While finance minister P Chidambaram has hinted at the possibility of the government reviewing its gold import policy after imports rose 138% to $7.5 billion in April, he may wish to just increase the amount of inflation-indexed bonds RBI will be auctioning later today. The reason why Indians are flocking to gold and away from financial instruments—as compared to 10.1% of GDP in FY05, the amount of household savings invested in financial instruments fell to 8% in FY12 and is probably lower today—is that few instruments give positive real rates of return. As our graphic on page 1 shows, bank FDs haven’t offered more than 1% real return in most years. Investing in the broad market—Sensex stocks or a Sensex-index fund—has offered 13.6% per annum real returns over the past decade, but a lot depends on the time period chosen. Do the same exercise over five years, when the Sensex was at a high, and you get negative returns of over 4% per annum. Indeed, as the graphic shows, gold has delivered good returns over the decade as well as over 15 years—this will change if transactions in gold are reported to the taxman as there will be capital gains taxes to be paid versus, say, investing in the stock markets where there are no taxes for holdings beyond a year.
So, if the government were to dramatically increase the amount of inflation-indexed bonds available for the retail sector, chances are a large number of investors may be tempted to choose these instead of gold. Keep in mind that, over the past 3 months, gold has delivered an inflation-adjusted return of minus 46%; over 6 months, the returns are bit better, but still at minus 34% on an annualised basis. Even over 2 years, the inflation-adjusted return is under 1%, certainly lower than what inflation-indexed bonds are expected to fetch later today. While the costs of inflation-indexed bonds can be quite high for the government in a rising inflation scenario, there is little danger of that today—indeed, despite what RBI Governor Subbarao may say about there still being an inflation risk, there is hardly any pricing power left in the non-food sector. Today’s PMI falling to a 4-year low is indicative of a fairly sharp fall in inflation, including in consumer prices, in the months ahead. If, for instance, the government were to issue R1,00,000 crore worth of inflation-indexed bonds which resulted in it having to offer interest rates of 2% more than it offers right now, this would increase its costs of borrowing by R2,000 crore. While that is a large sum of money, it pales into insignificance when compared to what it has the potential to do in terms of curbing gold imports. Over the next few months, it’s a good idea to test the hypothesis with more such bonds for the retail segment. Banning banks from selling gold coins or hiking import duties, on the other hand, will do little to curb imports as long as households don’t feel there is another credible riskless inflation-adjusted product out there.