gold prices, with prices moving from INR 5332 per 10 gm in 20022003 to INR 30,164
per 10 gm in 20122013 (CAGR of 19 percent), leading to a CAGR of 32 percent in value terms. In
comparison, import of gold in volume had only increased by a CAGR of 5 percent.

The other two large segments were crude oil, other petroleum products, machinery and other
equipment. These were considered more essential to the economy than gold and as a result, the
regulations to curtail imports have focused on gold. Consequently, there have been changes in
regulations that aim to curb gold imports. Because gold was the most important raw material, any
uncertainty in its supply had a crippling impact on the entire industry.

The gold industry in India was facing challenges at multiple fronts. These challenges were supply
constraints, limited recycling, import restrictions, smuggling, lack of standardization across
industry and alienation from the financial market and capital system. With multiple regulations
without any single co-coordinating body and lack of clear policy framework to incentivize inclusion
of gold into the financial mainstream, the industry was calling for a major policy directive.

Gold: The Value Chain

Gold had enjoyed a special significance in Indian culture. Backed by intricate workmanship and
designs developed over the ages, it had been an integral part of Indian lifestyle and culture for
centuries. Today, India was the largest consumer of gold jewellery in the world with 29 percent
share of the total global demand for gold as jewellery.

The value chain for gold includes mining, refining, trading, manufacturing, retailing of gold as well
as trading of gold-based financial products. The gold value chain had a distinct characteristic: it
catered to both consumption-led demand and investment-led demand. As a result, there were two
value chains with distinct drivers and needs; however, there was extensive intermingling of the
players across the two value chains. The industry value chain was comprised of sourcing (mining
and imports), refining, trading, manufacturing, and retailing (see Figure 1). While some of the
players catered primarily to consumption demand or investment demand separately, there were a
host of players catering to both consumption and investment demand.

Gold Sourcing: Mining & Imports
Due to Indias limited gold reserves, the yearly production of gold was around two tons in the
period 20112012, which amounted to just 0.2 percent of the total gold imported. It was important
to encourage exploration and mining activities of gold in India. FDI up to 100% in mining sector
with respect to gold is eligible for automatic approval. The concessions and mining leases for gold
were granted by State governments after prior approval from central government.

Most of the gold was imported only through a handful of bodies, including bullion banks and
Government trading agencies, and was largely organized and consolidated among fewer players.
Also, the imported gold was usually sold in bulk to manufacturers and dealers. Gold was imported
primarily in unwrought or semi-manufactured form (INR 292,000 Cr in 20122013). However,
some gold was imported as jewellery (jewellery import was INR 27,000 Cr in 20122013). These
imports however, were, lately subjected to government duties and taxes. Custom duty on Gold
imports was increased to 10% from 2% in 2012. The custom duty on gold jewellery was increased
to 15% in September 2013.

Resale Regulatory Restrictions
Along with other restrictions, the gold imports were subjected to a unique regulation clubbing it
with exports. The Reserve bank of India had put further curbs on gold import in July 2013
mandating the banks and nominated agencies to retain 20 percent (or one fifth) of every lot of gold
imports in the customs bonded warehouses. They were allowed to import further gold only once
they released the 75 percent of that stored gold for the purpose of exports. This put all the domestic
traders like Tanishq, TBZ etc. in a fix as they did not have any export business. This could result in
exporters demanding unjustified premiums for export replenishments and increase pressure on the
domestic supplies.

Refining
Refineries in India operate mainly on imported gold bars and scrap gold collected from the
domestic market. Refineries thus played a crucial role in the recycling of gold in the country. The
market for refining was small, however. Currently, it was estimated that refineries were operating
at 25 percent of total installed capacity due to a shortage of used jewellery. The market consisted of
a few larger units and other smaller units, mostly in the private sector and a few Government
refineries. In addition, none of the private refineries were LBMA (London Bullion Market
Association)-certified for gold, hence gold bars produced by them could not be used for exchange
traded funds (ETFs) or bought back by banks and as a result these refineries were not part of the
financial system.

Bullion Traders
Gold was sold from banks and other Gold importers to the wholesale bullion dealers (~ 200 in
number). Some of the big dealers cater to the jewelers and second level dealers. The complete value
chain is described in (See Figure 2 and 3).

Manufacturing

The last few years had seen the emergence of larger organized manufacturers of jewellery having
modern, well organized manufacturing units. With higher focus on design, quality, standardization
as well as efficiency (minimal gold loss); they primarily catered to consumption demand for
jewellery. These players operated primarily from the major jewellery manufacturing hubs in the
country. The rest of the jewellery manufacturing industry was fragmented, with a large share of the
output produced by small manufacturers. The manufacturing industry imparts the value addition of
more than INR 99,000 Cr. The taxation has been mainly governed via Customs and Excise
department and state departments for CST and VAT.

