India’s Sovereign Gold Bond (SGB) scheme, introduced in 2015, was designed to reduce the country’s dependence on physical gold imports and offer investors a secure, interest-earning alternative. However, a sharp and sustained rise in gold prices has turned the scheme into a financial burden for the government.
What was initially expected to be a cost-effective borrowing mechanism has now resulted in significant liabilities, with the government facing the prospect of redeeming bonds at prices far higher than anticipated. This explainer delves into how the SGB scheme unfolded, the miscalculations that led to its escalating costs, and the lessons learnt.
What is the primary objective behind India’s Sovereign Gold Bond (SGB) scheme?
The government launched the SGB scheme in 2015 to reduce India’s dependence on physical gold imports by encouraging investors to shift to digital gold. This was expected to lower the gold import bill and reduce the current account deficit. Additionally, the scheme aimed to provide investors with a safe and lucrative alternative, offering a 2.5 percent annual interest on their deposits.
Why did the government assume that the SGB scheme would be beneficial?
The government believed that since gold prices had stabilised after declining from their peak in 2011, issuing bonds linked to gold prices would allow the government to borrow cheaply. If gold prices remained relatively stable or increased moderately, the cost of redeeming the bonds would be lower than the interest the government typically paid on regular debt.
What went wrong with this assumption?
The key misstep was the government’s failure to anticipate the continuous rise in gold prices. When the SGBs were first issued in November 2015, gold was priced between $1,100 and $1,200 per ounce. Since then, prices have steadily risen and now exceed $3,000 per ounce. This dramatic increase has significantly raised the redemption cost of SGBs, making them far more expensive than initially anticipated.
Why didn’t the government hedge its exposure to rising gold prices?
To keep the scheme attractive, the government chose not to buy physical gold as the underlying asset. Officials assumed that gold prices would remain stable and failed to hedge the government’s exposure by taking positions in the international futures market. Consequently, as gold prices surged, the government found itself unprotected against the price risk, leading to substantial liabilities.
How much liability does the government face due to the rising gold prices?
Between the scheme’s inception in 2015 and the final issuance in February 2024, Rs 72,000 crore worth of SGBs have been issued. These bonds collectively represent 132,000 kg of gold. With gold prices now hovering around Rs 91,000 per 10 grams, the redemption value has swelled to Rs 1.20 lakh crore, placing a significant financial burden on the government.
Why are SGBs considered a costly form of borrowing?
SGBs have turned out to be an expensive borrowing mechanism because the bonds promise a return based on the prevailing gold price at the time of redemption. With gold prices more than doubling since the bonds were issued, the government now has to pay investors at much higher rates than it initially expected. Adding to the burden, SGBs offer a 2.5 percent interest rate and are exempt from capital gains tax upon redemption, further eroding the government’s potential revenue.
How does the cost of SGBs compare to regular government debt?
Initially, the government believed SGBs would be a cheaper borrowing option than regular government bonds, which carried a near-8 percent yield. However, with gold prices more than doubling, the effective cost of SGBs has become significantly higher than that of traditional government borrowing.
Did the SGB scheme succeed in reducing gold imports?
Despite the scheme’s intent to curb gold imports, India’s appetite for physical gold has remained strong. Annual gold imports have averaged $37 billion over the past decade, even after the introduction of SGBs. In a bid to discourage gold purchases, the government raised customs duties to 15 percent in 2022, but this only led to a surge in gold smuggling.
Why did the government continue issuing SGBs despite rising gold prices?
The government kept issuing new series of SGBs even as gold prices surged, without addressing the inherent price risk. This failure to pause or restructure the scheme earlier has compounded the financial liability. It was only in February 2024 that the government finally decided to halt new issuances.
Why are SGBs being described as a ‘naked short position’ for the government?
In financial terms, a naked short position means taking on a risk without any underlying protection. Since the government did not hedge its exposure to rising gold prices and issued bonds tied to the value of gold, it effectively created a large-scale naked short position. As gold prices soared, the government was left vulnerable, with taxpayers now bearing the burden of these rising costs.
What lessons can be learned from the SGB experience?
The SGB scheme demonstrates the danger of making long-term financial commitments based on optimistic assumptions without proper risk management. Hedging against price fluctuations and designing financial products with built-in safeguards could have prevented the SGBs from becoming such a costly liability. The decision to pause new issuances is a step in the right direction, but it comes after years of mounting financial strain.
