Are sovereign gold bonds a good idea?
Common sense suggests that the demand for an asset should be high when its price is low, and vice versa. However, in practice, the demand for an asset is quite often high when its price is rising. And, the demand tends to be low when the price is low and falling. This appears to be true also for sovereign gold bonds (SGBS). These are denominated in terms of gold. The demand for SGBS is high now when the price of gold is high and rising. Earlier, when the price of gold was low, the demand for SGBS was low.
Though SGBS were launched in November 2015, almost 35 per cent of the amount mobilised is in the current financial year. And, gold price, as of July 17, has shot up 39 per cent over the last year.
Historically, the price of gold has increased over time in the long run. However, only a relatively small part of this is real appreciation; a good part is due to the general inflation. A study for the long period, from 1836 to 2011, shows that gold’s average annual real appreciation rate is 1.1 per cent (Robert Barro and Sanjay Misra, Economic Journal, 2015). Historically, periods of high real appreciation have been followed more or less by periods of low real appreciation.
It is clear now that, ceteris paribus, more SGBS will get sold at a time when the real price of gold is high than at a time when its real price is low. Also, given that SGBS are, for all practical purposes, redeemable after eight years only, if the current real price is high, then the real appreciation till the time of redemption is likely to be low. More generally, it is likely that more SGBS will be ready for redemption in future at a time when the real price will be low than at a time when the real price will be high. An interesting conclusion follows now.
The Government of India may be — inadvertently — running a profitable “business” here — selling high and buying (or redeeming) low in real terms. This has a corollary. The investors could be entering now into a deal that may not be adequately rewarding.
It is true that SGBS can be good not just for the government but also for the economy. Investors invest in gold-denominated bonds and not physical gold. So, there is no need for the country to spend on gold imports. While this is true, it is still the case that effectively SGBS may not be good for investors.
All this is not to say that the SGBS are always bad for investors. In fact, they can be a good investment when the real price of gold is low relative to its plausible long-term trend. That is when the real appreciation till the time of redemption is likely to be good. So, SGBS can be a good investment. But not many investors invest when assets are available at relatively low prices!
What we need are instruments that are not just in the of interest society and government but also in the interest of investors, and that is indeed possible.
The SGBS are typically marketed by distributors as instruments that are better than physical gold. This is true but somewhat misleading. This is because the choice is not just between physical gold and SGBS; it can be more general. There are, in this context, other assets like bank deposits, units issued by mutual funds, real estate investment trusts (REITS), international funds, and so on. Some of these can be, at this juncture, probabilistically speaking, better investments for a period of eight years despite the 2.5 per cent interest, some tax benefits, and the denomination in terms of gold in case of SGBS.
The main issue is the future price of gold. It is true that if one senses that going forward the market for gold is likely to be weak, then the SGBS can be sold in the market before the redemption date. So, there is an exit route. But that is available in practice only if volumes traded are decent. Even more important, the difficulty is that if one has to keep making sense of which way the gold market will go, then the SGBS will fall in the category of speculation and not investment.
It does help to diversify. However, the ideal time for that was when the gold price was low. Finally, isn’t gold and accordingly an investment in the SGBS a safe haven? Well, not quite. The price matters. If one buys a “safe” asset at a high real price and then one has to possibly sell or redeem at a time when the real price is low, then the so-called safety is itself questionable.