Nov 092015

While FT Alphaville’s coverage of the Indian gold monetisation schemes started off with “why gold investing in and of itself is stoopid” they did note that

“people, especially in fledgling economies, are distrustful of sharing because they’re worried about payback. That kills trust, which consequently ensures capital isn’t put to productive use … there is also a real (and dare we say warranted) distrust of government and an historically deep-rooted inflation fear to take into account”

As Jayant Bhandari observed in his Precious Metals Investment Symposium presentation, India is a negative-yielding economy, with nominal yields on property and stocks below the 10 year government bond (even cows return -6% assuming zero labour costs). In such an environment, a zero-yielding asset like gold is better than a negative yielding asset.

The Indian government’s gold monetisation schemes, however, are more about addressing the symptom rather than the disease, which is the lack of trust in “payback”. Jayant says that high levels of corruption, superstition and irrationality in India “discourages accumulation of financial and intellectual capital”. But dealing with that, I guess, is a lot harder than trying to hoodwink “its population to take a leap of faith on the trust front”.

Why do I say hoodwink? Firstly, as I discussed in this post, the lending of any physical gold deposited in the schemes will have a one-off impact on throttling Indian gold imports. Secondly, as discussed in this post, the other uses the Government of India says it will make of the gold and the way it will run its Sovereign Gold Bonds Scheme mean that the government is simply going naked short gold in Rupees, as they themselves acknowledge in this press release:

“the risk of increase in gold price that will be borne by the government” and they “will not be hedged and all risks associated with gold price and currency will be borne by GoI”.

With that sort of risky behaviour from their own government, who really is stoopid – those holding physical gold or those trusting the government schemes?

Sep 102015

Would you lend money to someone in another country who told you they were doing it because interest rates in your currency were cheaper than their currency and not to worry about them paying you back if the size of the loan amount in their currency increased due any weakening in their exchange rate as they would set aside the money they saved in interest to cover that risk? I hope you answered NO!

Such foreign currency denominated loans are attractive to borrowers facing high interest rates who are willing to overlook the exchange rate risk (or be sold them by a bank underplaying that risk). Polish Swiss franc mortgages, which blew up when Switzerland dropped its currency peg, are the latest in a long line of such exploitation of unsophisticated or desperate borrowers. My Australian readers of mature age are no doubt familiar with the 1980s foreign currency loan scandal that “involved significant financial losses and personal suffering for many borrowers”.

So who is the latest desperate borrower to ask investors to lend them their foreign currency at cheap interest rates? Well if you only read mainstream media who just report press releases without any analysis, you’d have missed that it was the Government of India (GoI) asking average Indians to lend them their gold. Although in this case I think it is the lender than is going to lose, not the borrower.

Lest you think I am exaggerating, here it is clearly stated in this official press release on the Indian Sovereign Gold Bonds Scheme:

“The amount received from the bonds will be used by GoI in lieu of government borrowing and the notional interest saved on this amount would be credited in an account “Gold Reserve Fund” which will … take care of the risk of increase in gold price that will be borne by the government.”

What could go wrong with that? Certainly the Government doesn’t think there is much risk as the borrowing “will not be hedged and all risks associated with gold price and currency will be borne by GoI”. But don’t worry, “the Gold Reserve Fund will be continuously monitored for sustainability”, with sustainability being lovely bureaucratic speak for “are we losing money”.

The Government only seems concerned about the risks to the lenders, noting that “investors will need to be aware of the volatility in gold prices” and that the bond tenor “could be for a minimum of 5 to 7 years, so that it would protect investors from medium term volatility in gold prices” and giving investors the option to roll over the bond if the gold price falls. But don’t those same risks equally apply to person on the other side of the loan?

Why is the Government so confident that the Rupee price of gold will fall? Possibly they think that by “reducing the demand for physical gold by shifting a part of the estimated 300 tons of physical bars and coins purchased every year for Investment into gold bonds” the global gold market will be weakened?

I should note that this Sovereign Gold “Bond” is another example of government doublespeak as one does not initially lend gold but instead pays Rupees and is given a loan denominated in grams of gold, receiving Rupees back at the end (based on gold prices at maturity). There is a Gold Monetization scheme where you can deposit actual gold but there is little difference to the Gold “Bond” as the medium and long-term deposits are redeemable “only in cash, in equivalent rupees of the weight of the deposited gold at the prices prevailing at the time of redemption”.

I will at least give the Government credit for being explicit about what they are doing as they say “the deposited gold will be utilised in the following ways …

  • Auctioning
  • Replenishment of RBIs Gold Reserves
  • Coins
  • Lending to jewellers”

The first and the third point are basically the Government selling the gold and taking a (vaguely Gold Reserve Fund hedged) short position against the depositor. The last one is the only legitimate and minimal risk use of gold (but as I explained here, it has limited use in throttling Indian gold imports). The second is the Government effectively buying the depositor’s gold on the cheap, as long as interest savings outweigh Rupee price changes.

The key question of course is what will happen to Rupee gold prices. Yes, Rupee prices have been stable the past few years, but note the general downward trend in the INR/USD rate.


What would happen if the Gold Reserve Fund became “unsustainable”? Would the Government just give up all its interest saving gains and incur the cost of hedging its position, or decide that it might need to roll over the bond to protect itself “from medium term volatility in gold prices”. What me worry indeed.

