The finance minister deserves unreserved compliments for explicitly and unequivocally acknowledging in his Budget speech the imperative of reducing gold imports which led to the the unprecedented 30-plus year-high current account deficit of 4.7% of GDP in FY13 with gold imports accounting for over 3% of the deficit! And according to recent media reports, gold imports have surged again and the current account deficit for the latest quarter has increased to 2.1% from 1.2% of GDP. With this sombre background, Arun Jaitley, in his Budget speech, proposed sovereign gold bonds and monetisation of the existing domestic gold stocks estimated at over 20,000 tonne to reduce gold imports.
The proposed Sovereign Gold Bond Scheme is in its design and logic exactly like a gold ETF (exchange traded fund) with the difference being that the ETF doesn’t pay any interest but delivers gold returns to investors by investing the entire proceeds of subscription in metal gold which is held in demat form. Significantly, all the 14 gold ETFs in India, between them, hold no more than 40 to 50 tonnes of gold, which is a mere 5% of annual gold imports of 800 to 1000 tonnes. So a gold ETF does not at all reduce metal gold demand and all it does is substitute gold demand from individual metal gold investors to the professionally managed gold ETF.
It will be the same case if the government does the same to deliver gold returns to sovereign gold bond holders on redemption. In the highly unlikely event of the government using the subscription proceeds for a purpose other than investing only in metal gold, it will expose itself to extreme price risk as it would be committed to delivering gold returns to bond investors on redemption at the prevailing gold price. If gold price were to move from $ 850 per oz in late seventies to a life-time low of $270 in the late nineties and then back up to an all-time high of $1,920 in September 2011, the losses could be huge. Assuming the worst case of gold price rising from its recent low of $1,180 per oz to $1,920 (65 % increase) due possibly to potential monetary stimulus in Japan and Eurozone, the resulting shock could be fiscally overwhelming and way too disruptive.
If we again assume conservatively that gold bonds would attract the equivalent of 1000 tonnes of annual gold import demand, it will translate into the rupee equivalent of Rs 1.5 lakh crore ($25 billion) of net loss on redemption not counting the interest paid which will, all else being equal, increase fiscal deficit by similar amounts because of subscription proceeds not being invested fully in metal gold! Any multiple of 1000 tonnes will have multiplier effect and in the extreme scenario of the theoretically maximum subscription equivalent to the entire metal gold stock in India of 20,000 tonnes, will translate into a whopping loss of around Rs 30 lakh crore ($485 billion) to the exchequer on redemption at the assumed ruling price of gold of $1920 per oz and increase the fiscal deficit by like amount, representing 20% of the current GDP. Not only this, large investors in sovereign gold bonds could also cause the so called short squeeze, close to the due date of redemption, to profit at the expense of the government by speculatively pushing gold price higher fully aware that the government would be hugely short in gold, making the above mentioned whopping net loss to the exchequer even worse.
In February 2013, someone from the commodity exchange space, who should have known better, had proposed a variant on the theme of the above gold bond scheme. He suggested that the subscription proceeds of the sovereign gold bonds be invested in infrastructure projects and to deliver gold returns to bond holders without price risk and loss, the government may hedge its price risk by buying gold call options. But this hedging proposition, involving buying gold call options covering 1000 tonnes worth of annual gold import demand, while tenable in theory of options, will be untenable in practice. This will inundate call option writers/sellers and result in call options getting deep in-the-money because of resultant price increase way above the starting strike price at which the government will buy these call options. This will push the delta hedge ratio to almost 1 which would mean call options writers will have to physically buy almost 1000 tonnes of the metal, leaving the physical metal gold demand in the domestic market pretty much the same, if not more, and which anyway, as of now, will only be imported.
