Finance Minister Arun Jaitley deserves compliments for unequivocally acknowledging the imperative of reducing gold imports, which were the single largest cause of the unprecedented 30-year high current account deficit of 4.7 per cent of GDP in FY 2013, with gold imports alone accounting for over 3 per cent.

To reduce gold imports, Jaitley has proposed, among other schemes, Sovereign Gold Bonds and monetisation of the existing domestic gold stocks estimated at over 20,000 tonnes.

The ETF option The proposed Sovereign Gold Bond Scheme is, in its design and logic, exactly like a gold exchange traded fund (ETF) with the difference that the latter 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 together hold no more than 40 to 50 tonnes of gold, which is a mere 5 per cent of the annual gold imports of 800 to 1,000 tonnes.

So a gold ETF does not reduce metal gold demand — all it does is substitute gold demand from individual metal gold investors with like demand from a professionally managed gold ETF . This will also be the case if the government does the same to deliver gold returns to Sovereign Gold Bond holders on redemption. In the 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 will be committed to deliver gold returns to bond investors on redemption at the ruling gold price.

This is because this will amount to the government incurring a huge short position in gold, potentially exposing the exchequer to gold price increases. A sense can be had of the enormity of this risk by considering the fact that gold prices moved from a lifetime low of $270 in the late nineties to an all-time high of $1,920 in September 2011. Assuming the worst case, and hence the most prudent and conservative scenario, of gold price rising from its recent low of $1,180 per oz to its all time high of $1,920 (65 per cent increase), the resulting shock could be fiscally overwhelming.

The rationale for this is that if we again assume conservatively that gold bonds would attract the equivalent of 1,000 tonnes of annual gold import demand, it will translate into the rupee equivalent of ₹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 like amount because of subscription proceeds not being invested fully in metal gold.

Not only this, large investors in Sovereign Gold Bonds could also cause the so-called short squeeze, close to the due date of redemption, by speculatively pushing gold price higher fully aware that the government is hugely short in gold.

A hedging proposition In February 2013, someone from the commodity exchange space proposed a variant on the theme of this Gold Bond Scheme. He suggested that the subscription proceeds of the bonds be invested in infrastructure projects and that in order 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 proposition, involving buying gold call options covering a large quantity like say 1000 tonnes, is untenable as it will inundate call option writers/sellers and result in call options getting deep ‘in-the-money’ because of the resultant price increase, pushing the delta hedge ratio to almost 1.

This would mean call options writers will have to physically buy almost 1,000 tonnes of the metal, leaving the physical metal gold demand in the domestic market pretty much the same. This will also apply to the government seeking to hedge against gold price increase by buying gold futures because, given the size of the hedging demand, call options and futures will both have the hedge ratio of 1. This means the demand for the metal gold will be about 1,000 tonnes, except that it will shift from the government to the metal gold market; if not supplied in the domestic market it will have to be met through imports.

In other words, there can be no 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).

As for the proposal to monetise domestic stock of gold: 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: active trading, and 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. The dynamic of the global gold deposit and lending markets 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 in 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.

What works 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. What then they actually do is buy cheaper gold futures and short sell expensive gold in the spot market, and by carrying the arbitrage trades into maturity, earning risk free profits due to such mis-pricing. Such arbitrage trades continue until, as a result of these trades, price discrepancy eventually disappears.

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, which are much lower than currency rates because they are in theory and practice nothing but the difference between uncollateralised currency interest rates and those collateralised by metal gold.

Large gold-miners also 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. They have a natural hedge against price risk as they use the metal gold mined to repay their metal gold loans, and thus can raise capital at a fraction of cost of debt and equity capital.

To call lending gold to jewellers a metal gold loan is a misnomer because it is nothing but a sale and purchase transaction. The monetisation scheme will not deliver because any genuine depositor of any asset would want his deposit back on redemption and not sell it in the first place. So, whether the proposed gold deposit and lending scheme will deliver in practice will depend critically on whether we have both active gold trading involving, short selling and arbitraging and gold mines of global scale. Both these necessary and sufficient conditions are not satisfied in the Indian context, which means both the Sovereign Bond Scheme and Gold Monetisation Scheme will not deliver.

What, however, will, is what the RBI actually did, as recently as in 2013-14 to create a level playing field between gold and non-gold imports by stopping gold imports on consignment basis, unfixed price basis, and metal loan basis. These measures delivered not by imposing curbs and restrictions on gold imports, but by aligning gold import regulations under FEMA 1999 with those for non-gold, but essential, imports such as edible oil and coal.

The writer was an executive director of the RBI

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