In 2016, global jewellery demand, which is a key to the fortunes of the gold price, fell more than 20% to levels last seen during the financial crisis. Higher prices were partly a cause, as the average US-dollar-denominated gold price in 2016 was about 8% higher than in 2015, and higher still in key currencies like the Chinese yuan and Indian rupee, both of which fell against the dollar in 2016.
While higher prices clearly weighed on jewellery demand, this was not the primary cause. Gold price increases in prior years did not lead to as substantial a decline. For example, when the average gold price rose about 6.5% in 2012, jewellery demand fell only about 1.5%. In addition, when overall prices were $100 to $500 an ounce higher from 2011 to 2014, jewellery demand was still higher than it was in 2016.
The fact that nearly all of 2016's sharp drop in jewellery demand was attributable to China and India suggests country-specific factors were largely to blame. Year over year, official Chinese gold jewellery demand fell 17% and Indian purchases fell 31%.
Do these declines indicate secular changes to previous demand patterns? If not, what’s causing the temporary yet significant declines, and is there any reason to expect those causes to dissipate?
Some analysts speculate that Chinese jewellery demand’s massive fall was attributable to changing consumer preferences. According to surveys conducted by the World Gold Council, younger Chinese prefer to spend their money on experiences rather than material possessions. However, we doubt preferences could change swiftly enough to cause a nearly 20% year-over-year decline in jewellery demand.
Moreover, a dramatic change in household attitudes toward gold fails to explain why Chinese demand for bars and coins actually increased in 2016 - up more than 7% to nearly 237 metric tonnes for bars and 30% to almost 30 metric tonnes for coins.
Beijing Intervenes
Rather than a shift in consumer preferences, Morningstar equity analysts think the dramatic decline in gold jewellery purchases was driven by Beijing's efforts to stem capital outflows.
We estimate $1.4 trillion in net capital outflows from China from 2014 to 2016. Over the same interval, China's foreign reserves dropped by $801 billion as the People's Bank of China sold dollars to meet renminbi redemptions.
More concerning from Beijing's perspective, capital outflows had the effect of diminishing the efficacy of stimulus efforts. As the central bank pumped more money into the system, investors, corporations, and households were taking it abroad.
Beijing responded with measures intended to stem outflows, including tighter restrictions on outbound M&A and trade finance. Gold purchases were also targeted. According to the Financial Times in late 2016, even banks with licenses were having difficulty obtaining approvals to import gold.
Those efforts were largely successful, even if they failed to address the underlying causes of capital flight. We estimate capital outflows slowed to $85 billion on an annualised basis in the second quarter of 2017 compared with annualised outflows of $399 billion in the second quarter of 2016. China's foreign reserves have stabilised around $3.1 trillion.
Gold was a clear casualty of these efforts. From 2015 to 2016, Chinese gold purchases fell nearly 20% to 1,281 metric tonnes. Supply shortages widened, and the premium between the Chinese gold price and the world gold price spiked. The premium rose to well over $10 for most of the fourth quarter of 2016 and into 2017.
A divergence in price for a globally fungible commodity rarely happens when it can flow freely. If the drop in gold jewellery consumption was driven by weaker demand, we wouldn't expect the premium to rise so dramatically.
Since Beijing has started to relax capital controls, the fall in jewellery demand has slowed. The World Gold Council estimated Chinese gold jewellery demand at 314 metric tonnes for the first half of 2017, down just 3% from 325 metric tonnes for the first half 2016, albeit still well below the five-year average of 378 metric tonnes. As controls are further loosened, we expect demand to enjoy a fuller recovery.
India 2016 was particularly difficult for Indian jewellery demand for two main reasons. First, the government’s continued attempts to stem its current account deficit led to significant uncertainty, particularly around potential changes to the tax system. Second, another poor monsoon season led to a third year of disappointing crop yields, crippling the income of nearly two thirds of India's gold purchasers.
Strong Rupee Policy
India has long struggled with a current account deficit. In particular, the government is concerned with the detrimental effect it has on the rupee. Despite the fact that a weaker rupee could strengthen the global competitiveness of India's exports and narrow its trade deficit, Prime Minister Narendra Modi desires a strong national currency, which is a longstanding view of his BJP party. Modi used the 2013 decline in the rupee to attack the United Progressive Alliance, the ruling coalition at the time.
