In this Mining Journal article, I discuss India’s gold imports, the current account deficit, and the danger of mistaking financial cosmetics for real economic strength. The article was originally published in Mining Journal on 7 July 2014. It is reproduced in full below from my archive.

Originally published in Mining Journal on 7 July 2014

In the first quarter of 2013 India was facing a current account deficit of 3.6% of GDP. Hypothetically, if all gold imports were stopped, the majority of this deficit could be eliminated. Moreover, the money “saved” would have gone—with a bit of nudging from the government—into infrastructure and industrial development, helping boost growth and control chronic inflation of around 10%.

A reduced current account deficit would have improved the value of the Indian Rupee. India’s biggest import is oil, with demand rather inelastic, made even more inelastic by the controlled nature of oil prices within the country. Restricting gold imports was seen as a solution to many of India’s economic woes and as a way to increase government revenue.

The Indian government imposed an 11.3% import duty on all gold imports, creating bureaucratic complexities. Given that the Indian bureaucrat excels in creating a nightmare for businesses, the restrictions were expected to have a massive impact on reducing gold imports. And it did.

Official gold imports swiftly fell to a trickle. The current account deficit improved rapidly, currently at 0.2% of GDP, and the Indian currency strengthened significantly.

With time, it also became increasingly evident that Narendra Modi—seen as decisive, pragmatic, and pro-business—would become India’s next prime minister. In May 2014, his party, the BJP, won 282 seats and his alliance a total of 336 seats in the house of 543, giving him a clear majority.

All this led to foreign institutional investors pouring massive amounts of money into India to buy stocks. This new foreign money has been a very nice icing on the cake, helping improve the federal banks’ reserves. As I write this, SENSEX—the key stock market index—is at its highest ever, at 26,000, up 65% over the past 30 months.

India is now widely expected to exceed China in economic growth and hence become the next growth engine of the world economy.

But I want to challenge all this optimism, for it is based on a facade.

This is an era when even very sophisticated investors no longer worry about more than the next financials. Moreover, political correctness has made it very difficult for people to discuss certain truths, or even to hold them in mind.

India is an extraordinarily corrupt place. I have never met a bureaucrat who does not expect a bribe. The Indian bureaucrat is a sadist who wants people to demean themselves, grovel, and plead before offering bribes. He then normally does not do what he takes bribes for, if at all, he can recognize the giver a day later.

I was in India during the election process. While this is very anecdotal, it seemed that, in parts, it was about free alcohol, cash, and bicycles distributed to the voting public. The police and the election officers conveniently ignored what was happening. This was an opportunity for them and the local goons to solidify their traditional bonds. I don’t expect farsighted, enlightened politicians to emerge from such a process.

What about the massive anti-corruption movement that has swept India for the past few years? The reality is that, while you must indeed pay bribes for essentials, for which the government is to blame, Indian society wallows in corruption. I don’t know many middle-class Indians who are morally inhibited from stealing or gaining an unfair advantage over fellow citizens. Ironically, the Indian middle-class individual wants corruption to end, but wants himself exempted.

Corruption runs very deep and wide in Indian culture, in complex patterns, and is hardwired into the social structure, traditions, and beliefs. In this tangled mess are superstitions and dogmas, interplaying and keeping these social vices in place. There is nothing in human history to indicate that untangling such a predicament is without massive social upheaval and pain. This scares me about India’s future.

Those who grow up in the relatively simpler societies of the West fail to conceptualize the grip of this virus of social and cultural corruption. Lack of skills and problems with work ethic find their roots here. Fund managers and public policy analysts who think that such problems can be wished away by edicts (as is expected from the decisive Modi) or by aid money fail to understand the complexities, and that this kind of change can at best happen only over generations, and only through bottom-up awakening.

India’s GDP per capita is a mere US$1,504. It is a wretched place, with massive poverty, hunger, and tyranny. Contemplating the entangled nature of cultural corruption might show you that those who are tyrannized when empowered become worse tyrants.

With this background, let’s come back to gold.

The immediate effect of the imposition of restrictions on gold imports resulted in a premium of about 24% on the Indian retail price (‘premium’ calculated as the differential between the retail Rupee price and the international spot price). Official imports fell sharply, but most of the gold began to come in via smuggling. Smugglers have made an absolute fortune.

Interestingly, competition between smugglers has continued to reduce the premium to what it is today, only about 11%, slightly lower than the price of officially imported gold, and a minimal quantity is being imported through official channels to keep a facade of legality.

But hasn’t this at least improved the current account deficit? Yes, but only officially. Dollars parked outside India, or those that would have entered legally, became smuggled gold imports. Eventually, this will have more than nullified the positive impact that you currently see on the current account deficit.

India, given its corruption, lack of the rule of law, chaos, waste, and lack of skills, which find roots in cultural corruption – which, as I explain above, cannot be wished away by legal edicts and charity money – offers a very low return on capital. It is an expensive place to do business, making India uncompetitive in the international arena. As a result, Indian households primarily save their earnings in property and gold. I see no reason why Indians would want to buy less gold. However, if the economy stagnates, which I think is likely, Indians will feel that much more constrained economically to buy more gold. As a corollary, you might expect Indian gold consumption to fall if the international price rises.

This article was originally published in Mining Journal on 7 July 2014.