May 212015

The Indian Government has released its Draft Gold Monetization Scheme for comment, which builds on the earlier WGC & FICCI’s Why India needs a gold policy proposal. At this early stage it seems “likely fail in its current form as it does not address some key concerns for banks and consumers”, according to Reuters.

Whilst it may be news to Zero Hedge that gold pays interest (see In India, Gold Is Not Only Money But Now Pays Interest) this is not something new for India which has always had a gold borrowing and lending market although at the retail level it has not worked so well, with previous schemes obtaining less than 50 tonnes.

Positives for the current proposal are a low 30 gram (approx. 1 ounce) minimum deposit, a very transparent deposit and assaying process, and exemptions from Capital Gains Tax, Wealth Tax and Income Tax.

The main problem seems to be that banks will need to offer interest rates of 3% to 4% to make it attractive to investors but when those banks can import gold on consignment from western banks at rates lower than that, then “the government would have to give subsidies to encourage their [Indian banks] participation”.

Another issue is that “there is no guarantee that tax sleuths will not come calling hot on deposit, asking for the source” of funds that purchased the gold, as First Post notes. In addition, they note that the need to melt the jewellery “is abshagun, inauspicious and a strict no-no”.

The melting issue comes up a lot in the comments to the draft, but one helpful suggestion to “change the draft to deposit jewellery and get monthly interest on it” seems to miss the point of the whole scheme, which is for the gold to be used by jewellers. It also shows the difficultly in marketing this idea when people can’t see why it makes no commercial sense for a bank to pay interest on stored jewellery which it cannot use.

It is also a bit of a concern that the Government’s draft says that “banks may sell the gold to generate foreign currency. The foreign currency thus generated can then be used for onward lending to exporters / importers” which is basically saying the bank will go naked short gold (and no, they couldn’t hedge it as the cost of the hedge would eliminate the profit on lending cash – hence why the call for subsidies).

However, my main issue with this proposal is that it is a stop gap solution to the “problem” of gold imports. As Indians are net accumulators of gold any mobilisation of their existing gold into bank gold savings schemes does not mean that those people will not buy more gold. All they are doing is changing the way they hold their existing gold savings; they will still want to add to their existing savings (in aggregate). Any mobilised/recycled gold is just sold back to others who don’t want a bank gold savings scheme – the total amount of physical gold in the country stays the same, it is just that some are now holding bank gold savings schemes.

Consider that yearly Indian consumer demand is around 800t and estimated stocks within India in round numbers are (ignoring Temple Trusts who have about 2,000t):

Physical Gold held by Indians -> 18,000t
Physical Gold held by Jewellers -> 2,000t

In the banking system, this is the situation:

Bank gold asset (loans) to Indian Jewellers –  2,000t
Bank gold liabilities to Western Banks – 2,000t

If the scheme is so successful that they manage to mobilise 800t a year then Indian banks won’t have to import gold and can instead sell the mobilised gold to manufacturers who then transform it and sell it back to other Indians. After the first year this is what Indians will hold:

Physical Gold held by Indians -> 18,000t
Paper Gold held by Indians -> 800t
Physical Gold held by Jewellers -> 2,000t

In the banking system, this is the situation

Bank gold asset (loans) to Indian Jewellers –  2,000t
Bank gold liabilities to Western Banks – 1,200t
Bank gold liabilities to Indians – 800t

Effectively all that will happen is that the 800t is used to repay the consignment loans from Western Banks – the Indian Banks use the money from selling the 800t to the Jewellers to buy London gold which they then use to repay their Western bank gold loans. After the third year this would be the situation

Physical Gold held by Indians -> 18,000t
Paper Gold held by Indians -> 2,400t
Physical Gold held by Jewellers -> 2,000t

In the banking system, this is the situation

Bank gold asset (loans) to Indian Jewellers –  2,000t
Physical Gold held by Banks-> 400t
Bank gold liabilities to Indians – 2,400t

Now you may ask why does the bank have 400t of physical? By the end of the second year, the Indian Banks only have 400t worth of gold loans left, so when they sell the 800t to the Jewellers that year and buy 800t (which they have to otherwise they would be going naked short and thus pure speculating on the Indian gold price falling) it only has 400t of loans to repay, leaving it with 400t left over. Note that as Indians are not net sellers (in aggregate) the banks’ only option is to buy gold overseas, but in doing so they send currency out of the country, which is what the Government is trying to prevent.

In the 4th and subsequent years, there is no more demand to borrow the 800t of gold being deposited into the scheme – the jewellers only need 2,000t. Ultimately, if we remove the banks (who are just intermediaries) out of the picture what we have is that the gold that is being lent by some Indians is going to Indians who want to buy it – there is a mismatch here, one side wants to lend and still own it, whereas the other wants to own it outright. That cannot be squared with any fancy financial footwork – no Indian bank is going to go short gold in Indian dollars.

Indian Gold Price

So gold mobilisation is probably only good for a few years worth of gold import substitution and thereafter the Indian Government is back to its “problem”. All this work for a temporary solution. Easier to just talk to the main temple trusts and get them to fund the local jewellery industry IMO.