India is planning to issue sovereign bonds linked to the bullion price in an effort to divert some of the estimated 300 tonnes of annual demand for gold bars and coins, and reduce bullion imports that can push up the trade deficit.

The Reserve Bank of India (RBI) will issue the bonds for the government, with a minimum interest rate of 2 percent, according to a draft outline issued by the government late on Thursday.

"The main idea is to reduce the demand for physical gold," the draft said.

Indians prize gold as gifts and as a way of storing wealth. The country consumes nearly 1,000 tonnes of gold every year, most of it imported, and gold is the second-biggest expense on its import bill after oil.

To reduce imports, Finance Minister Arun Jaitley unveiled plans in February for a sovereign gold bond and a bullion deposit scheme.

While the deposit scheme aims to mobilise idle household gold, estimated at more than 20,000 tonnes, the sovereign bond would allow consumers to invest in 'paper' gold rather than physical gold.

The bond would pay an interest rate linked to the international rate for gold borrowing.

"An indicative lower limit of 2 percent may be given but the actual rate will have to be market-determined", the proposal said.

The bonds would be issued in denominations of two, five and 10 grams of gold or other sizes for a minimum term of five to seven years and they can be used as collateral for loans.

"The provision of a 2 percent interest rate and use of bonds as collateral are among the things that should attract investors," said Prithviraj Kothari, vice-president of India Bullion & Jewellers' Association.

However, Indians prefer to hold gold in physical form and might not embrace the proposal. Bullion-backed exchange-traded funds, which issue shares backed by the precious metal, have not been very successful in India.

The industry has also raised concern about the proposed deposit scheme, as consumers might not part with their jewellery in return for relatively low interest rates.

The government aims to issue bonds worth 135 billion rupees ($2.12 billion) or the equivalent of 50 tonnes of gold in the first year.

For easy and wide access, the government plans to market the bond through post offices and various brokers and agents.

One constraint could be the tax aspect. The draft notes that capital gains tax on the bond will be similar to that imposed on physical gold purchases. But Indian consumers typically buy gold coins and bars in cash, with very few paying tax.

These investors are unlikely to shift to gold bonds, economists said.

India has invited the public to comment on the plans by July 2.