Vijay Kumar Gaba

 Why to emulate Chinese investors?

Gold prices hit an all-time level in April and have corrected marginally since then. Again, this is the time when self-proclaimed investment gurus commemorate Indian households, especially the women, who have traditionally parked their savings in gold ornaments. They highlight how the uneducated and unaware “mothers” have managed to earn more return than savvy investors who invested in index funds etc. In my view, this narrative is completely flawed and does not merit any comment.

The all-time high gold prices in international markets have also triggered a deluge of reports forecasting a strong performance of gold in the coming years. The key arguments in favor of a strong rally in gold prices are (i) technical breakout; (ii) central banks amassing gold reserves in anticipation of the diminishing role of USD in the global economy; and (iii) the Dilemma of the Bank of Japan whether to protect bond yields or Yen. The traders have however pointed out that the higher gold prices are currently supported by the strong investor demand from China. The gold imports, other than the central bank buying, into China, have surged sharply in recent months and so have the trading volumes of gold in China.

In my view, gold is a declining asset and as such should offer sub-optimal returns in the decades to come. Particularly, for investors in a fast-growing economy like India, investment in gold makes little sense for household investors. It may be a bad idea for Indian investors to emulate their Chinese peers and invest in gold. Those advising Indian investors to invest a material part of their wealth (10% or more) in gold, because gold prices are likely to move higher due to buying by central banks and Chinese consumers/investors must consider the following:

·         Chinese households are much richer and more protected as compared to Indian households. China’s per capita GDP (US$13136) is almost 5x of India’s per capita GDP (US$2731). Chinese households enjoy much more social security and a higher standard of basic amenities like education and health.

·         The Chinese economy (US$18trn) is 5.3x in size as compared to the Indian economy (US$3.4trn). It is expected to remain much larger than India for the next 50 years at least, despite slower growth.

·         China has forex reserves of US$3.23 trn as compared to India’s US$640bn. Though both countries have reserves close to 18% of their respective GDP, India runs a current account deficit of appx. US$100bn as compared to current account surplus of US$253bn for China. China needs to diversify from US and European treasuries and USD assets to protect its reserves from depreciating. For now gold is one of the popular option for it. India on the other hand does not have similar needs, given our current account deficit.

·         The per capita income in China has grown at a CAGR of 6.1% over the last decade. In this decade, Chinese equities have provided a CAGR of 3.5% and real residential prices have barely risen. Whereas Gold in CNY terms has yielded a CAGR of 7.75%. However, for Indian investors, per capita income has grown at a CAGR of 5.3%, real property prices have grown 1.1% and equities have yielded a return of 11.4 CAGR. Chinese investors therefore have reasons to buy a hedge against inflation and negative real rates. The Indian investors on the other hand have little reason to diversify from high-yielding equities and positive real rate offering debt. Besides, they need to invest heavily in their education and health, unlike their Chinese peers.

 The total foreign exchange reserves of India stood at a comfortable US$594.8bn; appx 16% of the estimated FY24 nominal GDP of US$3.6trn. To put this number in perspective, in the last twelve months, India’s trade deficit (Export-Imports) was US$229bn. For FY23, the total current account deficit was US$67.1 while net receipts of capital account were US$57.9bn.

Notably, the forex reserve position of India has not changed materially in the past five years. The forex reserves of India stood at US$422.53bn at the end of FY18, appx 16% of FY18 nominal GDP. The reserves peaked in September 2021 at US$642bn as Covid-19 induced lockdown resulted in the collapse of trade. The recent low was recorded in October 2022 (US$531bn). Since then the Reserve Bank of India has recouped over US$60bn of reserves, bringing the reserves to a comfortable position.

For records, the forex reserves broadly include foreign currency assets (89%), Gold (7%), Special Drawing Rights (3%), and reserve position in IMF (1%). The share of USD or US denominated assets in total forex reserve is usually 60 to 70%; similar to the composition trade invoicing of India. Hence, USDINR movement impacts the reserves materially. 

The forex reserve movement during FY23 has however highlighted a few red flags that need to be tracked closely, especially in view of the slowing global economy (cloudy export outlook), rising energy prices (rising import bill) and shrinking US-India yield differential (pressure on USDINR exchange rate).

·         FY23 The Current Account Deficit of India increased to US$67.1bn against US$38.8bn for FY22.

·         Net capital account receipts were lower at US$57.9bn vs US$86.3bn in FY22. Foreign Direct Investment (FDI) was lower at US#28bn vs US$38.6bn in FY22. Foreign portfolio investment remained negative (-US$5.2bn) after an outflow of US$16.8bn in FY22

·         External Commercial Borrowings were also negative (-US$8.6bn) against a net ECB inflow of US$8.1bn in FY22.

·         High cost NRI deposits (+US$9bn vs US$3.2bn in FY22) were notable contributors to the capital account.

·         INR exchange rate weakness contributed negatively to the overall reserve position for the second consecutive year.

A major global credit event may not put India in a crisis situation like 2008 or 2013. Nonetheless, a significant deterioration in the reserve position may put pressure on the INR exchange rate, credit spreads, and bond yields.

Yesterday some media reports indicated that according to an internal assessment by the finance ministry “India balance of payment (BoP) is likely to slip into a $45-50 billion deficit in the current fiscal year.” (see here) This is obviously not good news for the INR exchange rate. Nonetheless, USDINR has rallied to its best level in almost two months, in the past two days.

It is pertinent to note that India’s current account has remained mostly negative since the global financial crisis (2008), with a brief period of surplus during Covid-19 pandemic. India’s current account deficit was $23.9 billion in the quarter ended June 2022, the worst since the last quarter of 2012. India had witnessed a serious current account crisis in 2013 that required the RBI and government to initiate some drastic measures like reducing limits under LRS. Of course, the present situation is not as dire as 2013, since we have a much stronger Fx reserve position now as compared to 2013. Nonetheless a close watch is warranted on the foreign flows, both portfolio and capital account. In the first nine months of the calendar year 2022, RBI has drained over US$100bn from the Fx reserves. The RBI has specified that this reduction in Fx reserve is due to two factors – (i) valuation adjustment (fall in value of non-INR denominated bonds and fall the relative value of Non-USD currencies in the Fx reserve); and (ii) intervention in Fx market to support INR exchange rate.

Various analysts have estimated that over 50% of drawdown in the reserves could be attributable to the valuation adjustment and the rest to the RBI’s forex market intervention.

As of this morning, there are little indications to suggest that this trend of fall in reserves, either due to valuation adjustment or market operations, may not continue for at least next 6-7 months; given the forecasts of a deeper recession in Europe (more fall in the value of EUR, GBP, CHF and European treasuries); persistent weakness in JPY; and slowdown in the US economy. Poor export growth and thinner FPI/FDI flows might keep India’s current account and Balance of payment under pressure.

The private sector capex is showing no sign of a significant pickup. Most of the capex so far seems related to maintenance, upgrades, debottlenecking etc. The outlook for exports is also not very encouraging.

The government has frontloaded capex, especially in roads, defense and railways. 2HFY23 might witness some slowdown in government capex as the fiscal position tightens (1HFY23 fiscal deficit has been higher due to front loaded capex despite buoyant tax collections).

Overall, we may have some strong macro headwinds for markets in 2023. Investors need to remain watchful and not get carried away by the recent recovery in benchmark indices.