The forthcoming Union budget will be presented against the backdrop of several structural distortions in the economy. One distortion seen over the past two to three years is how large amounts of savings are moving into gold purely as an investment avenue. Gold imports nearly doubled in just one year (2011-12) to $60 billion. This was unprecedented. Gold imports alone were about 3.5 per cent of the GDP. If they hadn’t doubled in 2011-12, and had remained in the normal range of $30 to $35 billion, the current account deficit would have been far more benign, around 2.5 per cent of the GDP, rather than 4.2 per cent, which is regarded as very risky.
It is this bulging current account gap that caused the exchange rate to become so volatile in the last quarter of 2011, when it rapidly slipped to Rs 56 to a dollar, raising fears that it would touch Rs 60. The government then began raising the import duty on gold to prevent high gold import. However, that is hardly a solution as gold smuggling is back in fashion. In this financial year, gold imports have not abated significantly and the RBI governor has warned that the current account gap in 2012-13 might be even higher at 5 per cent of the GDP, exacerbated by negative export growth. This is not good news.
There is a reason why small and middle investors are preferring gold as an investment prospect while moving out of other equity-linked financial products, particularly mutual funds and insurance-linked investment instruments where massive savings were being channelled earlier. A large number of middle class investors have found, to their utter dismay, that banks and insurance companies had been consciously mis-selling pension, insurance cum investment products to savers, informally suggesting a certain minimum tax-free return that could be withdrawn within five years or so.
This has permanently damaged the faith of the middle class investor in such schemes. The financial services industry has no idea how much psychological damage it has caused to the investor psyche. It will take a long time to recover, and fostering a culture of long-term investment in insurance and pension products linked to market investments will take some years.
The finance minister, last fortnight, publicly admonished insurance companies for large-scale mis-selling of insurance. The insurance regulator, IRDA, has reported massive complaints of unfair business practices by those marketing these financial products, which have risen from 7.6 per cent of total customer complaints in 2009-10 to 32 per cent in 2011-12. This has been happening even in conventional insurance policies after severe curbs were placed in 2010 on unit linked insurance plans (ULIPs), which were nothing short of a scam. Even banks had been regularly advising their savings and fixed depositors to move their money to ULIPs and other market-linked pension products designed by their insurance arms. Is there a conflict of interest there? No wonder fresh premiums in unit linked insurance schemes have collapsed from Rs 60,000 crore in 2009-10 to a mere Rs 17,382 crore in 2011-12.
I am elaborately describing the plight of the middle class saver simply to illustrate how irresponsible financial services institutions, aided by lack of regulatory intervention, have destroyed the small investors’ confidence at a time when the economy badly needs to channel much higher long-term savings into productive sectors such as infrastructure. Instead, the middle class, hurt by both inflation and unfair practices by financial services institutions, is buying more and more gold.
Imagine buying additional gold worth over Rs 1,00,000 crore a year, which cannot be channelled productively into the economy. If the same money were invested in safe and secure — and honestly sold — financial instruments, it would be funding the long-term infrastructure needs of the country.
It is also instructive to see how the irresponsible conduct of financial services at a micro level ends up creating macro distortions in the economy, which eventually assume structural dimensions. As I said earlier, the permanently higher and worrisome current account deficit owes partly to the additional gold buying over the past two years.
More broadly, the finance minister needs to restore the confidence of the middle class investor who now have little faith in anything other than gold and real estate as the means of preserving and growing her savings. In recent years, additional inflows into equity mutual funds have also stagnated because the small investor has generally become wary of the equity markets. The average annual returns over a five-year period — since January 2008 — given by some of the better known equity mutual funds are in the range of 5 to 7 per cent. The investor would naturally wonder whether it would have been far better keeping the money in fixed deposits.
The budget must also tackle another critical issue that might indirectly help in addressing the troubling inflation question, which is also responsible for macro distortion in savings patterns. No one so far has been able to clearly explain why inflation has structurally remained so elevated for so long when GDP growth has slipped to 5.3 per cent. After the 2008 global financial meltdown, there was a fundamental shift in thinking among central bankers around the world. It was generally accepted that the asset price bubble (such as in real estate) could have a long-term impact on inflation and that central banks and governments must use appropriate instruments to mitigate asset bubbles that might permanently feed into higher inflation. As part of this exercise, the RBI had conducted a preliminary study of real estate prices and land transactions across scores of Indian cities. One is not sure what came of that exercise eventually.
A recent RBI report had pointed out that in spite of the 2008 global financial meltdown, real estate prices in urban Bihar and UP had actually gone up. Real estate prices in smaller urban pockets are going up rapidly. The velocity of land sale and purchase has also gone up as villagers are selling land and moving closer to the national highways. In my view, a certain level of cumulative liquidity has been embedded in India’s growing land transaction market and this is fuelling structurally higher inflation levels as part of the money released from inflated land deals feeds into the demand stream. But this needs to be researched further.
The finance minister must come up with some creative ideas to increase the supply of land on a large scale to mitigate the inflationary expectations fed by land prices. This will require some vision as politicians in India deliberately restrict supply of land to eventually make five to seven times profit while allowing land use change for urbanisation. A tax on vacant land held beyond a period could be a solution. But this will require a self-sacrificing spirit from the political classes. Are they up to it?