Gold bond scheme comes with attendant costs

After the first round of deliberation and feedback, the gold bond scheme and the gold monetisation scheme have been approved by the cabinet and some details have been released in the public domain.

The final operational contours of both the schemes, including the most important -- interest rates, are still awaited. I am making an attempt to simplify the 2 schemes for the benefit of the readers and outline some of the key ingredients that will need to be finalised if these schemes are to be successful.

First the basics – The Gold Bond Scheme (also called the Sovereign Gold Bond Scheme) is aimed at retail investors who buy physical gold for investment purposes. The Gold Monetisation Scheme, on the other hand, is a major revamp of the existing Gold Deposit Scheme that encourages existing holders of gold to surrender their physical gold and convert it into electronic format.

Let's take the Gold Bond scheme first. From the retail investor's investors view point, it is an extremely simple scheme. Instead of paying the money to a jeweller/bank to buy a 10 gm gold coin, you invest the money in a 10gm Sovereign Gold bond, which promises to pay you the market value of the 10 gm gold coin after 5-7 years. Additionally, the SGB will also pay you interest every year (as a percentage of the purchase price) till the redemption of the bond. Now, if you had bought the 10 gm gold coin, forget getting any income from the gold coin, you would have to pay money from your pocket for its safe storage and insuring its value. Here you will not only save on these charges, but actually get some interest from the government. The goodies do not end here. If you redeem the bond after 7 years and get paid the price of the 10 gm gold coin, which has appreciated from the purchase price, then there may not be any capital gains tax on the capital gains made by you. If you need the money before the maturity date, the bonds would be easily tradeable in the market and you will be able to get almost instant liquidity. Thus, from a customer point of view it will be a much better deal than buying the 10 gm gold coin.

If the SGB is so attractive for the investor, will it be a runaway success or is there a catch in it?

Like all good things, this also comes with a cost attached and it is not clear just yet who is going to bear it. If you look at the 7 year rolling returns of gold over the last 35 years, it averages around 10% per annum. The government borrows 7 year money at around 8% p.a., which itself is less than the average return on gold. If 3% p.a. is going to be paid as interest to the SGB investor, then it leaves around 5% p.a. to go into the gold reserve fund, which may prove to be grossly inadequate to cover the price risk on gold, and hence, the government's borrowing cost is likely to be much higher than what it is paying today. In effect, the Indian taxpayer may end up paying a heavy price for the government's promise to the investors in SGBs.

One way the investor himself can be made to partially pay for this cost is having a differential higher selling price and lower redemption price, which anyways is the norm in the physical gold market. Otherwise, the fear is that the investment will be too attractive and make the borrowing cost of government of India much higher than is warranted thus penalising the Indian tax payers.

But, even if we set aside this extremely important point, let's look at the other considerations which will decide the success of the SGB scheme in terms of the standard parameters of any investment instrument:
1. Convenience of Investing –
This is one thing that can make or break the scheme even if the return is attractive. The KYC norms should be implemented in a uniform manner across the spectrum of resellers so that this does not become an impediment in making this investment especially for the truly retail investor who would invest small sums of money.

The government needs to work out a method to allow convenient systematic monthly investments in gold which is one of the most popular ways for retail investors to take investments in physical gold.

It is not clear how the government intends to monitor the limit of 500 grams per investor per year and whether the operational complexity introduced to monitor and enforce this cap will derail the whole scheme.

The reseller network needs to be widespread and for that their remuneration needs to match the current spreads on selling of physical gold. Obviously, the investor needs to pay for this by way of differential selling price and it needs to be benchmarked to the price at which physical gold is available. For his purpose, if the reference rate needs to be for 22 carat gold rather than 24 carat gold, it should be adopted so that the SGB scheme is not branded as an expensive scheme even where it is not warranted.

The government should use its considerable PR acumen to make the SGB acceptable on social occasions in lieu of actual gold.

2. Safety – Since this is a Sovereign bond the only real risk is the risk of price of gold going down, which anyways the investor in physical gold takes. If at all, the risk is lower in this instrument than it is in physical gold because of the assured return.
3. Liquidity – This is an important criterion as physical gold has excellent liquidity and the government must ensure that the popular market makers offer spot/online liquidity options even if it is at a discounted price and that there is active trading in the markets for the SGBs
4. Returns – As discussed above, the real danger currently seems to be that the returns might be too attractive. The fear is that retail investors will buy their quota of SGB and sell it off to the aggregators, who could make a killing.
To summarise, there are several crucial operational and regulatory matters that need to be known before judging the attractiveness or otherwise of the SGB for retail investors but in all likelihood this is going to be a runaway hit.
The Gold Monetisation Scheme will be covered in the second part of this article next week.

The writer is CA and Sebi registered Investment Adviser. Email: harsh@harshroongta.com