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With the rupee continuing to touch historic lows against the dollar virtually every day, the focus of policy is now on supporting the Indian currency. Worsening of the current account deficit (CAD) remains the main drag for the rupee. The shortfall has been in excess of 4% of the gross domestic product, well above 2.5%, which is considered to be the sustainable level. Therefore, any effort towards stabilizing the rupee will have to inevitably consider options to reduce the CAD. Increases in the CAD have partly been on account of structural problems in the Indian economy, reflecting in somewhat inelastic demand for commodities, particularly that of oil, gold and coal.

There is a clear consensus that gold imports—which touched a peak of $60 billion in the fiscal year 2010-11 with another $56.5 billion imports in the previous financial year—need to be compressed in a meaningful manner. These imports have been targeted via an increase in import duties. Efforts have also been made to channel privately held, idle gold in the country into the banking system. The Reserve Bank of India (RBI) recently made changes to the gold deposit scheme (GDS) of 1999 to make it more lucrative investment vehicle for depositors. GDS has the potential to garner a sizeable part of privately held gold and inject it into the banking system. This, in turn, can be used to increase the supply of dollars and help stabilize the rupee.

There are other options that RBI could consider to make the GDS more attractive for the banks, allowing them to use gold deposits to fetch dollars. Gold holdings with the private sector are estimated to be in the range of 7,500 to 10,000 tonnes. Even if a small part of these reserves are channelled into the banking system, they could help bolster RBI’s foreign exchange reserves and increase the pool of financial savings.

One option could be to allow Indian banks to hold a part of their cash reserve ratio (CRR) in the form of gold. This will create the right incentives for them to raise gold deposits aggressively. Holding a part of CRR in gold also reduces the cost for banks for maintaining the CRR as interest paid on such deposits will be lower than a regular deposit. This option has the advantage of bolstering foreign exchange reserves of RBI directly.

The Indian central bank could borrow from the Turkish example. In September 2012, the Central Bank of the Republic of Turkey (CBRT) introduced a similar scheme for Turkish residents. Turkey has quite a few parallels with India with respect to gold, among them the absence of a significant domestic output and large private sector holding. Turkey like India has also seen its CAD widening in recent years and as a result the Turkish lira has also been under pressure.

To encourage banks to raise gold deposits, CBRT allowed banks in Turkey to hold a part of their reserve requirements as gold, thereby transferring a part of publicly held gold onto the central bank’s balance sheet. With many Turks historically preferring to invest their wealth in physical gold instead of traditional banking instruments, estimates suggest that there may be as much as 5,000 tonnes of gold being held “under the pillow" in the country. These investments, which are effectively held outside the economy, could be converted to bank deposits while simultaneously allowing banks some leeway in their reserve requirements.

Initially set at 10% of reserve requirements, the level has been successively raised to its current 30% as the policy has succeeded in attracting gold back into the economy. Turkey’s banking sector regulator estimates an increase in the banking sector’s collective precious metal account rising from TRY1.8 billion (around 5,746 crore today) in September 2010 to TRY15 billion by September 2012. This coincided with a rising Turkish lira and falling interest rates, until recently.

Another option could be to allow banks in India to use the gold reserves they raise to access dollar financing in the overseas market against gold as collateral. Such loans will carry lower rates compared to conventional loans. Banks can, in turn, use these loans to finance the growing demand for trade credit in the country, especially from the oil companies.

These options appear unconventional in nature, but in light of the pressure on the rupee—something that can persist on account of the US Federal Reserve tapering off its quantitative easing and the resultant capital outflows from emerging markets, they may be worth considering. And, with rupee having weakened sharply over the last two years, macroeconomic and financial risks are only increasing. Therefore, while conventional option of dealing with a run on the currency by raising interest rates has been used without much success, somewhat unconventional approaches should also be considered. Otherwise in the face of continued weakness and unhinged expectations of further rupee weakness, partial rollback of convertibility may become imperative.

Gaurav Kapur is senior economist, Royal Bank of Scotland N.V. Comments are welcome at theirview@livemint.com

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