Gold bond scheme should work; you can take a punt at taxpayer's cost

The sovereign gold bond scheme announced two days ago by the government has a reasonable chance of working for one simple reason; it does not seek to separate you from the physical gold you own, but merely tries to lure those who see gold as a form of long-term investment to take a punt on the metal.

The basic contours of the scheme are simple: you invest rupees today at the international price of gold, get an additional two percent (or a bit more) interest annually, and when you exit after five or seven years, you get the latest price of gold plus interest - and the same capital gains treatment as physical gold assets.

The implications of the scheme are the following:

One, the market risk is yours. If the market price of gold is lower than at the time you invested, your nest-egg will depreciate. You get less than you put in, assuming the interest paid is not enough to make up for the capital loss. But if the price is higher, you win.

Two, the scheme will not appeal to those who want physical gold for jewellery or for future use. It is merely for people who believe gold will retain value against inflation over the long term.

Three, the two percent interest payable annually means holding sovereign gold bonds will be more rewarding than gold ETFs (exchange traded funds), which may have transaction costs in buying physical gold as the underlying asset.

Four, the scheme could appeal to savers who want physical gold sometime in the future. If, say, you want to gift your daughter 1 kg of gold seven years later, instead of buying the gold now, you can invest in the sovereign bond and convert the cash into physical gold seven years hence. If this is what people use the scheme for, demand for physical gold will shift to some time in the future.

Five, the government will have to bear the currency and market risks - which means it can both borrow cheap (if gold prices fall) or expensively. If we assume that gold prices tend to cover inflation, and that the rupee has always depreciated against the dollar, this may turn out to be an expensive way of borrowing for the government. It won’t help with the fiscal deficit.

Broadly speaking, the scheme will effectively skim a portion of the investment demand for gold with the taxpayer taking on some of your risks.

It is useful for investors, but for government the costs - market and currency risks - may not be worth the benefits of lower gold imports.

You can have a punt at the taxpayer’s cost.