Finance Minister Arun Jaitley, in the 2015-16 Union Budget, had announced the development of a financial asset - Sovereign Gold Bond - as an alternative to the precious metal, and the borrowing through issuance of the bond will form part of market borrowing programme of the government.

SGBs are government securities denominated in grams of gold. They are substitutes for holding physical gold. Investors have to pay the issue price in cash and the bonds will be redeemed in cash on maturity. The Bond is issued by Reserve Bank on behalf of Government of India. As per the scheme, the gold bonds will be sold only to resident Indian entities including individuals, Hindu undivided families, trusts, universities, and charitable institutions. The gold bonds are denominated in multiples of gram(s) of gold with a basic unit of one gram while the minimum investment limit is two grams.

The maximum subscription is 500 grams per person per fiscal (April-March) and for joint holders, the limit will be applied on the first holder. The issue and redemption price are in Indian rupees fixed 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 Jewelers Association Ltd.

The quantity of gold for which the investor pays is protected, since he receives the ongoing market price at the time of redemption/ premature redemption. The SGB offers a superior alternative to holding gold in physical form. The risks and costs of storage are eliminated. Investors are assured of the market value of gold at the time of maturity and periodical interest. SGB is free from issues like making charges and purity in the case of gold in jewellery form. The bonds are held in the books of the RBI or in demat form eliminating risk of loss of scrip etc.

The Sovereign Gold Bonds will be available both in demat and paper form. The tenor of the bond is for a minimum of 8 years with option to exit in 5th, 6th and 7th years. They will carry sovereign guarantee both on the capital invested and the interest. Bonds can be used as collateral for loans. Bonds would be allowed to be traded on exchanges to allow early exits for investors who may so desire. In Sovereign Gold Bonds, capital gains tax treatment will be the same as for physical gold for an 'individual' investor. The department of revenue has said that they will consider indexation benefit if bond is transferred before maturity and complete capital gains tax exemption at the time of redemption.

Objectives of government for issuing Sovereign Gold Bond

· To reduce the demand for physical gold

· To shift part of the estimated 300 tons of physical bars and coinsØ purchased every year for Investment into ‘demat’ gold bonds.

These objectives are important. India imported Rs. 2.1 lakh crore worth of gold in the financial year 2014-15, not counting jewellery. So far, Rs 1.12 lakh crore worth of gold has been imported between April and September 2015. The idea is that by reducing these whopping quantities of imports, the government can try to narrow India’s current account deficit and trade deficit. This is not the first time the government has looked at gold as a means of controlling the current account deficit. It has periodically sought to limit gold imports by increasing the import duty on the yellow metal, but these moves met with limited success.

OBJECTIVES OF THE PAPER:

· To understand the impact of scheme on Balance of Payment

· To understand potential impact of scheme on the foreign exchange

· To understand if the scheme will generate exchange rate instability

What exactly the government intends to do is that by issuing these bonds the government of India essentially wants to control the imports of physical gold, which, apart from oil is one of the prime reason for widening of current account deficit and excreting further pressure on rupee to depreciate against the dollar.

Now, by investing in these bonds, gold savvy investors would hold gold in the form of financial security and not in physical form of gold. The value of these bonds would be linked to the value of gold in international markets. So for the investor, in essence it is as good as holding gold in a financial security format, and what’s more is that these gold bonds would generate further returns in the form of gold interest which gets accumulated till the maturity of bond.

While investor is investing in Sovereign Gold Bonds, these bonds will reduce the amount of gold that is being imported in India, thus comforting the trade deficit and pressure on rupee. While the risk for investor is minimum, the risk emanating from these bonds shifts from the investor to the government. The rationale for this is that, at the maturity of these bonds government would pay the investors in terms of cash for the values of gold along with the accumulated interest on it. So for example, if an investor buys a 100 gm gold bond today with a maturity of 8 years along with a coupon of 1% per annum, the investor, at the maturity of bond would get cash value 108 gm of gold (i.e. 100 gm principal and 8 gm of accumulated interest there on the bond).

Anticipating a situation where the investors of these bonds after receiving cash in turn goes out to buy physical gold instead of holding cash on maturity, then what this situation can transmit is importation of an added quantity of gold (gold principal of 100gm and 8 gm of interest thereon) when the bonds mature. At that point there would be more demand for importing physical gold in terms of quantity than ever before. The import of this massive quantity gold requires the importer to make payments in terms of dollars; the situation can lift up demand for buying dollar than ever before. This is so because, investors of gold bond would now start converting cash holding (rupee) received from the redemption of bonds into purchasing dollar so as to make payment for the purchase of physical gold. As more and more investor’s starts engaging into this trade strategy there would be more and more demand for gold as well as dollar, causing stress on two fronts, first on Balance of Payment especially widening of current account deficit and second on the foreign exchange rate stability. These two aspects could manufacture situation of a crisis for the government, principally, if the government has not hedged its position in gold commodity market.

