India's gold custodian, the Reserve Bank of India (RBI), holds gold in its reserves worth around $2,974 million (1999-2000), down from $3,391 million in 1997-98 and $3,496 million in 1990-91. Add to this the exports of precious stone-studded gold jewellery that is galloping each year (in 2000 jewellery exports were $8.409 billion, up 15 per cent from 1999).

All this, therefore, calls for the urgent need to set up an exclusive bullion exchange in India. The urgency because our fiery neighbour, China, announced on March 5, that it would set up a National Gold Exchange (NGE) in Shanghai by end 2001. The move is aimed at reducing government control over the strictly controlled gold trading market there. A nine-member panel has been set up for this purpose. Last year, China produced 173 tonnes of gold and used about 207.5 tonnes.

Gold's popularity has not yet faded in India. The 2001-02 Budget proposals have brought back focus on the Old Economy. Further, in this year's Budget, the finance minister has lowered the import duty on gold to Rs 250 per 10 gm from Rs 400 earlier. One can see some reasons for gold to become attractive once again and a preferable investment avenue with the cross-section of investors-if not from `enlightened' urban investors. The demand for gold, therefore, is sure to grow.

With gold's impressive demand and attractive import figures, why is it that India's huge battalion of consumers (individuals, jewellery makers and exporters) are looking to New York's Commodity Exchange (Comex) or the London Bullion Market Association (LBMA) for daily rates? Why can't India's gold rates be taken as a benchmark for global gold trade?

"We are desperate to start a bullion exchange in the country so that India's rates can become a pointer for the global gold market," says Mukul Sonawalla, president, Bombay Bullion Exchange (BBA). "Earlier this year, we had forwarded a proposal to the Forward Markets Commission (FMC) to set up a bullion exchange in India. Negotiations are going on and we are awaiting the FMC's nod." The proposals are "confidential", Mr Sonawalla hastens to add.

Negotiations between the FMC, the BBA and the RBI to set up a bullion exchange in the country have been on for over a year now. "Introducing derivatives trading for gold in the country is a very complex subject and we are not too sure whether we really need derivatives trading in gold", said a source in FMC requesting anonymity. "We are weighing all related aspects in this regard before coming to any conclusion".

Little wonder then that neither Mr Sonawalla nor the RBI and FMC officials are willing to give any time-frame for introducing derivatives for gold in India.

Despite this, the Bankers' Training College in Mumbai recently held a two-day seminar on `Gold Banking', aimed at preparing bank executives to handle gold trading. The seminar deliberations were said to be "confidential, only for the bankers and not for the general public.".

The need for hedging: The need for gold derivatives emanates from the fact that commercial users of gold are exposed to volatile prices (which, for various reasons, have been sliding over the past two years) and therefore, need to stay hedged. (The recent import duty reduction on gold itself lobbed off in just one day some 3 per cent of the value of stocks with bullion banks and traders).The debate on gold derivatives has been continuing for the past five years.

The KN Kabra Committee on commodity futures had suggested the introduction of gold futures. Even the Gold Banking seminar held in New Delhi on August 2-3, 1997, had pointed in this direction. The then deputy RBI governor, YV Reddy, had said: "Futures trading is already active in other commodities, so there is no reason for disallowing gold to be traded again through an appropriate regulatory framework."

But all this was in mid-1990s, whereafter the global gold market has undergone drastic changes what with the Washington Agreement entered into on September 29, 1999 by leading European banks. The signatories to this agreement have agreed to sell gold in phases. After this, there has been a surge in gold supplies leading to erosion in its value (from the peak of $330/troy oz in mid-1999 to the current level of $262/oz).

So, what's the international experience in gold derivatives?
In her executive summary on `Gold Derivatives-The Market View', Jessica Cross, an expert in the field, says: "Hedging has enabled gold producers to realise higher than spot prices in recent years. However, the mining industry is facing a number of derivative-related challenges... The Washington Agreement has precipitated a review of hedging practices of both mining companies and bullion banks."

Ms Cross says that in the long run, hedging hardly impacts on prices, for, research indicates that "hedges over full tenure must come to delivery and thus rolls off the collective hedge books".

Internationally, gold hedging has been used primarily by mining companies to finance their exploration activities. In the bargain these companies have benefited by getting higher prices by hedging. Prior to the Washington Agreement, the prime players were bullion banks, gold producers, and some dozen top hedge funds.

The total gold supply, according to Ms Cross, during June 1999 and December 1999 increased to 4,843 tonne in December 1999 from 4,511 tonne in June 1999. This led to a sharp decline in carryover short (net long) positions to 387 tonne from over 393 in June. By March 2000, these had fallen further to a meagre 46 tonne. She says: "We can say that a number of factors are coming together which could suggest that the peak of gold hedging is over. The causes are in the main market-related rather than exogenous to the industry... For the first time in 15 years...we can foresee a change in the fundamentals that have supported and encouraged the enormous growth in hedging."

However, there's one fundamental difference between international and Indian gold markets - the overseas markets are supply-driven, while India's market is demand-driven. Earlier, because suppliers controlled the market they, along with bullion banks and hedge funds, set the gold prices. Therefore the importance of lent gold, lease rates and the like that contributed to prices fixed by the LBMA and followed throughout the world.

With gold supplies increasing substantially after the September 1999's Washington Agreement, equations in the global market have changed from being primarily a suppliers' market to a buyers' one. Therefore, it is now the turn of the world's largest gold consumer to take the lead in fixing prices that will be followed by global suppliers. This, however, can be done only if the product is traded on a formal exchange.

At present, a majority of importers in the absence of any formal derivatives trading platform in India, to stay hedged (in the international markets) play in the vibrant informal markets in Mumbai, Delhi and Gujarat. They pay high contract trading premiums/costs to members of LBMA and New York's Comex, which add to the overall cost of imported gold. In addition, they pay hefty transportation charges to transport gold from Europe (producing/supply centres) to Dubai (largest international market) to India.

Finally, according to Bhargava Vaidya, a leading bullion analyst and a strong propagator of bullion hedging: "By setting up a bullion exchange, India can cut on the intermediary transportation cost (from Europe to Dubai), become a hub for gold supplies in the entire South-east Asian region, where demand for gold continues as in the earlier years. We can get gold directly from suppliers, and, therefore, can swing the global gold market focus from Dubai to India. This will also help India earn some additional revenue and importance."

It remains to be seen how long it takes the mandarins of North Block, RBI and FMC officials and office bearers of BBA to wake up to this opportunity to make India the new Golden Hub of the South-east Asian region.