Gold is a big part of the problem. According to the World Bank, official gold imports constituted almost 8% of India's total imports in 2015, second only to oil. Imports are necessary to meet the country's huge appetite for gold that can't be met by domestic production. Exhibit 18 shows the relationship between gold imports and the current account. Gold is a particularly unproductive import, as it provides little utility outside of potential investment or aesthetic purposes.
India has long sought to limit gold imports by levying import taxes. In recent years, the government has doubled its efforts. Before 2011, the tax was a flat INR 300 per 10 grams, or about $15 per ounce at 2011 exchange rates. In 2012, this was switched to a 2% import tax rate, allowing the total amount collected to rise with higher gold prices. By early 2013, the government increased the rate two more times to 6%.
Delhi rolled out a host of anti-gold policies in mid-2013. The import tax was hiked to 8% in June 2013 and 10% in August. Meanwhile, the government stipulated that dealers and banks pay cash in advance for imports in an attempt to prevent them from importing gold with credit and collecting payments from customers later. In July, India’s central bank announced that banks and dealers would be required to reexport at least 20% of their gold imports, that is, exporting the gold immediately after importing.
The mid-2013 policy push hammered imports, which declined from 162 metric tonnes in May to just 30 metric tonnes in June. Gold-hungry buyers made up some of the difference by recycling old jewellery, which usually accounted for about 10% of domestic supply in previous years. At the time of the July announcement, this was expected to rise 20%-30% for the full year 2013.
Higher taxes also led to increased smuggling of gold. In the 2010 to 2011 fiscal period, India’s Directorate of Revenue Intelligence reported 121 cases of attempted gold smuggling. In just two years, after the significant rise in the gold import tax, attempted smuggling rose to 885 cases.
Recognising that the import tax was doing little to stem the underlying demand for gold, the government issued draft rules for a gold monetization plan in May 2015. Ideally, this scheme would allow the country to use the country’s large idle gold ounces already held in Indian households to supply its strong domestic demand, minimising the need for imports.
In this plan, owners would deposit gold at banks and earn interest. In turn, the bank could loan the gold to jewellers, who would use it to make and sell jewellery while paying the bank interest. Yet despite the potential upside of feeding India’s gold appetite and reducing its current account deficit, the plan faced many challenges.
Sweeteners for Gold Hoarders
First, gold depositors expected a certain level of interest payment to justify participation. According to Keyur Shah, head of Mumbai-based retailer Muthoot Pappachan's precious metals division, even if tax-exempt, the rate should be “more than 4% to induce households to part with their gold.” On the other hand, of course, high rates would weaken the attractiveness of the programme for banks accepting the gold deposits.
Second, while banks would be permitted to loan deposited gold to jewellers, the bank first would have to strip stones, melt jewellery, and test for purity to ensure quality. For depositors, gold received in the future may not be the same as the gold deposited. In addition, depositors would have to provide proof of ownership, which could prove particularly troublesome for the large “unreported” wealth in India, particularly if it’s multigenerational jewellery. In all, these requirements added complications that weakened the programme's attractiveness for both banks and depositors.
Third, if a bank loaned all of the gold it took as deposits, it would be effectively short gold, it had sold it to jewellers, but still owes it to depositors. If all depositors attempted to withdraw from the bank at the same time, the bank could face a "gold crunch" where it would need to turn to the import market, likely creating a huge spike in the local premium. Proposed lock-up periods could minimise the chances of this happening, but would also weaken the attractiveness of the programme.
The programme's failure wasn't terribly surprising. Similar programmes had failed in the past. One such effort came in 1999, but failed because of low interest rates, just 0.75% to 1%, and the requirement to deposit a minimum of 500 grams, an amount many middle-class homes couldn't spare. While the newer programme’s tax exemption and lower minimum make it more attractive, interest rates would have to be kept higher for it to work.
In February 2016, the government introduced a surprise 1% sales tax on gold. Although it only applied to jewellers with more than $2.2 million of annual turnover, about 50 kilograms of fine gold, the tax took effect almost immediately on March 1, 2016.
On March 2, jewellers launched a protest strike that lasted 41 days. Nevertheless, the tax had a huge impact on gold imports: gross imports declined 43% to 511 metric tonnes in 2016.
By the end of 2016, India was reported to be exploring cutting the import tax to 6% from 10%. On one hand, the country had made some progress. Gold purchases fell significantly because of higher prices, crackdowns on undisclosed income, and the government’s decision to withdraw old high-value bank notes.
