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Safeguarding sovereign gold bonds - Outside View by S.S. TARAPORE

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Safeguarding sovereign gold bonds
Jun 29, 2015

The government has released the Draft Outline for the Sovereign Gold Bond Scheme. The objective is to reduce investment demand for physical gold bars and coins which is estimated at around 300 tonnes per annum.

Key features

The bonds will be issued on behalf of the Government of India with a maturity of 5-7 years and with a sovereign guarantee.

The subscriptions would be in rupees and the maturity proceeds would be paid in rupees but linked to the international price of gold.

The cap on these bonds per person would not exceed 500 grams.

The nominal rate of interest on these bonds would be linked to the international rate for gold borrowing, with a floor of 2 per cent and the indicative rate being 2-3 per cent. The rate of interest would be paid in grams of gold and would be paid on maturity.

The bonds could be used as collateral for loans and would be traded on the stock exchanges.

Tentatively, it is envisaged that capital gains on these bonds would be on the same terms as for physical gold, but the issue is still under consideration.

The issuing agency would be running a price risk i.e. the price of gold in US$, and also the US$-INR-exchange risk. The government would bear the gold price risk. Since it is envisaged that in the first year the amount raised would not exceed 50 tonnes, it would not be hedged.

The raising of gold bonds of 50 tonnes would amount to approximately Rs 13,500 crore which would be accommodated within the borrowing programme for 2015-16

Issues for consideration

The Scheme, if successful, could bring about a sea change in the pattern of savings in India. But there are a number of issues which need to be addressed.

Size of Individual Investments: Given that the objective is to reduce the demand for physical bars, the maximum investment by an individual to 500 grams per year appears low and could be raised to one kg per year.

Rate of Return to Investors: The rate of return to investors should be sufficiently attractive to attract investors in gold to switch to the gold bond. The scheme envisages a rate of return, possibly marginally above the gold borrowing rate in international markets viz. 2-3 per cent per annum. To make the scheme really attractive, the rate of return should be at least 4 per cent and free from income tax. At this rate investors would move away from bars.

Long-term Capital Gains: As a major impetus, capital gains from investments in Sovereign Gold Bonds should be totally exempt from long-term capital gains.

Bearing the Risks of Gold Prices and Exchange Rates: The Draft Scheme does not provide for covering the risks of either the gold price or the US $-INR exchange risk, at least in the first year. M.G.Warrier, a perceptive writer on these issues, points out that the absence of gold–backing might impact the scheme. He argues that one way out would be to increase the gold component of the country's foreign exchange reserves (Business Standard June 22, 2015). While increasing the gold component of the reserves is highly desirable, it should not be only contingent on the issue of Sovereign Gold Bond, but on the merits for sharply raising the gold proportion in composition of forex country's reserves, from the present level of 5.5 per cent of the total reserves, as part of an overall strategy of diversifying the forex reserves. More importantly, the final scheme should clearly state that both, the risk in the international price of gold as also the risk of changes in the US$-INR rate, would be borne by government. As V.K.Sharma puts it, the government should be fully aware of the potential hit on the fisc (Business Standard June 20, 2015). The risk just cannot be wished away or left vague and post facto pushed on to the Reserve Bank of India.

Deployment of Funds Raised Under the Sovereign Gold Bond: In the context of the risk, which has to be taken cognisance of, the deployment of funds need close attention. Apart from the interest rate on these bonds, which would range between 2-4 per cent, there would be a need for an attractive margin for the distribution channels. More importantly, there is a need to take note of the gold price and exchange risk which could range anywhere upwards of 8 per cent per annum. Prima facie, those opposed to the government taking measures to move away from physical gold would emphasize that this would be a large burden on the fisc and, therefore, the scheme should be abandoned. It is here that there is a need for innovative thinking. The money raised under the Sovereign Gold Bond should not be part of the government's borrowing programme. Somewhat akin to the Market Stabilisation Scheme, introduced when the capital inflows were heavy, the government should not use these funds to meet its expenditure. These funds should be ring-fenced and placed with fund managers with a mandate of investing in an array of domestic instruments such as Equities, Certificates of Deposit, Commercial Paper and Corporate Bonds. The return on these investments would be sufficiently high and thereby minimise any burden on the fisc.

Concluding observation

The Sovereign Gold Bond Scheme has great potential but it is necessary to constructively tackle the problems in the scheme. Blind risk-taking should be avoided and dealt with, rather than deflecting the problems. The ideal solution would be to set up a Bullion Corporation as recommended by the K.U.B.Rao Working Group. The schemes currently pursued by the government are second best. With some modifications in the Draft Scheme, the Sovereign Gold Bond Scheme could be successful. Individuals should unhesitatingly invest in the Sovereign Gold Bond provided the interest rate is around 4 per cent.

Please Note: This article was first published in The Freepress Journal on June 29, 2015. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.

Disclaimer:

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