It will be the same case if the the government were to hedge against gold price increase by buying gold futures because given the sheer size of the hedging demand, call options and futures will both have the hedge ratio of 1 meaning that the demand for the metal gold will be about 1000 tonnes; only that it will shift from the government to the metal gold market and which, if not supplied in the domestic market will, as now, have to be met through imports. This is the very basic theory and practice of futures and options hedging and pricing which is governed by the so-called no-arbitrage argument or, what is the same thing as the law of one price. In other words, there can be no free lunch or the case of eating one’s cake (investing cash proceeds of gold bond sales in projects and not in gold) and having it too (replicating and delivering gold returns without investing in physical gold). In a lighter vein, if only to dramatise to best effect, the analogy of futures and options hedging with a dialogue of the character Gabbar Singh in film Sholay is apt and I quote: “Oh village folks if there is anyone who can save you from Gabbar, it is none other than Gabbar himself!” So also if there is any asset which can deliver gold returns with gold price risk, it is none other than gold itself. Of course, this holds for any other asset like equity stocks, bonds, foreign currency, real estate etc. So to conclude, the proposed Sovereign Gold Bond Scheme will not deliver in practice.
Turning to the other Budget proposal on the so called monetisation of 20,000 tonnes of domestic stock of gold which, as the finance minister very rightly observed in his speech, is mostly neither traded nor monetised, I will begin with his own statement that the domestic metal gold stock is mostly not traded. Of course, globally, deep and liquid metal gold deposit and lending markets exist but only for two reasons: the first being active trading and the second gold miners borrowing metal gold to raise money at ultra low interest rates to fund their capital investment in either new mines or in expansion of their existing mines. And there is no third reason for this.
The dynamic of the global gold deposit and lending markets in New York, London, Singapore and Hong Kong involves gold borrowing demand coming from short sellers and large gold miners. In particular, short selling arises from speculators, hedge funds and other participants betting on declines in gold price. But since there is the market discipline of delivery into a short sale, short sellers have necessarily to borrow metal gold to deliver into the short sale which gets adjusted after some time when short sellers either buy metal gold back to cut their losses due to stop loss limits or to book their profits and using the gold so bought back for repaying the borrowed gold.
Another reason for short selling metal gold is engagement by market participants in cash futures arbitrage when gold futures are cheaper relative to the spot market ie when no-arbitrage argument/law of one price of derivatives is violated. What then they actually do is buy cheaper gold futures and short sell expensive gold in the spot market and carry the arbitrage trades into maturity and earn risk-free profits due to such mispricing. Such arbitrage trades continue until, as a result of these trades, such price discrepancy eventually disappears; the faster this happens, the more efficient the market is. Since globally there is large scale demand for such borrowed metal gold, supply comes from gold deposits and, like in any bank deposit and loan market, there are deposits and lending/borrowing rates known as gold lease rates and these are way too low compared to currency rates because they are in theory and practice nothing but the difference between the uncollateralised currency interest rates and those collateralised by metal gold.
As I mentioned above, other than short sellers and arbitrageurs there is only one more kind of metal gold loan borrowers, namely, large gold miners who borrow metal gold for longer periods to sell the metal in the spot market and use the sale proceeds to fund capital investment in new mines or in capacity expansion of their existing gold mines and have a natural hedge against gold price rise as they use the metal gold mined to repay their metal gold loans without any price risk and thus have the natural advantage of raising capital at a fraction of cost of debt and equity capital unlike other non-gold businesses.
Significantly, as regards lending gold to jewellers, to call it a metal gold loan is an oxymoronic misnomer because, effectively and substantively, it is simply nothing but a sale and purchase transaction as, both in finance theory and practice, a deposit and lending transaction is one where whatever is borrowed has necessarily to be repaid and to that extent it is a no-brainer to see that the proposed monetisation scheme will not deliver because any genuine depositor of any asset would want his deposit back on redemption and maturity date and not sell it in the first place.
So to conclude whether the proposed gold deposit and lending scheme will deliver in practice will depend critically on whether we have in India both active gold trading involving, as I said before, short-selling and arbitraging and gold mines of global scale. And as we already know, the above necessary and sufficient conditions are not satisfied in the Indian context. In view of all these reasons, both the Sovereign Gold Bond Scheme and the Gold Monetisation Scheme will not deliver. What, however, will deliver is restoring the level playing field between gold and non-gold essential imports like edible oil and coal by stopping gold imports on consignment basis, on unfixed price basis and on metal loan basis.
The author is former executive director, Reserve Bank of India