Note: As I was writing this, the Indian Government effectively discontinued the Gold Monetisation Scheme (GMS). GMS is separate from the Sovereign Gold Bond (SGB) scheme. With GMS, you deposit physical gold and receive interest paid in Indian Rupees at the prevailing market rate at the time of deposit. Everything concerning the role of the Indian Government as the sovereign issuer of the Rupee still applies. Both GMS and SGB don’t make much sense for their stated reasons i.e. to encourage Indians to import less gold or to have the Government hold more gold. However, GMS carries a default risk because “the redemption of principal at maturity shall, at the option of the depositor, be either in Indian Rupee equivalent of the value of deposited gold at the time of redemption, or in gold.” Redemption in gold means if the Government uses the gold deposited by individuals (for trade, or sells it in the market for foreign exchange or even Rupees) instead of hoarding it, there’s a chance of default. You’re trusting the Government to pay you back in a “thing” it can’t create out of nothing, unlike Rupees.
On September 9, 2015, the Indian Government introduced Sovereign Gold Bonds (from here on, SGBs), these are Government bonds indexed to the prevailing market price of gold, Indian Government offered an additional interest of 2.75% on top.1 So, an individual invests hoping for additional return from gold appreciation, since otherwise they could just as well hold regular sovereign bonds. The government, on the other hand, hopes the gold price doesn’t increase or stays the same, so it has to pay out less. However, there is more to this.
It must be kept in mind that no physical gold is involved in SGBs; the Indian government does not hold any physical gold as backing against these bonds. So, while the pricing is indexed to gold, payments i.e., interest and principal at maturity are in Rupees only.
The main claimed reason why the government introduced this scheme was to reduce gold imports. Since all payments are done in the sovereign currency, the Rupee, the idea was that it would reduce demand for foreign exchange being used to buy gold, and hence also reduce downward pressure on the Rupee.
The government might have also naively thought that the Rupees it acquired from this bond would ‘fund’ government spending, so-called ‘borrowing’. However, the Indian Central Government (the sovereign) doesn’t need Rupees. The Indian Government’s Treasury and Central Bank, i.e., the Finance Ministry and the RBI, are the sole issuers of state money. By imposing tax obligations, fees, fines, and other forms of payment for services in Rupees, the Indian Government creates demand for it. The said payments can only be made in state money.
This implies that the Indian Government doesn’t really need to borrow Rupees to spend in Rupees, as commonly stated in school textbooks. In fact, the government must spend money into existence before taxing it. Textbooks say that taxes fund government spending. If that is the case, where do people get the money to pay taxes? The government must have created it in the first place.
The so-called ‘borrowing’ (i.e., bond issuance) is merely to maintain target interest rates and exchange rates (as set by the RBI) and drain excess liquidity. With open capital flows, strict targeting of both exchange rate and interest rate isn’t possible. To prevent outflows and depreciation, the government typically raises interest rates in tandem with foreign central banks, particularly the Federal Reserve of the U.S., since it is the reserve currency issuer. However, such operations don’t ‘fund’ Central Government spending.
What does all this have to do with SGBs? I have read in several business newspapers that SGBs were a waste of money and a burden on the ‘taxpayer’ because the gold market price appreciation has forced the government to pay out more Rupees to the bondholders. Many are even concerned about this making the government insolvent.
From what I said earlier, that the Indian Government cannot run out of Rupees, you can unequivocally conclude that the Indian Government can always make the payments for SGBs. The Indian Government cannot involuntarily default on its own debt as long as the payments are in its own currency. It can always instruct the RBI to credit the relevant accounts with Rupees. Any default is therefore voluntary.
Demonetisation was a voluntary default on government debt; banknotes are a perpetual, non-interest-bearing liability of the RBI until redeemed for payments to the Central Government. The government removed the ‘perpetual’ aspect of it. Hence, it was a voluntary default. This debunks one of the points made by idiots at the time, that demonetisation would reduce the liability of the RBI and allow it to spend more. The Indian Government (Finance Ministry) can always increase spending. Whether it results in inflation depends on aggregate demand, private savings, capacity to expand, etc., not whether some banknotes were removed from circulation.
Back to SGBs; the only time a sovereign currency-issuing government can’t pay is if the debt is in anything other than their own currency (in India’s case, the Rupee). If the Indian Government decides to issue U.S. Dollar debt of $1 billion and float it at 10% interest, India will have to somehow obtain $1.1 billion to pay it back. This can only be done through exports, capital inflows, or foreign aid. Only the U.S. Federal Government (Treasury and Fed) can create widely accepted state U.S. Dollars.
