Gold smuggling explains the decline in the CAD?

Economic Times, 12 December 2013

When India brought back restrictions against legal gold imports, there was a surge of capital and labour devoted to criminal organisations. The sharp decline of official gold imports, from $16.5B in the June quarter to $3.5B in the September quarter, most likely went with a sharp surge in business for smugglers. This has raised doubts about the interpretation of the remarkable decline in the current account deficit from 4.9% to 1.2% of GDP. However, the presence of gold smuggling does not distort the observed CAD.

In the early 1990s, India learned the folly of its old ways, and removed most restrictions on gold imports. This put an end to gold smuggling. The revenue stream from smuggling fuels organisational capability in the underworld, which can also be used for terrorism or protection rackets or other kinds of criminality. It is best to keep all gold activities above the board. By the early 2000s, we saw big listed companies engaged in gold-related activities ranging from jewellery to gold loans.

These developments collapsed with the defence of the rupee of mid-2013. Hoping to contain the current account deficit, the government imposed an array of restrictions on gold. On the surface, these restrictions delivered: Gold imports dropped from $16.5 billion to $3.5 billion; white money activities collapsed. The remaining $13 billion of imports almost surely shifted to smuggling.

The current account deficit fell from $21.8 billion to $5.2 billion between the June and September quarters. Some think that this decline -- of $16.6 billion -- does not mean much, as roughly $13 billion is merely this artificial reduction in gold imports. This suggests that the apparent reduction in the current account deficit is not a true reflection of what is going on.

Let us think about the full chain of payments for gold smuggling. When a criminal sells gold worth Rs.62 to someone in India, in exchange for cash, he needs to pay $1 to a seller of gold outside India. That requires a hawala transaction where Rs.62 is sold in return for $1. There are exactly two ways in which this can be done: dollars are moved out of the country by overstating imports or understating exports.

Suppose a machine is imported for $200 when it is truly worth $100. For all practical purposes, what has happened is that $100 of gold has been concealed inside the body of the machine. Hence, when import overinvoicing takes place, the observed value of total imports is correct and the observed CAD is correct.

Suppose software that is truly worth $200 is sent out of the country, and shown as official exports of only $100. On the side, gold worth $100 comes into the country illegally. In this case, $100 has been taken out of both imports and exports. Hence, the reported CAD remains correct. All that happens is that the apparent exports are understated.

We do not know whether smuggling is being done using import overinvoicing or export underinvoicing. But regardless of how it is done, the presence of gold smuggling does not distort the observed CAD. The decline of the CAD is real -- regardless of what we believe about gold smuggling.

If the hawala business works through import over-invoicing, then the observed exports and imports are correct values. If the hawala business works through export under-invoicing, the apparent exports and imports are both understated. Since both mechanisms are at work in the hawala business, we can conclude that the apparent exports and imports seen in the September quarter are both a bit lower than the true values. In truth, export buoyancy is even greater than that seen in the data.

Households in India have good reason to buy gold -- this is a way to escape financial repression (forced purchases of government bonds by financial firms) and the inflation tax. Restrictions on gold are a capital control against outflows. This episode is a reminder of the ineffectiveness of capital controls. With trillions of dollars of goods and services moving across the boundary, misinvoicing of 10% or 20% is enough to achieve very large capital flows.

The government's moves have given $210 million per working day of revenues to criminal organisations. It has brought labour and capital back to what was a dead business. Poor macro/finance policy in mid-2013 was a godsend for criminals who have created organisations doing gold smuggling and hawala. When these controls are removed, this organisational capital will be deployed into other kinds of criminality. Recall how the Bombay blasts of 12 March 1993 utilised the organisational capabilities of smugglers.

When India was a developing country, it was okay to not have macro/finance policy capabilities. Now that we are a $2 trillion economy that is mostly open, it is not prudent to have such weaknesses.

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