The sovereign gold bond was conceptualised as an instrument which could kill two birds with one stone. It would partially satisfy Indian investors’ demand for gold, which has to be imported, and help fund the central government’s borrowing needs at a low interest rate.
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However, sovereign gold bonds (SGB) have turned out to be far more expensive than vanilla Treasury instruments that the government uses to borrow from the market. While the interest on SGB is much lower than that on gilts and T-bills, the bond is tied to the price of gold, and adds an implicit forex risk due to its link to the US dollar.
In mid-2016-17, the government issued SGBs with an eight-year tenure at a 2.75% interest rate. The price of gold of 999 purity was at ₹3,119 per gram then, according to the India Bullion and Jewellers Association Ltd. That gold was redeemed this year at ₹7,190 per gram.
In effect, the government will pay 13.5-14% compounded on the SGBs redeemed this year, given around 11% CAGR of gold prices plus the interest. The price appreciation is amplified by the rupee’s fall from ₹71 per US dollar to ₹84 during that period. Gold, meanwhile, appreciated by around 9.5% in the last eight years. T-Bills and gilts offer interest rates, around half the total cost of SGBs.
This makes SGB a great instrument for investors and a very expensive proposition for the government since this is a zero-sum game and the investor gains equal the government’s costs. Moreover, to attract investors, the capital gains tax on SBG had been exempted (the interest income is taxed). So, the investor receives interest on the bond (unlike with physical gold) and tax-exempt price appreciation without any of the hassles of storage or worries about purity.
Costly proposition
The government has now woken up to this situation. The Union budget in July targeted a gross issuance of ₹18,500 crore of SGBs in FY25, much lower than ₹29,638 crore assumed in the interim budget in February. Net government borrowing via SGBs (after redemptions of earlier issues) was slashed to ₹15,000 crore from ₹26,138 crore as estimated in February. In FY24, the gross and net borrowings via SGBs were ₹26,852 crore and ₹25,352 crore respectively.
The Budget also reduced import duties to 6% from 15% which lowers input costs for jewellers, compresses margins for smugglers and immediately reduces the price of gold in rupee terms.
However, a final decision on the quantum of SGB issuance will be taken around the time of the RBI’s next meeting in September. It would be rational to cut gross issuance further. The government is paying much more for SGBs than it does for the provident fund.
Gold is likely to remain a good hedge against inflation and geopolitical crisis as it has traditionally been, and investors will continue to look at it in that light. However, the government should look to retire this instrument as soon as possible even though, given the eight-year tenure, it will be redeeming the SGB series until FY33. This is a pity for investors but the government shouldn’t bear the exchange and capital appreciation risks on this instrument.