Basically, three situations can arise. One, the price of gold in international market rises accompanied by dollar depreciation. If this situation fructifies then the price rise in gold and fall in dollar with respect to rupee will have an offsetting effect with each other. In second situation, same result can transpire if the price of gold in international market falls and dollar appreciates vis-a-via rupee, again they would have an offsetting effect with each other. The crisis would occur or aggravate in third situation, if both, gold and dollar start moving in a upward direction, i.e. the price of gold in the international market rises with the dollar appreciating with respect to rupee causing a full blown crisis in balance of payment and the foreign exchange rate stability.

In order to avoid the crisis, as assumed in third situation, what government can do is hedge its position in gold market as well as currency market by taking up a position in commodity derivatives and currency derivatives to buy gold futures/options along with a arrangement in currency futures/options market. The effect of putting in place the hedge should guarantee that the government will be able to purchase gold at a prefixed price and be able to lock-in the price of dollar with rupee.

Let's see how this is achieved by looking at scenarios in which the price of gold makes a significant move either upwards by delivery date and dollar appreciates.

This can be well understood with some hypothetical illustration given below:

Let’s assume, the government will need to procure 10,000 kilos of gold. The prevailing spot price for gold is USD 34730/kg (rate as on 4th January 2016) while the price of gold futures for future dated delivery is USD 35000/kg. To hedge against a rise in gold price, the government decides to lock in a future purchase price of gold by taking a long position in an appropriate number of Gold futures contracts. With each Gold futures contract covering 100 kilos of gold, the government will be required to go long 100 futures contracts to implement the hedge.

In the second position government needs to hedge its position in currency market by entering into long position to buy dollar for making payment for gold purchases. The prevailing spot price for USD/INR =Rs 66.60 (rate as on 4th January 2016) while the price of the pair in futures market is USD/INR = Rs 70.00. What this arrangement would do is lock-in the price of both gold as well as currency. So now the total value of contract in INR is Rs 24,500 million (35,000 x 70 x 10,000) for buying 10,000 kilos worth of gold.

The effect of putting in place the hedge should guarantee that the government will be able to purchase the 10,000 kilos of gold at USD 35,000.00/ kilo for a total amount of Rs 24,500 million. Let's see how this is achieved by looking at scenarios in which the price of gold and dollar/rupee pair makes a significant move upwards by delivery date.

Let’s assume that the gold price and the price of dollar goes up by 10% by the delivery date, i.e. gold price is USD 38,203.10/ kilo and Dollar to Rupee is Rs 73.26, then the gold and currency futures price will have converged with the gold & dollar spot price and will be equal to USD 38,203.10/ kilo and Rs 73.26 per dollar. As the government had entered into long future’s position at a lower price for gold and dollar (USD 35,000/ kilo and USD/INR = Rs 70.00), government would gain USD 38,203 - USD 35,000 = USD 3203 per kilo in gold and Rs 73.26 – Rs 70 = Rs 3.26 in currency market. With future contracts in commodity and currency market covering a total value of 10,000 kilos of gold, the total gain from the long futures position would amount to Rs 104.42 million.

CONCLUSION:

Government can utilize this highly reliable and transparent hedging platform to de-risk its balance sheet. For government who is willing to take an exposure in international markets, this contract will offer an efficient price risk hedging. The twin contract of gold hedge and currency hedge will track the value of gold and currency excluding all other factors. Due to this, the contract value shall be lesser than the regular gold price and currency price, which will lead to safeguarding our Balance of Payment and shielding our Foreign Exchange reserves.

REFERENCES:

1. https://www.rbi.org.in/Scripts/FAQView.aspx?Id=109

2. http://finmin.nic.in/swarnabharat/sovereign-gold-bond.html

3. http://www.theoptionsguide.com/gold-futures-short-hedge.aspx

4. http://www.theoptionsguide.com/gold-futures-long-hedge.aspx

5. http://www.moneycontrol.com/commodity/ace/goldhedge-price.html

Received on 16.01.2016 Modified on 25.01.2016

Asian J. Management; 7(1): Jan. –March, 2016 page 53-55

DOI: 10.5958/2321-5763.2016.00008.1