India’s gold futures trading was never cost-competitive; With the commodity trading tax, the disparity only widened
Despite being one of the largest consumers of gold—next only to China—with an annual demand of close to 1,000 tonnes, India lacks an efficient gold ecosystem. The Indian gold market consists of several functional gaps, with significant variation in price and quality of gold across channels and point of sales. Jewellers prefer to buy certified gold from established agencies abroad because of which the country is heavily dependent on gold imports to meet its domestic demand. While the government continues its commendable effort towards gold monetisatiom, a rudimentary analysis suggests that the lack of transparency in dealings and in price is the biggest hurdle. What India needs is a formal trading platform that facilitates transparent buying and selling of gold. Such a platform can help in price discovery, remove price disparities and arbitrages, establish quality control, and enable integration with financial markets, thereby creating a better gold recycling process and in turn creating a robust gold ecosystem.
Ideally, a spot exchange would be tasked with the responsibility of transparent price discovery. This way the systemic problem of non-standardisation of pricing, that arises because of a thriving informal over-the-counter (OTC) market for gold procurement, can be quelled. Despite the fact that gold enters the country through formal channels, it soon flows out of the formal system into the informal market. The result of this has been poor price discovery for gold. For monetisation to truly work in India, transparent price discovery is imperative, but in the absence of a spot market, one must turn to the commodity exchanges in India to fulfil this responsibility.
In 2013-14, the then finance minister introduced a commodity transaction tax (CTT) on all non-agri commodity transactions. It was believed that trading in non-agri commodity futures is no different from trading in security derivatives except for the underlying asset. Hence, in order to bring parity and to allegedly counter the movement of volumes of trade from security derivatives to commodity derivatives, a 0.01% CTT was introduced on non-agri commodities. Agri commodities were exempted from CTT to encourage farmers to trade on commodity exchanges to hedge their risk. Another important consideration then was to increase revenue collections for the government. The security transaction tax (STT) in the place of long-term capital gains tax had fetched the government considerable revenue, without having a detrimental effect on volumes of trade. Unfortunately, the same could not be said of the commodity markets.
The aftermath of CTT resulted in commodity trading volumes shrinking by as much as 41% in the same financial year and 42% in the subsequent financial year. It also resulted in many traders abandoning trading on commodity markets in India as CTT increased cost of transactions substantially. Tax collections from CTT was less than 1% of STT collections. In fact, it could quite easily be argued that because of the reduction of trading volumes, the net result of CTT on revenue collections was negative rather than positive. Based on studies conducted by the Forward Market Commission (FMC), the erstwhile commodity regulator had recommended that CTT be withdrawn or significantly reduced to rekindle trading volumes. In 2015, the CTT exemption was extended from agri commodities to also agri-processing commodities. However, non-agri commodities received no respite.
Trading volumes across all commodities saw a significant drop in volumes. The drop in trading volumes of gold futures have deeper ramifications, especially in the present day objective of gold monetisation. Despite the fact that gold futures were delivery-based contracts, CTT was applicable. The average daily turnover for gold futures on MCX fell by as much as 65% within three quarters of CTT being imposed. Furthermore, before the imposition of CTT, there were as many as 4,00,000 unique clients trading in gold futures. Within a year, post the introduction of CTT, this declined by 50 per cent. The result of CTT has been two-fold. One, India has exported a large share of the gold futures market to other commodity exchanges, especially Dubai. The trading cost for 100 troy ounces of gold on Indian exchanges before CTT was R197 which increased to nearly R525. On the Dubai exchange, the cost was and remains around R65. India was never cost competitive when it came to gold futures trading. With CTT, the disparity only widened. Second, jewellers traded on the exchange to hedge price risks, moved to the over-the-counter informal market because the cost of hedging through an exchange was no longer feasible.
The incumbent government has been proactive in its approach towards monetising gold. If indeed the government is keen to ensure the success of gold monetisation, they must begin by removing CTT on gold futures. This move alone would induce many erstwhile traders, exporters, jewellers and their like to return to the exchange. Since gold futures contracts are all delivery based, the market is more likely to attract hedgers rather than pure speculators. A vibrant gold futures market is essential because it leads to transparent price discovery. It is only through transparent price discovery that consumer trust will be won and trust is most definitely a prerequisite for gold monetisation.
Nirupama Soundararajan is senior fellow, and Arindam Goswami is associate fellow, Pahle India Foundation