Opinion
Ajit Ranade: Hedge sovereign gold bonds but do not discontinue them
Summary
- SGBs have lately proven very costly for the government as gold’s rising price was left unhedged. Hedging the risk of huge redemption payouts would let Indian investors and the economy benefit from these bonds.
Sovereign Gold Bonds (SGBs) were introduced nine years ago. These were launched to give investors an opportunity to invest in the much-loved yellow metal in dematerialized form. It would be liquid and safe, could be mortgaged or traded, and exempt from capital gains tax at maturity.
Investors benefit both from rising gold prices as well as currency depreciation. The intent of the scheme was to wean away Indians from their seemingly insatiable appetite for physical gold.
India has consistently been among the world’s top importers of gold. Recently, the average annual drain on foreign exchange due to these imports has been upwards of $40 billion. That is eight times the average annual imports of military hardware. Or, in rupee terms, it is five times the annual budget allocation for the national rural employment guarantee scheme.
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Hence, any dent in the gold import bill saves precious foreign exchange, reduces India’s trade deficit and helps deepen our financial sector. SGBs are part of formal financial savings, unlike just investment in the physical metal. The liability created by these bonds is purely in domestic currency, which poses a much smaller risk to the sovereign.
Since 2016, the government has cumulatively sold SGBs equivalent to about 150 tonnes of gold. This sale is less than its potential, given that in the initial years, SGB distribution suffered from indifference and neglect. These bonds were not marketed aggressively, nowhere like the gold loans pitched by flashy brand ambassadors. Retail investors had no recourse to small-ticket investment with the same ease as investing in mutual funds or stocks.
The situation improved over the years. We might be at an inflection point now after eight years, since awareness has spread, investment apps have got better and advice is more easily and reliably available. Even the Reserve Bank of India (RBI) has an excellent app for its Retail Direct platform, both for investment in SGBs and government securities.
SGBs are seen as serious competition to gold-backed exchange traded funds (ETFs). It is at this crucial juncture that the government seems to be stepping away from the scheme. In a media interaction, India’s finance secretary said that the government is thinking of discontinuing the SGB scheme. That would be a big mistake.
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The reasoning was that the two initial objectives of SGBs have not been met. First, he said, physical imports of gold have not dipped substantially. Second, the payout by the government is turning out to be too costly. The Centre has cheaper options to carry out other forms of borrowing through bonds.
But SGBs were never introduced as a source of financing the government’s deficit. The data suggests that from all the tranches sold till early 2024, the total amount raised was about ₹80,000 crore, while the outgo on redemption of these tranches is projected at around ₹140,000 crore. An approximate calculation reveals a compound rate of around 7.5%. That is not much higher than the Centre’s present cost of borrowing.
More importantly, the SGB investor is paying income tax on the 2.5% interest income. This should be considered in the calculation of their net cost. Also, SGBs save foreign exchange, and these shadow savings must not be ignored, even if they are difficult to estimate accurately. Governments always prefer to have liabilities in their own currency, which is what SGBs enable.
The most important point, however, relates hedging the cost of gold to reduce the eventual outgo on redemptions. It is here that the government seems to have faltered. Gold ETFs are required to stock physical gold to hedge against gold price fluctuations and to meet redemptions. But the government could simply buy call options simultaneously with the sale of every tranche of SGBs. This protects the price that it will pay on bond redemption.
Using call options is like buying insurance at a small cost. For instance, SGBs issued in March 2017 were priced at ₹2,943 per gram (or per unit). On maturity in March 2025, the redemption price is ₹8,634. This represents an annualized return of 14.4% over eight years, which is much higher than the 7.5% or 8% cost of other bonds. But this cost has risen sharply due to a spike in gold prices internationally, the recent steep slide in the rupee and the fact that no hedging was done. But averaging over all tranches, given that SGBs are sold regularly ‘on tap,’ along with proper hedging, will bring down the cost of borrowing. Besides, gold prices are likely to stabilize or go down from now.
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SGBs are a great investment opportunity for small savers and help deepen financial savings. They should be widely sold, though perhaps with quantitative caps per PAN. Every reform, whether it’s the GST rollout or improving the ease of investing in systematic plans of mutual funds, takes time to take off. SGB scheme might be a that takeoff point. The benefits of SGBs are underappreciated. This has resulted in gold sellers offering spot discounts on the sale of gold coins, which was unheard of in pre-SGB days.
India’s import duty on gold has come down from 15% to 6%. This also reduces the SGB-redemption cost to the government, since payouts go by the landed price of the metal. Finally, SGBs help nudge the gold economy away from the dark shadows of illicit trade into the bright light of the formal financial sector. Do not discontinue sovereign gold bonds. Just tweak them and optimize their cost through hedging.
The author is senior fellow with Pune International Centre.
