Gold duty cut backfires; Centre's hope to save Rs 10,000 cr on SGBs evaporates

The Centre's decision to slash the customs duty on gold from 15 to 6 per cent was calculated to significantly reduce its financial obligations regarding the impending redemption of Sovereign Gold Bonds (SGBs).

The expectation was clear: By driving down gold prices, the government could save an estimated Rs 10,000 crore.

However, the reality is proving to be more complex. Instead of reaping the anticipated savings, the move has left the government grappling with a much larger payout than expected as gold prices remained resilient.

Market reaction

The market reacted to the duty reduction as anticipated, with gold prices falling by 4.1 per cent on the day the announcement was made.

This decline also caused the market price of SGBs to drop by 6-8 per cent, roughly equivalent to the customs duty paid by investors when purchasing these bonds. This strategic price reduction was calculated to reduce the government's financial obligations.

(SGBs are government securities denominated in grams of gold. They are substitutes for holding physical gold. Investors can purchase SGBs in cash and the bonds will be redeemed in cash on maturity. These bonds are issued by the Reserve Bank of India on behalf of the Government of India.

Unmet expectations

One of the main reasons given for lowering the customs duty was to reduce the widespread smuggling of gold into India. Estimates suggest that 150-200 tonnes of gold are smuggled into the country annually due to high duties.

The government aimed to narrow the price gap between international and domestic gold, making smuggling less profitable and increasing legal imports.

While this rationale seemed solid, the reality has proven more complex. Despite the duty reduction, smuggling networks have remained resilient, bypassing legal channels and undermining the policy's effectiveness.

Purchasing decisions

The duty cut was also intended to make gold more affordable for Indian consumers, particularly for purchasing jewellery, which holds deep cultural significance.

Although gold prices initially dropped, increasing consumer interest, the overall impact on consumption has been less dramatic than expected.

Indian consumers' purchasing decisions are influenced by various factors beyond price including seasonal trends, festivals and economic conditions. Moreover, global fluctuations in gold prices can overshadow the tax cut's benefits, complicating the situation further.

Unforeseen financial strain

An overlooked aspect of the customs duty cut is its effect on the SGB scheme.

Introduced in 2015, SGBs were intended to reduce physical gold demand by offering an investment option linked to gold prices coupled with an annual interest rate of 2.5 per cent.

While initially seen as a cost-effective way to raise funds and decrease gold imports, the duty reduction has highlighted an unintended consequence.

The drop in gold prices following the duty cut affected the redemption value of SGBs, which are directly tied to the domestic price of gold. For example, when the duty reduction was announced, gold prices in India fell by 4.1 per cent, from Rs 72,609 per 10 gram to Rs 69,602.

While this price drop may have been favourable for consumers, it also meant that the government would have to pay more than expected when these bonds matured.

Shooting prices

When SGBs were first introduced, the government likely did not anticipate the sharp rise in gold prices. Since 2015, gold prices in India have increased by 180 per cent, creating a significant financial burden on the government, which is obligated to honour these bonds at maturity, including both the capital gains and interest payments.

For instance, in the first tranche of SGBs, the government raised Rs 245 crore when gold was priced at Rs 2,684 per gram. By the time these bonds matured, the price had surged to Rs 6,132 per gram, representing a 128 per cent increase.

This forced the government to pay 148 per cent more than it had initially raised, significantly straining its finances.

Financial obligations

The customs duty cut has exacerbated the challenges posed by the SGB scheme.

The government's financial obligations continue to grow, with gold prices remaining high due to geopolitical uncertainties and central banks' increasing gold reserves.

Only four of the 67 SGBs issued have matured, leaving 63 tranches that will mature in the coming years, further straining government resources.

Rethink on SGBs

In response to this mounting burden, the government is rethinking its approach to the SGB programme.

No new SGBs have been issued recently, and the target for gross issuance in FY25 has been significantly reduced. This pause suggests that the government may consider ending the SGB programme or altering its structure to make it less attractive to investors. However, such changes could reduce its appeal and effectiveness.

The customs duty cut on gold, initially seen as a positive and strategic move, is yet to deliver the expected results. Smuggling persists, domestic consumption has yet to see the anticipated surge, and the unintended consequences of the SGB scheme have placed a heavier financial burden on the government.

As gold prices remain unpredictable, the government faces difficult decisions in balancing its policy objectives with fiscal responsibility.