The world price of gold has crashed from over $1,800 per ounce to under $1,590 per ounce. This should sober the buying frenzy of both consumers and bullion speculators, who have driven up the gold price sharply over the last year.
They have argued that gold prices can only go up for several reasons: the Fed is pumping out billions which are being financialised into gold derivatives; gold is a hedge against inflation; uncertainty about the euro future will cause a mass switch to bullion. However, nothing can keep going up forever, which is why bubbles burst.
However, how many borrowers know that if gold prices crash, they will have to put up additional collateral or have their collateral seized and sold? The lenders are also in danger: they might find that they have lent more than can be recovered from the crashing value of collateral, as happened in the US mortgage bust.
So, the RBI needs to tighten up norms for lending against gold. The margins should be high and the total exposure of any lender to gold loans must be a modest fraction of all loans. Lenders must be obliged to explain the risks clearly to borrowers, something that was not done in the US mortgage market.
It makes sense for the government to come out with inflation-indexed bonds, to offer investors a substitute for gold, as a credible hedge against inflation.