Modi's Gold Bonds Must Outrun Inflation to Woo Bullion Addicts

  • India's inflation-adjusted interest rate stands at 3.59%
  • Only citizens and local institituions can buy the bonds

The success of India’s first gold-backed bonds will hinge on returns beating inflation-adjusted interest rates and a shift in its bullion-obsessed culture.

Prime Minister Narendra Modi’s cabinet last week approved the sale to help curb gold imports, after they caused the current-account deficit to widen to a record in 2013 and sent the rupee to an all-time low. The target audience is people who now buy about 300 metric tons as an investment each year, or about a third of imports. Standard Chartered Plc said returns need to be close to the so-called real rate that stands at 3.59 percent.

Modi’s biggest challenge lies in changing perceptions about the metal that’s central to everyday life of Indians. Besides purchases linked to weddings and Hindu festivals, the World Gold Council estimates that 60 percent of demand is from rural areas where the lack of access to banking makes bullion the only form of investment.

“The government should try to keep the returns equal to the real rate,” said Nagaraj Kulkarni, senior Asia rates strategist at Standard Chartered in Singapore. “A more critical thing is to educate people in rural areas as they constitute the majority of the gold consumers and may have difficulty in understanding the product.”

The sovereign-guaranteed bonds will be issued in denominations of 5 grams, 10 grams, 50 grams and 100 grams for a term of five to seven years, the government said in a Sept. 9 statement. Purchases will be capped at 500 grams per person each year and will be offered to only Indian citizens and institutions, it said, and the securities will be traded on exchanges.

‘Minimum Return’

The coupon will be calculated on the value of the metal at the time of investment, according to the statement. In draft guidelines issued in June, the government had said “an indicative lower limit of 2 percent may be given but the actual rate will have to be market determined,” and the first year’s issuance equivalent to 50 tons would be around 135 billion rupees ($2 billion) and can be accommodated within the borrowing target for the fiscal year ending March 2016.

“Even if the government offers a minimum return of 1 to 2 percent, there will be buyers for the gold bonds,” said Badrish Kulhalli, a fixed-income fund manager at HDFC Standard Life Insurance Co. in Mumbai. “They are backed by the sovereign and you are earning some income.”

Modi, who swept to power last year on the pledge to invigorate Asia’s third-largest economy, wants to reduce India’s reliance on imports by wooing citizens away from physical gold and monetize an estimated 20,000 tons or more of bullion -- more than double holdings in the U.S. -- stashed in India’s homes and temples.

Savings Shift

Shipments were 891.5 tons in 2014, according to the World Gold Council, which expects consumption of between 900 tons and 1,000 tons in India this year. Gold imports contributed to the current-account deficit reaching a record $88.2 billion in the year ended March 2013 and the rupee’s slide to an unprecedented 68.845 a dollar. Import curbs imposed since then along with a slump in crude oil prices helped narrow the gap to $27.5 billion in the last fiscal year. The rupee has strengthened 3.6 percent from its record low to 66.48 as of 9:11 a.m. in Mumbai on Wednesday.

“If you can channel your physical savings into financial savings by the gold monetization plan and gold bonds, then you can further curb your reliance on offshore capital to fund growth,” said Suyash Choudhary, Mumbai-based head of fixed income at IDFC Asset Management Co., which manages about 547 billion rupees. “This can bulletproof India against volatility in offshore financing” and market swings arising from the Federal Reserve raising U.S. interest rates, he said.

The monetization plan will allow Indians to deposit their jewelry or bars with banks and earn interest, while the banks will be free to sell the gold to jewelers, thereby boosting supply. However, a deposit plan run by the State Bank of India since 1999 has only attracted 15 tons of gold because of uncompetitive interest rates, according to UBS Group AG.

Limited Trading

The issuance size of the initial gold bonds may hinder their success, according to Kotak Mahindra Asset Management Co. An initiative to revive inflation-linked bonds in 2013 failed to find favor with investors after increases in living costs outpaced returns and their relatively small size limited trading, making it difficult for investors to exit holdings.

“The government will need to increase the size of the bond sales in the coming years to get the full benefit of this plan,” said Lakshmi Iyer, Mumbai-based chief investment officer for debt at Kotak Mahindra, which manages 483 billion rupees. “If you’re able to entice investors’ interest and manage it well, it will have a positive impact on government finances.”

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