Smuggling Rises
On the other hand, while total purchases had fallen, smuggling continued to rise. The World Gold Council estimates that 140-160 metric tonnes were smuggled in 2016, up from 120 metric tonnes in the prior year. The rise is particularly concerning, as India's Directorate of Revenue Intelligence estimates that it only detects 5% to 10% of smuggled gold. Smuggled gold avoids all taxes, robbing the government of tax revenue while failing to stem the adverse consequences on the rupee.
With the 1% sales tax added in 2016, the overall tax rate on gold jewellery had risen to 12.2%, composed of a 10% import tax, 1% excise tax, and 1.2% value-added tax. To simplify what had become a complicated tax system, India launched the goods and services tax in July 2017.
The GST replaced the excise duty and value-added tax, but would continue to sit above the import tax. The GST was announced to be 3%, increasing the total tax from 12.2% to 13%. Though it’s higher than the taxes it replaces, the rate was lower than what the industry had feared. A summary of the changes in the gold tax is shown in Exhibit 20
Yet despite the higher total tax rate, the GST allows firms to offset tax with input tax credits, avoiding double taxation throughout the supply chain. With uncertainty removed and a more simplified tax system in place, we think the market's fears of more rate hikes will diminish.
We think underlying fundamentals of strong Indian demand remain, so demand should improve as uncertainty around taxes and near-term weather headwinds fade.
According to the International Labour Organization, India has yet to see the labour shift from low productivity sectors like agriculture to high-productivity sectors akin to other developing nations in the region. As a result, while agriculture accounted for only 15.4% of India's gross value added, it accounted for nearly 50% of employment. Excluding urban workers, agriculture's share of employment rises to more than 60%.
With agriculture's outsized impact on employment, it's no surprise that many Indians' incomes are largely affected by crop output. With the majority occurring roughly between July and September, rainfall has a huge impact on yields, as it provides critical water, especially to farmland that has no other form of irrigation.
Weak rains result in weaker output, and thus weaker incomes. And because gold is a discretionary purchase/luxury good, it is much less likely to be purchased when money is tight.
Why Rainfall Matters
The last three years have seen significant shortages in rainfall, particularly in the southwest monsoon season. In 2014 and 2015, rainfall was 10% lower than the long period average from 1951 to 2000. In 2016, southwest monsoon rain improved, but it was still short of the average. In addition, post-monsoon-season rain was significantly lower than the long period average.
The impact of weak rainfalls can be most readily seen in water-intensive crops like cotton. Despite a general improvement in yields, production declined significantly in the last few years, in step with the rain shortfall.
As the monsoon begins in India as we write, year-to-date rainfall has tracked well against historical standards. Through mid-July, Indian rainfall of roughly 340 mm is 1% higher than the long period average. Under more normalized weather, we expect crop production to improve, driving a return to better incomes for India’s rural population.
Gold is highly prized in India. From an investment perspective, gold is seen as a store of value that can be secured and transported easily. From a cultural perspective, it’s a symbol of wealth and status, and is used in many Hindu and Jain ceremonies. For example, in Hinduism, first man and lawgiver Manu declared that gold ornaments should be worn for important ceremonies and occasions. In addition, gold is key to many regional festivals, such as Akshaya Tritiya, Pongal, Onam, and Ugadi in the south; Durga Puja in the east; Gudi Padwa in the west; and Baisakhi and Karva Chauth in the north. India’s festivals intensify in the fall, beginning in September.
Gold is also considered a traditional gift for brides. Following the birth of a girl, families immediately begin saving for the stridhan, a gift of gold given to the bride for financial security in her marriage. Demographics portend a future increase in marriages. Based on India's 2011 census data, more than 40% of India's 1.3 billion population is currently 25 years old or younger. In the 20- to 24-year-old cohort, fewer than half of Indians are married.
However, marriage rates skyrocket to 78% for 25- to 29-year olds and improve to 90% for 30- to 34-year-olds. India’s young population provides a strong base for gold demand for years to come as marriages increase.
In Hinduism, it's considered unfavourable to wed during Chaturmas, a four-month holy period typically from July to October. As a result, weddings tend to occur in October through December.
Given that major festivals and weddings intensify in September and October, gold demand tends to rise in September. Since this follows the summer harvest, farmers’ incomes are boosted, giving them additional cash at the start of gold-purchasing season. This timing becomes especially important, as nearly 70% of India's population lives in rural areas, particularly dependent on agriculture.
In conclusion, while government policies hammered Chinese and Indian gold jewellery purchases in 2016, buying has since begun to stabilise and should increase in the years to come, pushing prices back to $1,300 by 2020.