SGBs are only gold-indexed bonds; there is no physical gold involved. On the other hand, if the Indian Government issued a bond where you provided 1 kg of gold bullion and were paid back 1.1 kg of gold bullion at the end of the year, the Indian Government would somehow have to pay back 1 kg plus 100 grams of gold. This debt has default risk since it is possible that the Indian Government is unable to provide gold. If the payment was in Rupees, it could always be done.
In fact, the Indian Government can issue Rupee bonds indexed to anything! Oil, silver, USD/INR exchange rate. As long as the payment is in Rupees, there is no default risk. The question is: who does it benefit?
The real result of the SGBs is that people with lots of money get even more money. That is what sovereign bonds do: give free money to bondholders with zero risk of default. If foreigners bought SGBs (I do not believe they did), they get more Rupees (just like Indians), but they also exchange them for foreign currencies, putting downward pressure on the exchange rate. However, in this case, the government can force them to hold Rupees and prevent conversions. This is not a default since only Rupees were promised, not convertibility.
And of course, rich people who get more money may decide to spend it on luxury or imported goods, which may not benefit society as a whole and may cause inflation (due to resource constraints and exchange rate pass-through). But not necessarily, as rich people tend to be hoarders (‘savers’), it is likely that most of the wealth increase for the rich ends up being hoarded in other financial assets, not real goods or services. Given how bad income and wealth inequality is and how much power the super-rich have, I do not believe giving them free money is a good thing.
Throughout history, many countries have issued such ‘free money’ assets. Brazil, for example, during its inflation crisis, issued inflation-indexed bonds in Brazilian Real. When inflation skyrocketed in the 1990s due to a balance of payments crisis, the people who bought the inflation-indexed bonds (very likely to be the ‘elite’ class) kept their real purchasing power and preserved their wealth, while those who kept cash or non-inflation-indexed savings accounts lost purchasing power.
The final issue with bond issuance is that while the Indian Government can always make payments on SGBs, it also ties itself by artificially capping fiscal deficits. An increase in payments on SGBs, in the absence of an increase in tax revenue, will result in a higher fiscal deficit if spending on everything else is kept the same. Due to self-imposed caps on fiscal deficits and to please international finance capital, the government may have to cut spending in other areas such as capital expenditure on public services. This will cause economic stagnation and increase income and wealth inequality further.
However, such limits are purely self-imposed. Sovereign governments aren’t financially constrained in their own currency. All my points still stand.
That begs the question: did SGBs reduce gold imports? The answer is an unequivocal no.2 This is at least partly because, for Indians, gold is not merely a form of investment; people have an emotional attachment to gold. It is used during weddings, and gold signifies wealth. The 2024 election discourse surrounding mangalasutras only confirms this.3
Gold smuggling is also widespread, and before the 1990s, it undermined the fixed exchange rate and likely increased the foreign debt burden on the Indian Government (since the debt was denominated in foreign currencies). Even now, gold smuggling remains widespread, primarily done through flights. Often, the gold is embedded within other devices or carried in compound form. Corruption and collusion between smugglers and customs officials also exacerbate the problem.
Regardless, duties and tariffs on gold are still a better way to reduce imports than providing Rupee-denominated financial instruments. The main issue is that the rich have far too much purchasing power, enabling them to buy massive amounts of gold, which undermines government policy. Taxing both the income and wealth of the rich would decrease their purchasing power, and higher gold import duties combined with stricter surveillance on gold smuggling would also help. More political will is needed to make this successful.4
Conclusion: SGB gives free money to rich bondholders but Indian Government can always pay for it since it is denominated in Rupees.
That’s all.
- https://www.rbi.org.in/commonman/english/scripts/PressReleases.aspx?Id=1644 âŠī¸
- https://www.business-standard.com/markets/commodities/india-s-gold-imports-up-331-to-record-high-of-14-86-billion-in-nov-124121601020_1.html âŠī¸
- https://thewire.in/banking/golden-dreams-costly-reality-sovereign-gold-bonds-burden âŠī¸
- https://www.ndtv.com/india-news/karnataka-bengaluru-airport-on-actor-ranya-rao-gold-smuggling-case-dri-points-to-state-protocol-department-7910886 âŠī¸