Glittery Alternatives

The Sovereign gold bond scheme has a higher chance of success than the gold monetization scheme and can reduce gold import bill by $2.2 billion. However, developing other safe channels for investment is essential to reduce gold imports.

The Ministry of Finance finalized and announced the launch of the sovereign gold bond scheme on 9th September, 2015. It also announced a gold monetization scheme, which has been tried in various forms before this announcement. Given the general concerns regarding current account deficits and large amounts of gold sitting idle in bank lockers, this is a welcome move to shift the money into the more productive financial sector, though the two schemes are likely to see differing levels of success.

Indians fetish for gold is well known. India is the largest consumer of gold and the world’s largest gold importer. On average, India’s gold imports equal about 30% of global annual gold mining. India imported about 132 metric tonnes of gold in August, 2015, and is estimated to cross 950 metric tonnes for the 2015 calendar year. Though 2015 has seen a significant drop in gold imports, the value of gold imported is at a staggering $13.4 billion between January and June, 2015.

India's Yearly Gold Imports.

India's monthly gold trade.  Note: this chart excludes jewellery trade. Source: Koos Jansen, BullionStar Blogs

Source: Koos Jansen, Bullionstar Blogs. Note: This chart excludes jewellery trade.

Historically, gold imports in such magnitude have been a problem for the policy makers. Gold imports directly exacerbate the current account deficit situation in India. Gold, after oil, is the most significant commodity imported by India; it accounts to around 10% of India’s imports. This makes a noticeable dent in India’s forex reserves, given India’s poor export earnings.

Flight to Safety

The demand for gold mainly comes from ornamental and jewellery purposes and for investment. Leaving aside the former for the moment, about 25-35% of gold imported is meant for investment purposes. Investors who are risk averse prefer to invest in gold (buy gold bars and coins), which is a relatively stable and less volatile asset. In a volatile financial market, investors also prefer to hedge their riskier investments by buying gold bullion.

It has been observed that gold imports increase during times of financial volatility. In May 2013, for example, when the Federal Reserve announced the tapering of their QE program, the ensuing volatility in emerging markets, including India, saw a huge spike in gold imports (see above chart for the corresponding period). Investment in gold also drastically increases during periods of macroeconomic instability. Between 2010 and 2012, when India experienced consumer price inflation above 10%, gold imports hovered around 1000 metric tonnes. This is because the real return on other assets will be negative given the high inflation rate (With inflation at say 11% and the rate of interest on a fixed deposit at about 9%, the investor is making a loss of 2%).

With macroeconomic instability around the corner again with a slowing Chinese economy and the possibility of US interest rate hike, gold imports are on the rise in India.

Alternatives to Gold

Gold Bonds: It is in this context that the Finance Ministry launched the Sovereign Gold Bond (SGB) scheme. Briefly, in the SGB scheme, investors can buy bonds that are backed by gold instead of taking delivery of physical gold bars. These bonds will be issued by the RBI, on behalf of the government, on payment an amount linked to gold prices. It is essentially a derivative based on underlying gold prices, but importantly, has sovereign backing. The bond will have a tenure of 5-7 years and upon maturity, the investor can either take physical gold (equal to the quantity bought) or the current value of gold. The bond will also pay a coupon (or a rate of interest) of up to 3% per annum, which would not have been available with physical gold. Further, the gold bond will be more liquid than physical gold as it can be traded on exchanges. With these conditions, the scheme looks quite attractive for investors who would want to buy gold. [Read Draft proposal here]

The RBI, on the other hand, will lend the money collected through this process to the government, which can use it for its fiscal expenditure. This process should supplant the lending by RBI to the government through buying of G-Secs. “If successful, this should lower the government’s market borrowing (since SGBs will be within the fiscal deficit) and the gold import bill by a similar amount (USD 2.2 billion),” reports Nomura, a Japanese brokerage firm.
Gold monetization: The other scheme approved by the government is monetization of gold. Under this scheme, investors can park their existing stash of gold with banks, which will convert it into a monetary deposit and pay an interest. The aims is to bring domestically held surplus gold holdings into circulation by encouraging individuals to get the metal melted, deposit it with banks and also earn interest on it. The melted gold will be made available for jewellers as raw material so as to restrict the increased dependence of imported gold.

Can it be effective?

Of the two schemes, there is much higher possibility of the SGBs being effective. Indians are attached to their ancestral or inherited jewellery and might not be tempted to melt their gold for the meagre 1% rate of interest offered by the monetization scheme. Further, temple trusts and other institutional holders of gold have traditionally stayed away from various gold monetization schemes that have been put forth.

Finally, apart from these schemes, in order to reduce the imports of gold for investment purposes, the government should focus on the macro conditions that drive investors to purchase the shiny metal. Having a low and stable inflation rate is one of the necessary prerequisites to encourage investment in traditional financial instruments. Further, developing other safe and sound investment alternatives such as a corporate bond market can shift the demand for gold into more productive channels in the financial system.

Anupam Manur is a Policy Analyst at Takshashila Institution and tweets @anupammanur