Unfavourable design: Sovereign gold bonds are a drain on govt finances

Sovereign gold bonds, introduced in November 2015, may be on their way out, according to a report in this newspaper. The government had budgeted issuing such bonds worth Rs 18,500 crore this financial year, but thus far it hasn’t issued any. Gold bonds are supposed to mature after eight years, paying 2.5 per cent a year on their face value; they can be redeemed at the prevailing rate for gold. They had turned into an expensive drain on the treasury, and since they were not succeeding in their main aim, their withdrawal is welcome. They should stand as an example of the dangers of trying to use one policy instrument to address multiple different ends.

 

When these bonds were introduced, it was hoped they would do several things: That they would curb physical demand for gold, which has historically been high in India; that they would introduce an additional route for the financialisation of household savings; that they would add to the government’s coffers; and that they would reduce gold imports, at a time when India had just emerged from a brush with a balance-of-payments crisis, caused among other things by a huge import bill for gold. It did not seem to be considered that success in one of those aims might damage another. Nor was the exchange-rate risk, and the commodity-price risk, accounted for properly.

 

In effect, the price increases in gold since 2015 have caused sovereign gold bonds to be quite remunerative. Gold prices have increased by about 11 per cent in terms of their compound annual growth rate (CAGR) since 2015; when the interest rate of 2.5 per cent is added to that, the effective CAGR would be over 13 per cent. It should be noted that capital gains tax had been exempted on these bonds as well. This adds up to a difficult budgeting exercise for the government at a time when it is seeking to reduce its fiscal deficit. Further, it is more expensive as a source of finance than the regular bond market. The notion that the government could use Indians’ famous hunger for gold to reduce its own borrowing costs has been belied. It is thus not surprising that the scheme is being brought to an end.

 

Officials may argue that the scheme has outlived its purpose since India no longer has a troublesome current-account deficit. It is true that capital flows into India continue to be high enough to finance its imports. However, it is not the case that a reduction in domestic demand for gold has helped India to reach this point. In fact, this exercise has been an illustration of the futility of various schemes to manipulate household demand in this manner. Over the past decade, Customs duties on gold were first raised to about 15 per cent, also to reduce domestic demand for gold. This mainly incentivised smuggling. Meanwhile, global gold prices rose, which did not seem to have been foreseen as a possibility by the designers of the sovereign gold bond scheme. Now the government has lowered duties on gold imports back down to 6 per cent, and is likely ending the bonds. No material difference has been made to the structure of domestic demand or India’s structural vulnerability when it comes to gold imports; the treasury has merely lost a great deal of money.