Sovereign gold bond could be more popular than gold ETFs and physical gold, says ratings agency
Gold sovereign bonds being issued by the Reserve Bank of India (RBI) may triumph over other comparable products in the market such as gold exchange traded funds (ETF) and physical bars, and can lead to a reduction in India's current account deficit (CAD), says India Ratings and Research (Ind-Ra).
"The sovereign gold bond scheme is an attractive product and may address the pure investment demand for gold. Also, gold sovereign bonds are easy to implement relative to the gold monetisation scheme," the ratings agency said in a research report.
Indian households’ fascination for gold is as old as India’s history and has only grown over the years. As a result, gold jewellery has been used both as an asset and as a hedge against adverse circumstances. The household investment in physical asset had risen to 66.4% in FY12 from 49.6% in FY06, before declining to 58.7% in FY14. The households’ fascination for gold however did not diminish much. Their savings in the form of gold & silver ornaments had reached Rs37,267 crore in FY13 before declining somewhat to Rs33,427 crore in FY14. This rising demand in gold was met by a huge increase in gold import to $56.5 billion in FY12. The surge in gold import was quite destabilising for India’s current account deficit (CAD) which increased to $88.1 billion in FY13, an unprecedented and unsustainable level of 4.8% of GDP. As a result, the government resorted to a higher import duty/restriction on gold import and gold import fell to $28.7 billion in FY14.
The RBI will issue sovereign gold bonds between 5th and 20th November 2015, which would be linked to the price of gold. The objectives of sovereign gold bonds are (i) to reduce the demand for physical gold and (ii) shift part of the estimated 300 tonnes of physical bars and coins purchased every year for investment into ‘demat’ gold bonds. These bonds can be purchased only by resident individuals or entities and the upper limit could be 500gm per person per year. The bonds will be issued in denominations of 2g, 5g, 10g of gold or other denominations and the tenor of bonds could be for a minimum of five to seven years. The price of gold will be taken from the reference rate as decided. It will then be converted into Indian rupee using the RBI reference rate for issue and redemption. On maturity, the investor will receive the equivalent of the face value of gold in rupee. The scheme will carry an interest of 2.75% payable semi-annually.
According to a statement from the Finance Ministry, price of bond will be fixed in Indian rupees on the basis of the previous week’s (Monday–Friday) simple average of closing price of gold of 999 purity published by the India Bullion and Jewellers Association Ltd.
Talking about some of the pros of the sovereign gold bond scheme, Ind-Ra said that a successful launch of this product may ensure that physical gold is used mostly for manufacturing jewellery and sovereign gold bond for investments. It said, "Investors of gold bars or coins may find gold sovereign bonds a better investment than holding a physical stock because it will offer the benefit of gold without any handling and storage costs. It will relieve investors of the need to check the quality of gold and with valuation, no longer an issue, these bonds will be easier to use as collateral. In case of a gold bond, the counterparty is the government of India. If the price of gold increases, the government takes the risk of higher prices, if they fall, the investor would be given an option to roll over their holdings for an additional period."
The pros of the gold monetisation scheme include, the scheme offers all the benefits of physical gold minus the risk. It will convert the unproductive asset (lying idle) into a productive asset (used by the gems and jewellery sector). It will help in reducing the black economy, as gold along with real estate is often used as safe haven to park black money. The reduction in intermediary including speculators may be positive for stabilising gold prices. If the gold monetisation scheme turns out to be successful, then it will lead to a spurt in the supply of gold leading to a decline in gold prices, as the recycling of domestic gold will be without any import duty. Banks have some incentives in this scheme, like the freedom to decide interest rates on gold deposit and the ability to sell gold to raise foreign currency, it can also be part of statutory ratios. It will thus have a positive impact on the current account deficit, the ratings agency said.
However, the sovereign gold bonds are beneficial only if it is bought for investment purposes, the ratings agency said. "As the bonds will be issued in denominations of 2g, 5g, 10g of gold, a minimum investment required would in the range of Rs5,000 and above. This means small investors will not be able to take advantage of this scheme unlike the case with gold ETFs or gold mutual funds (MFs). In case of sovereign gold bonds, both upside gains and downside risks will be with the investor. However, in case gold prices fall, losses from a systematic investment plan (SIP) in gold ETFs or gold MFs will be lower than for lump sum investments in sovereign gold bonds," Ind-Ra added.
The cons of the gold monetisation scheme include, the scheme envisages holding gold only in its pure form, resulting in the melting of the deposited jewellery and ascertaining its pure gold value. This will be a disincentive for a large number of households who generally want to keep gold in the form of jewellery and may not want to see their long-preserved, family-inherited, emotionally attached, piece of gold lose its identity and feel, for meagre returns. Also, the jewellery making charges paid at the time of buying it will be lost in the process. Moreover, ascertaining of pure gold out of the jewellery will often result in lower valuation of the gold held by households. First, the loss of jewellery making charges and secondly lower valuation together will be a double whammy for households. There is also lack of clarity on the tax treatment, on the conversion of physical gold into the gold deposit scheme, the ratings agency said.
In addition, interest on the gold bonds will be taxable as per the Income Tax Act.
The gold monetisation scheme is also a welcome step taken by the government to unlock the value of gold held by households or institutions and to reduce the dependence of Indian investors and gems and jewellery sector on imported gold. Also, it is an improvement over the existing gold deposit scheme 1999.