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How Can the State Bank of India Pay Interest in Gold?


 -- Published: Tuesday, 12 August 2014 | Print  | Disqus 

By Keith Weiner

 

An article caught my eye this week. The Tirumala Tirupati Temple in India has deposited gold at the State Bank of India, and is getting paid interest on their deposit. There is something unique about this. The interest is paid in gold.

 

To understand why no one else is paying interest in gold, letís first look at how one can use any asset class to make a dollar income: speculation. Buy something. Wait. Sell it at a higher price. You can use bonds, stocks, real estate, artwork, or classic Ferraris. By the way, no matter what you use, you are converting what had been someone elseís capital into your own income. This is capital destruction on a massive scale.

 

Using gold to produce a dollar income is simple. Just sell a covered call with a strike price a little higher than the current market price. You get paid a premium immediately. If the gold price does not rise, then you can repeat the trick and sell another call. If it does rise, you must sell the gold at the strike price. This earns you a profit, as it is above what you paid. Then just buy more gold and do it again.

 

If you keep your books in dollars, and trade for dollar gains, you donít really care how much gold you have. You only care about how many dollars. If the gold price doubles, you may end up with about half the gold. But who cares, at least youíre making a steady stream of dollars that you can consume.

 

Making a gold income is something else.

 

You canít just sell calls, or sell the gold itself. If you do, and the gold price rises, you will have to buy the gold back. However, the same dollars you have will get you less gold at the higher price. For example, you start with 100oz gold. Today the price is about $1,300 per ounce, and you sell a December call option. It has a strike price of $1,325 and you get paid immediately $25 per ounce or $2,500 for the contract.

 

Unfortunatelyóyes this is unfortunate as we shall see in a momentóthe gold price jumps in September. It goes to $1,500 and holds steady there. In December, you deliver the gold and per your contract you are paid $1,325 per ounce. Now you have $1,325 100oz = $132,500 + the option premium of $2,500 = $135,000.

 

When you go to buy your gold back, you discover the catch. At the new price, you can only get $135,000 ų $1,500 = 90oz. Even after picking up almost two ounces worth of pennies in front of the steamroller, it still squeezed 10 ounces out of you. Your 100oz shrunk to 90oz.

 

Would you like to play again?

 

This is why the headline in the International Business Times caught my eye. The bank is paying 1% on the templeís gold, in gold! It may not sound like a lot, but that means for every 100oz the temple deposits, it gets back 101oz next year. It does not face the risk of having its gold called away at the next crisis flare-up.

 

I wondered how the bank could pay this interest in gold. After all, if you canít make a yield on your gold and the temple canít make a yield on its gold, how can the State Bank of India make a yield on gold?

 

I asked some of my friends from India this question. I got two basic answers. One way they could do this is by selling the gold and investing the proceeds in a dollar denominated instrument that pays interest. The bank makes, say 4%, and pays the temple 1%. It sounds feasible, but there is a very basic catch. As we saw above, if the gold price rises, there is a loss in gold.

 

The templeís account is denominated in gold. If the books are kept using gold as the unit of accountóas they should beóthen the dollars must be marked to market. This is a profoundly important but subtle point.

 

On gold books, if you hold gold, then there are no profits or losses. Only when you buy an asset such as the dollar (i.e. sell gold), do you start marking gains and losses on your books, whenever the dollar price changes.

 

Going back to our example, you begin with 100oz of gold. You buy 130,000USD, at the price of 23.93mg (a dollar price of 23.93mg gold is equivalent to a gold price of $1,300 per ounce). Now you have 100oz worth of dollars (itís awkward, at first, to say that, but itís perfectly valid).

 

Then the dollar price falls 13.3% to 20.74mg (i.e. the gold price rises to $1,500). You still own 130,000USD. Now itís worth only 86.68oz. You have lost 13.32oz. This is bad enough for the investor, but itís a much more serious problem for a bank.

 

A bank balance sheet has assets matched to liabilities. The liability is the gold deposit owed to the depositor, in this case 100oz. The asset is whatever the bank bought, in this case 130,000USD. Now, this sum of USD is only worth about 86oz. The bank has a very big problem. If this happened in enough accounts, it would be bankrupt.

 

I am not satisfied with the first answer. Several people told me that itís just the risk the bank takes to do business. I disagree.

 

Lending money incurs risk. You hope the borrower will repay it. You do all of your diligence to verify that the borrower has the means and intent to repay. There is a chance that, despite this, he defaults. An analogy is that you have car insurance because no matter how carefully you drive, you may crash.

 

The falling dollar price is not a mere ďriskĒ. It is a certainty. Just look at a graph over the past 100 years. In the analogy of driving a car, this is like driving over the cliff edge into the Grand Canyon. A collision is certain.

 

The second answer I got was less complicated and more sinister. The bank could be planning fraud, and not intending to ever repay the gold. They might get the government to declare that all gold deposits are redenominated in paper money.

 

I donít know which of these two answers is correct. I hope they are both wrong, and there is something real backing their gold deposits. If you know something about this, I would love to hear from you.

 

The gold interest rate is a very important topic. The world is not yet prepared to grasp it. However, with each insolvency, quantitative easing, falling currency, bail-in, and the inevitable rise of the gold price, the tide is turning.

 

http://monetary-metals.com/

 


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 -- Published: Tuesday, 12 August 2014 | E-Mail  | Print  | Source: GoldSeek.com

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