Can anything beat the allure of gold?

At present, the demand for gold is down and the current account deficit very comfortable. But we can never be sure how Indians will behave when it comes to gold. It is for this reason that the government has been working on devising alternative instruments that would deliver the same benefits to holders and potential buyers of the metal. This could further reduce the physical import of gold.

Can anything beat the allure of gold?

The gold bond and monetisation schemes are progressive steps taken by the government in this regard. Both assume that the potential client is not strongly inclined to have physical gold in possession and that by providing similar rewards, this inclination will only decrease.

Good for government

The Gold Bond Scheme is an excellent one from the point of view of the government. Here, households buy a bond that is linked to the weight of gold in rupee terms. The bond is for 5 to 7 years, which means there is a good investment tenor for the same. The government may pay a nominal interest rate, say 1 per cent, and take over the price risk as it has chosen not to hedge the same. The amount is put in a fund, which can be used to cover the increase in price in future.

The way this gold reserve fund operates is important. If the money lies idle, it will be useful in taking liquidity out of the system when these bonds are purchased. If the fund invests in other assets, then there could be a return for the government.

In fact, such funds could be lent to the State governments with the interest cost being used to cover the price risk. The amount is to be a part of the fiscal deficit, which does not matter as it would only be an accounting entry with no money being spent if kept in the locker, with the nominal interest rate paid being the only cost.
Why buy?

Why should an investor buy this bond? A conventional investor who values gold would not like such an option, as it is better to have physical gold in the locker where it would not earn any money, but there would be a guarantee that it exists. Besides, buying a bond involves adhering to all the KYC norms, and hence if gold is to be used to escape the taxman, this is not a very attractive option. But if capital gains are indexed or exempted, then it could be a jolly good option.

There would not be too many long-term investors here who would like to keep a gold bond for 5 years. Those dealing in the short term would be using the commodity derivatives market and trade on, say, NCDEX where one can take a call on short term movements. Locking in for 5 years may hence, not be very appealing, especially as there is no option of redemption in gold.

But assuming that some people do opt for a lock-in, there would be two options for them. One is that they keep rolling over the bond. This is of advantage for the government and works well where there are taxes to be collected on such appreciation. But if everybody wants to redeem the same, then the outflow from the government would be to that extent. However, by making it a pure monetary transaction, the physical demand for gold would be eschewed.

Hence, this is an excellent scheme for the government, though the investor would come from a very niche segment that sees value here. If it works, it would add to the entire basket of financial instruments available today for savers.
The second scheme

The gold monetisation scheme is trickier. Here the individual deposits physical gold with the government (through the agents) and can ask for the gold back at the time of redemption in case it is short term of up to 3 years. For medium and long term, it is to be only in cash, which can make it equivalent to the gold bond and hence would be interchangeable in concept. There would be few people who would like to give up their gold for cash and also make themselves known to the taxman! While the cost here is higher for the government as it has to reimburse for the conversion, assaying and storage charges, the main problem would arise when there is demand for physical gold. As long as the deposit is renewed, it serves the government well. But if there is large scale redemption, then there would be the need to import gold from the market. This can be avoided, provided there are fresh deposits coming in every year, just like bank deposits. But any specific positive or negative event can cause an adverse movement and demand for gold. Given that part of the gold would have been lent to the jewellers, there could be a mismatch between the supplies and demand.

The government has done a commendable job in trying to mimic the purchase of physical gold with these two new schemes. But one is never sure how individuals will behave especially when it comes to physical gold. The gold futures contract or even the spot contract which are offered on commodity exchanges (where one can demand gold anytime when traded on an exchange at the time of expiration) has not quite lowered the physical appetite for gold. The fact that the KYC norms cannot be dodged can be a major deterrent for the investor as most of the gold transactions escape the organised network.

It would be the investor community which is not savvy enough to go to the exchanges that will find these instruments attractive. The monetisation scheme is quite restrictive as it expects people to give up gold and not ask for it if held beyond 3 years. This can be a weak point to start with.

The writer is the chief economist at, CARE Ratings. The views are personal
Source: www.bullionbulletin.in

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