Retailers

The past decade had witnessed the emergence of organized players, with Government liberalizing
gold imports into the country. The industry was, however, still fragmented, with local and
independent stores constituting roughly 80 percent of the overall market, in comparison to a much
higher proportion of share from organized players. Despite that, there has been a sharp increase in
the share of organized retail, which was almost negligible 15 years ago. Over the period between
2008 and 2013, the share of regional chains has increased significantly from 7 percent to 17
percent, while the share of national chains has grown from 3 percent to 5 percent. Around 65% of
total gold demand in 2012 was jewellery demand with almost flat demand in tonnage, but
appreciation in value has been driven by rising gold prices.

While the share of organized players in Gems and Jewellery industry had been increasing, there was
a risk of a slowdown in this trend due to regulatory restrictions on gold imports and price
differential between official and unofficial supply of gold in the market. Lack of optimal checks by
government to restrict unaccounted gold trade had also encouraged sale of smuggled gold into
market at lower prices putting pressure on organized retailers.


Rising Demand for Gold

Jewellery Demand

A unique feature of Indian demand for gold jewellery was its steady growth leading to appreciation
in terms of value by 4.2 times in nominal terms, despite higher import duties. The jewellery
demand accounted for around 64 percent of the total market demand. This demand was led by the
need for gold and non-gold jewellery that caters to specific wear occasions. However it was
different from any other luxury products in terms of appreciation in value over time. Moreover
unlike other luxury products, gold purchase, even as a jewellery was always backed with a strong
investment perspective.
Investment Demand

Investment demand was mainly in form of bars and coins accounting for about 36 percent of the
total market demand. The high investment demand in India was driven by lack of alternate
investment or savings options, perceived capacity to hedge against inflation, ability to invest in gold
in small denominations, ease of investing unaccounted money in gold and the limited presence of
alternate investment or savings options for a large section of the society. (See Figure 5 & 6)

Gold-Based Financial Industry

The investment demand for gold was also fulfilled through financial products. There were different
types of products available in the market. Retail investors may take positions in gold through
financial instruments such as gold ETF, e-gold, and gold-based mutual funds.

Gold ETFs

These were exchange-traded funds backed by gold. Gold ETFs were provided by about 14 financial
institutions in India and were traded on the NSE and BSE. They provide returns that closely match
that of gold, though there was a need for actual backing with physical gold up to 90 to 95 percent of
the value of the gold ETF. It was also possible to back these (up to 20 percent) with the gold deposit
schemes of banks. However, retail investors need not take physical possession of gold during the
transaction. The instrument works on a platform similar to equity trading, with investors needing
equity demat accounts to have positions.

There was a comparatively larger market for gold ETFs globally, with combined holdings of 2,691
tons at the end of 2012. However, the market for gold ETFs in India was smaller, with gold holdings
of around 40 tons (around INR 10,660 Cr of total assets under management). Of this, the top four
funds (Goldman Sachs, Reliance Mutual Fund, SBI Mutual Fund, and Kotak Mutual Fund) have
around 75 percent share. Launched in 2007, gold ETFs were relatively new, with significant rise in
volumes only in the past two years. However, recent pressures on CAD had led to instances of
market regulator SEBI turning down applications for new gold ETFs.
Gold funds

These were usually fund of funds schemes backed by gold ETFs. They operate along similar lines to
mutual funds, and do not require a demat account. Being fund of funds, they incur recurring
expenses of the underlying scheme (gold ETFs). Gold funds also offer Systematic Investment Plans
(SIPS) that allow customers to invest in small value.

Overall, the market for financial products was comparatively new in India, with low off-take and
limited product options. Recent pressure on CAD also had led to initiatives impacting the industry.
Banks/NBFCs dealing in Physical Gold
Banks earlier sold gold coins and bars to the customers at premium. However, selling of gold coins
was suspended due to import restrictions from banks on gold coins (imports were the only source
of certified gold coins in absence of LMBA accredited refinery in India). Banks were not permitted
to buy back the gold coins or give loans against gold coins or bars. This tightened the reverse
liquidity of gold into the market as the gold coins bought by customers were not being bought back
by banks. Also while loans could be given up to value of 50 grams of gold jewellery and specially
minted coins by some financial institutions, it was also restricted by RBI recently constraining the
supply of gold back into market. Also as a result of overregulation, the customers were being
pushed back to old system where the jeweler also acted as a financial institutions without any
monitoring and control mechanism.

Gold Trading

Trading of physical gold was done by dealers and gold jewellery manufacturers and retailers.
Physical gold was usually purchased in bulk from importing agencies and then resold to smaller
jewelers across the country. This trading caters to both consumption and investment demand in the
market.

