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Finding the fair value of interest rate on Gold deposits

, May 26, 2015, 0 Comments


gold deposits MarketExpress-inIndia is known for its fascination for Gold. Families buy gold to gift in marriages and on other special occasions; to store wealth, especially in rural India, where they see greater value (monetary as well as security) over institutional savings products; or for jewellery and ornaments. The buyer in most cases attaches an emotional value to the asset.

The practical uses of this commodity, however, are minimal and this is the central reason, Why many investors, like Warren Buffet, might not like to add it to their portfolio of assets. Probably driven by this factor, but more importantly, to draw the country’s hidden wealth to join the currency in circulation as well as to reduce India’s dependence on imported gold, the Central Government of India announced a Gold Monetization Scheme in Budget 2015, the draft details of which were released last week on the Government of India website (

The scheme provides for individuals to deposit their gold in a bank and earn an interest rate, payable in gold, on this deposit. So, for instance, if a deposit accepting bank decided to offer 1% annual return, a 100 gm deposit would become 101 gm gold in one year’s time. This, however, requires the gold to be melted (for purity tests) and converted into gold bars. On maturity, the customer may redeem either in gold or in cash, but has to decide which, at the time of making the deposit.

An individual when they decide to monetize their gold, would have to give up its ornamental value in exchange for the interest rate that banks would offer on her gold deposit. The labour cost of making jewellery is significant and varies from around 4% to as much as 25% depending on the work involved. Furthermore, given the auspicious and sentimental value which households attach to jewellery, the threshold to entice jewellery owners into this scheme is rather high.

3- Cash Reserve Ratio (CRR): Commercial Banks in India are required to hold 4% of their deposits with the Reserve bank of India. No interest is earned on the CRR balances maintained by the banks.

4-Statutory Liquidity Ratio (SLR): Additionally, commercial banks in India are required to maintain 21.5% of their deposits in the form of gold, cash or government securities before providing credit to the customers. Such holdings generally offer lower interest rate over retail and commercial loans or corporate bonds.

Around 75% of the total gold demand in India is in the form of Jewellery of which those who are willing to give up the ornamental value or those who are looking to set aside old jewellery for their offspring and open to letting them redesign in line with the ongoing fashion, are likely to participate in the gold deposit scheme. The remaining around 25% of the owners who own Gold bars and coins might show less resistance.

The interest rate to be offered on gold deposits is left to the banks to decide.

The main supply side factors which are likely to influence this decision are a) the cost of borrowing gold from international markets and b) the economic value of the incentive which the Government proposes to offer to banks for accepting Gold deposits, i.e. the offer to utilise gold as part of banks’ CRR/SLR requirements with RBI.

The cost of borrowing gold from international markets is determined by the international gold lease rate which along with the country risk for India adds up to around 1.5% in today’s market.

The CRR/SLR incentive is still under discussion and probably not close to finalisation yet. However, a consent to include gold for CRR calculation could be significant as it could potentially replace costly cash (assume bank’s cost of funds at close to RBI Policy Repo Rate of 7.50%) maintained with the RBI at zero percent interest.

If this proposal is indeed taken forward, there may potentially be a cap on the amount of CRR cash that banks may be allowed to replace with relatively low cost (of borrowing) gold. Depending on this cap factor, banks might be in a position to add an extra percentage of returns to the gold depositors.

With regards to SLR, gold is already an eligible asset to be kept aside by banks to meet their SLR requirements. Though, an extra amount of gold mobilised through gold deposits is likely to be found beneficial to banks as it allows them to replace government securities with higher yielding corporate debt.

If we use the AAA rated corporate bond yields as a benchmark, then the value of replacing Government securities with corporate bonds could be in the region of 50 to 60 basis points (spreads are higher in the loan market). However this may also be seen in context with the current economic environment where credit off-take is low and many banks are holding excess SLR; banks in this case are less likely to derive significant value from this, just now.

Taking these supply side factors into account, banks might just be willing to accept gold deposits at interest rates in the region of 2.5 to 4% depending on the modalities of the incentives. There will be additional costs including the cost of storage and/or the cost of hedging the price risk of the gold interest rate, which banks might deduct.

On the demand side, competition may be seen from other asset classes. For an investor who is willing to forego the ornamental value of gold to take part in gold deposits, the choice would be between selling gold upfront or holding it to derive better value over other available asset classes. The threshold is around 8.5% bank fixed deposit rate (for cash) which an investor can earn per annum by selling gold upfront.

annual returns gold marketexpress-in

Historical data suggests that the volatility of annual returns from Gold in INR terms has been significant, ranging from -17.76% annual return to 67.15% since April, 1995 (see chart). This might just overwhelm the bonus interest offered on gold deposits.

The Opinion and views set out in this article are those of the author(s) and do not necessarily reflect the views of any institution.

1-World Gold Council: Global Demand Trends, First Quarter 2015.

2- In this regard, it is interesting to note a FICCI and World Gold Council release on ‘Why India Needs a Gold Policy’ report (December 2014) which quotes survey data to show that more than 70% of the respondents were ‘willing to consider interest-bearing gold-based investment products, even if the gold they receive at the end of the tenure is different from what they deposited.’

5-Price data for