July Budget and slashing of SGBs: A setback for portfolio balancing

Understandable if govt decided not to bear exchange and capital appreciation risks on SGBs anymore, but this would be a pity for investors who would no longer have this option to balance portfolios

The July Budget made two changes in the treatment of gold that affect investment portfolios. The reduction in import duties to 6 per cent from 15 per cent in the latest Budget lowers input costs for jewellers and compresses margins for smugglers. The July Budget also implies a cut in the issuance of sovereign gold bonds (SGBs). It targets a gross issuance of Rs 18,500 crore of SGBs in FY25, which is considerably lower than projections of Rs 29,638 crore of gross issuances in the Interim Budget.

Gold is a traditional haven in times of crisis and a hedge against inflation. Indian import demands are also tied to seasonal stuff like weddings. India is usually the largest or second-largest gold importer, with China often importing more.

Net government borrowing via SGBs (after redemptions of earlier issues) is slashed to Rs 15,000 crore from Rs 26,138 crore as estimated in February. In FY24, the gross and net borrowings via SGBs were Rs 26,852 crore and Rs 25,352 crore, respectively. A final decision on SGB quantum of issuance will, however, be taken around the time of the RBI’s next meeting in September.

The bulk of government borrowing is done via rupee-denominated instruments with auctions run by the RBI. This market is totally institutional in practice, though individuals can lend to the government in theory. Individuals can also invest in mutual funds that invest in government debt.

The SGB is unusual in that it’s a debt instrument, tied to the price of gold and offered to individuals and families. The price is transparently linked to the price of gold, by taking the average of the closing price of gold of 999 purity (as published by the India Bullion and Jewellers Association Limited) for the last three business days of the week preceding the subscription period for an SGB. The redemption price is fixed the same way. An SGB also offers 2.5-2.75 per cent interest per annum. The tenure is eight years, but redemption is possible after five years. The bonds can also be traded in demat format.

Individuals can buy a minimum of 1 gram worth of SGBs, and a maximum of 4 kg per annum. The instrument offers several advantages. It eliminates physical risks of storage and chances of being cheated. It allows investors to profit from price appreciation and hedges against rupee depreciation.

From the government’s perspective, it enables GoI to borrow at low interest rates and reduces the outflow of forex (gold is among the three most popular items in the Import Bill). From the investor’s perspective, it offers interest, which is unavailable for physical metal.

Assuming gold appreciates in price during the tenure of an SGB, the capital gains are also exempted from tax, while the interest is subject to income tax. It is, therefore, an attractive instrument for a conservative investor, since gold generally keeps pace with inflation.

The SGB was introduced to discourage physical import of gold, while aiding the Centre in bridging the fiscal deficit. The interest rate of 2.5 per cent is much lower than yields on ordinary treasury instruments (most treasuries are offering between 6.5-6.9 per cent yield at the moment).

But while the interest outgo is low, the government does have to contend with gold price appreciation and currency risk. If gold appreciates a lot, that cost is borne by the government at redemption. The exchange rate risk is also borne by the government since gold is imported.

The boffins in the finance ministry may have done the maths and decided it makes sense to cut back on SGB. If we look at the price of gold, this is easier to understand. International gold prices are set in USD per troy ounce and rupee prices are tied to international rates plus customs duties, transport costs, making charges (in case of jewellery), and so on.

The world has seen plenty of geopolitical crises and inflation in the last five years and global prices have moved from $1,510/troy ounce in August 2019 to $2,431/troy ounce (August 5, 2024). A troy ounce is approximately 31 grams. That’s an appreciation of 9.9 per cent compounded for dollar investors.

For Indians buying gold in rupees, the USD was running at Rs 71 in August 2019 and it’s running at Rs 83.9 now (August 13, 2024). The USD appreciation versus the rupee (around 3.3 per cent compounded) is priced into the capital gains. The government payout for the SGB adds another 2.5 per cent to that equation for the bonds.

Taking price appreciation and rupee depreciation into account, the total costs incurred by the government for SGBs of the 2016-2017 series, which are now due for redemption, compounds out to 13.7 per cent over the 8-year period. The issue price of the SGB 2016-17 Series-I was Rs 3,119/gram, with an annual interest rate of 2.75 per cent offered. Gold is now at Rs 7,190/gram. At these prices, the redemption gives a compound annual growth rate (CAGR) of 11 per cent to investors. Additionally, investors received 2.75 per cent interest per annum.

This is, of course, a great return for investors who bought that series. Similar calculations apply to those who invested in other SGB series, though the price and exchange movements varied. We may assume similar calculations will continue to apply in future. Taken together, the cost of GoI eventually works out higher.

From an investor’s perspective, this is a great instrument since it sweetens the pot with interest income plus the hedge against currency risk and the chance of capital appreciation.

Incidentally, there’s a well-documented trend due to the fact that gold is priced in USD. If the dollar is strong, the price of gold tends to be low due to USD denomination. If the dollar weakens, gold prices go up. If the Federal Reserve cuts interest rates or eases monetary policy, the USD generally weakens because yields on US government treasuries reduce. A soft USD often leads to higher global gold prices.

Indian households are said to hold around 27,000 tonnes of gold, roughly 14 per cent of global reserves. Pledging gold for loans is a common practice. It’s estimated that around 20 per cent of gold held by households is pledged. SGBs are also easily pledged over the counter, the process is even quicker and cleaner.

It would be understandable if the government decided that it didn’t want to bear the exchange and capital appreciation risks on SGBs anymore, despite the lower interest rates. This would be a pity for investors who would no longer have this option to balance their portfolios.