Commodity-based trading of gold was done through exchanges such as the Multi Commodity
Exchange of India (MCX), National Commodity & Derivatives Exchange Ltd. (NCDEX), National
Multi-Commodity Exchange of India Ltd. (NMCE), and National Spot Exchange Limited (NSEL).
Several organizations engage in trading activities, including bullion dealers and jewellery
manufacturers. Most of these transactions were done by industry players and not by retail
investors. For example, jewellery retailers would hedge position in MCX while buying jewellery
directly from vendors.

Gold based futures market was still in very nascent stage. The futures transactions were limited due
to liquidity issues in gold and the price visibility was not more than 1 month. At the same time
Options were not allowed in gold for trading.




Potential of Gold in the Indian Economy

It was widely believed that gold had a potential role to play in the Indian economy. Gold had earlier
been used as collateral in the unorganized sector and was strongly entering into the financial
system through formalized lending against gold holdings. Gold was to reach its position as a
normalized and taxed store of wealth and a standardized trading commodity at retail level. This
would reap benefits for all stake holders including the exchequer, regulators, consumers industry
and intermediaries alike.

The long term milestones for the industry were reduction of gold imports without constraining the
supply side, increased usage of gold standards to effect commoditization of gold in retail market
and institutionalization of a robust and centralized regulatory framework to increase the
deployment of gold as capital in the economy.

Increasing monetization of gold was also imperative to free up the locked wealth in the Indian
economy. From 2005 to 2012 the percentage of gold demand as investment instrument had
increased from 19% to 36% (See Figure 12) thus presenting a stronger case for monetization of
gold. However, a strong policy framework to monitor, regulate and encourage this exercise was still
not in place.

Unofficial gold market

A significant source and result of market and regulation inefficiencies was unofficial gold trade.
With annual volumes as high as 100 tonnes per year, gold had been the first choice for smugglers
due to very high value to volume ratio, non-traceability after the supply into market and significant
profits per transaction. The price difference in the international and domestic market was huge
(about 250$/oz., 1 oz. = 31 grams approx.), and was mainly because of import restrictions and high
custom duties. With size of total gold industry around USD 45 billion, it had the potential to give
rise to one of the biggest illegal industries in India. Recent restrictions posed by government on
import of gold had only given a boost in gold smuggling which was estimated to cross 150 tonnes in
2013. This not only had economic repercussions in terms of loss of revenue to the government and
increased inflow of unaccounted money into the system, but also posed serious social threat as it
was acting as source of organized criminal activities and terrorist financing. This issue required
immediate attention and serious steps to reduce regulatory inefficiencies to curb illegal trades and
smuggling in gold were needed.

Challenges to the Industry
Gold catered to two very distinct demandsconsumption and investmentwith very different
needs and challenges. Some of these challenges could impact the industrys performance if left
addressed. While certain structural challenges kept the industry from reaching its full potential,
there were recent regulatory challenges that could further diminish the growth prospects for the
industry.
High import dependence

Out of total demand, only ~5% of gold was supplied from Indian mines. Gold was the second-
largest import item after crude, with an import bill of INR 307,000 Cr (including gold as part of
jewellery) in 20122013(See figure 8). Of this, around INR 152,000 Cr of imported gold was for
jewellery manufacturing catering to the domestic market and around INR 92,000 Cr was for bars
and coins; the remaining gold exported primarily as jewellery. The high CAD (4.8 percent of GDP) in
India had led to concerns over the import bill of gold that catered to the domestic gems and
jewellery industry and bars and coins manufacturing. Consequently, a series of regulatory
measures had been taken to reduce gold imports. While the regulations aimed to reduce the current
account deficit, they also had put pressure on the growth of the gems and jewellery industry.

Limited recycling

The supply of gold from old gold scrap was only around 13 percent of total domestic consumer
demand for gold in 2012, which was less than 1 percent of the above-ground stock of gold in India.
This was due to the unique positioning of gold in the minds of the Indian consumer, whereby the
sale of family gold was seen as a social taboo and to be considered only in the case of acute financial
crisis. There was also a lack of incentive to sell household gold, since there was a loss in value on
the sale of gold jewellery and the buyback price provided by jewellery retailers for old gold was
lower (up to 10 percent) than the gold selling price to account for impurities in the used gold. (See
Figure 7)
Given the import dependence and limited recycling, there have been initiatives to encourage higher
recycling such as the Gold Deposit Schemes of State Bank of India, which targeted both retail
customers and trusts to loan out their gold holding. However, these schemes had limited success
due to insufficient coverage and communication, unattractive scheme structure, and consumer
inhibitions.
It was imperative to increase gold recycling and bring the idle gold stock into the market and
embed gold into the financial fabric of the countrys economy.

Absence of industry wide standards for gold refining and imports

India was the only large consumer of gold without any refinery accredited by international
standards. There was no common standard for Gold bullion (999.9 Kilobar, the most prevalent
product accounting for ~70% of trades) (See Figure 15). The absence of any LMBA accredited
refinery led to unavailability of authentic 99.9% pure gold. At the same time it also affected the
yield and quality of the recycled gold because of the impurities present in the initial stage itself.

Another big challenge was the absence of a uniform standardizing and certification authority in
India at the retail level. Currently only about 10,000 Hallmark certified suppliers were present in
the industry. Presence of Hallmark had been limited due to logistical issues like lack of Hallmarking
centres and low customer awareness regarding gold standards in India. More importantly Hallmark
certified gold also rendered itself to uniformity in prices which was an important step towards
integration of different bullion markets across India.

Overregulated consumption industry and under-developed investment industry

The industry faced regulatory challenge due to lack of differentiation between consumption and
investment resulting in overregulated consumption and under-developed investment industry.
Currently there were 8 different agencies under three different ministries overseeing the complete
Gold Value chain. For different players in the supply chain, multiple regulatory bodies existed which
governed the transactions. There was absence of a central body to facilitate all utility functions
related to gold like price discovery and act as centre for inter-dealer bullion trading. (See figure 10)

The financial industry for gold-based products also faced regulatory challenges. Approvals for new
gold ETFs had been rejected by the SEBI in an effort to contain gold imports. Also, some regulations
prevented banks from sourcing gold from the domestic market. However, these multiple
regulations had resulted in inefficiencies in the market and constrained business growth. A central
regulatory structure was required to provide holistic understanding of gold across facets, develop
specialized expertise on gold transactions across consumption and investment market.

Further, a large section of the jewellery industry was playing the role of financial institution by
catering to investment needs and money lending, particularly in rural areas. And since it was not
regulated like other financial institutions, it could be a risk to consumers who were not aware.
There was a high demand for physical gold for investment purposes due to the attractiveness of
gold as an investment option, lower availability of alternate savings or financial options, and limited
financial products backed by gold. Initiatives to increase gold involvement in the financial system
could bring in the consumers to a more secure investment and lending environment.
Initiatives in the Foreign Markets

Gold markets in Turkey, Dubai and China had developed from similar challenges in the previous
years. Shanghai Gold Exchange was started in China to act as a marketplace for gold transactions.
Aggressive acquisition of overseas gold mines was effected to secure gold supplies. Dubai also
launched a separate gold exchange to tap into increasing gold demand in Middle East.

Turkey faced current account deficit issues similar to India. Turkey followed a set of coordinated
measures to tackle these challenges. Between 1985 and late 2000s, Turkey established 3 world
class LMBA certified refineries that produced gold bars and coins. Using Reserves option
mechanism, the Turkish Bank incentivized gold deposit products to collect idle gold. The Turkish
Bank also allowed use of gold bullion to satisfy reserve requirements in 2010 and increased gold
reserves limits to 25% in 2012 to increase monetization of Gold. Within 2 years, more than 300
tonnes of gold was monetized through various such measures (See figure 15).

Way Forward

The gold industry which had a potential of being a kingpin of the Indian financial system and
treasury, was facing potential stagnation, with challenges at multiple fronts. It was therefore
imperative for various stakeholders, such as the government, RBI, and industry, to drive large-scale
transformation and ensure a sustainable and growing industry. A clear policy framework was
required to be designed to address key structural and regulatory challenges.


Problem Statement:

Propose a draft policy document which analyses above issues outlining initiatives and possible
solutions to the challenges faced by the gold industry, answering the following key questions:

1. What institutional mechanisms are required to bring the complete gold Industry under
uniform governance to drive long term direction setting on gold?
2. How can the supply constraints in gold be reduced without affected CAD?
3. What kind of infrastructure and policies are required to enhance industry efficiency
(including but not limited to uniform standardization and price uniformity) and ensure that
gold gets embedded into the financial system of Indian Economy?

Exhibits


Fi
gure 1: Gold Value Chain in India

Figure 2: Value addition across value chains in Gems and Jewellery Industry
(others include other precious metals like silver, platinum and gemstones)


Figure 3: Indian Gold Industry Structure

Figure 4: Gold price trend (2005 -2012)


Figure 5: Demand trend for Domestic Gems & Jewellery and Gold Bars & Coins market

Figure 6: Gold Demand: Indias share in Global Demand (by volumes of gold consumption)


Figure 7: Recycling of Gold - Ratio of gold supply from scrap to gold demand


Figure 8: Indias total Imports 2012-13


Figure 9: Agencies overseeing Gold industry regulations


Figure 10: India: Gold Stock by Category


Figure 11: Annual Investment Returns


Figure 12: Consumption v/s Investment share of Domestic Gold Demand


Figure 13: Percentage of Gold in total reserves held by Central Banks

Figure 14: Gold Reforms in Turkey and its economic parameters


Figure 15: International Gold Standards and Accreditations, gold refineries in different countries