My Love for Gold

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Pavneet Singh Kochhar's picture

"Gold plunges to two-year low" "Rout tarnishes gold's lustre as safe haven" "Gold's fall not a harbinger of happy days" These were some of the headlines trading on the internet and newspapers across the world as gold prices plummeted to $1352 an ounce and experienced the biggest one day drop in the past three decades. This drop led to huge losses on gold reserves with central banks and hedge fund investors such as John Paulson were among the biggest losers. The last biggest slump took place in January 1980 when gold lost $97.5 in a single day. Gold plunge might have made soon-to-be brides happy, but it has sent shockwaves across the world for investors over the uncertainty of gold’s future. This biggest swoop has put to doubt the image of gold as a safe-haven for investment.

Gold was once considered as a monetary standard between 1821 and 1971. Prior to that silver was also a monetary standard for nearly four hundred years. However, silver has lost much of its significance after the fall of the standard. Even though gold is no longer a standard, it has enticed investors particularly central banks, who have hoarded massive amounts of gold. At the end of April this year, central banks/nations owned 31,694.8 tonnes out of which United States and Euro area had 8133.5 tonnes and 10,783.4 tonnes, respectively [1]. 

Gold prices have sharply increased in the past decade from around $250 in 2000 to over $1600 $ in 2012, a sharp six fold increase (Figure 1). The gold reached an all-time high of $1920 a troy ounce in 2011. Gold has always lured investors and gold market is considered as one of the mature markets yet complex and less understood since gold prices are vulnerable similar to prices of equities or bonds, determined by several economic factors, market trends and most importantly supply/demand discrepancies. As pointed out by Aram Shishmanian, CEO of World Gold Council, that, “Gold operates on the basic economic fundamentals of demand and supply. Our view is that demand is strong while supply remains constrained, and that this dynamic ultimately drives the long-term price of the metal” [2].

Causes

Gold prices are prone to economic news particularly emanating from US and Eurozone [3]. Here are some of the factors which might have triggered this tremendous fall in gold prices and its ramifications.

US Federal Reserves (Fed)

Fed have been aggressively buying bond to revive the economy still struggling post-recession. Currently Fed is spending $85 billion a month on treasury bonds and mortgage-backed securities with Fed’s balance sheet swollen to over $3 trillion which was under $1 trillion in 2007-08 [4].  The last quarter’s data (Jan-Mar 2013) shows that US economy grew at the rate of 2.5%. With unemployment rate declining to 7.6%, which is expected to go down further, and decline in interest rate on a 30-year fixed mortgage, speculations abound on how long central bank will continue to support bond buying binge. Also, with decreasing inflation and dollar gaining strength, it is believed that Fed may soon taper, if not end, the bond buying program.

Cyprus

Elimination of Cyprus from the Eurozone sent shockwaves for the global economy. Coming under pressure, Cyprus was forced to close down its second largest bank and raid depositor’s uninsured savings to fund for recapitalization and to secure 10 billion euros bailout from the European Union and the International Monetary Fund (IMF). The government tightened the withdrawal limit for Cypriots to 300 euros a day. On the brink of default, Cyprus raised 23 billion euros by increasing taxes and garnering little support from international lenders and a fractious parliament. Cyprus also agreed to sell 400 million euros worth of its gold reserves which emanated a negative signal that central banks of other struggling European countries may follow the suit.

Weak Chinese Data

China’s growth rate stumbled unexpectedly to 7.7% (Jan-Mar 2013) due to low domestic demand and weakening international demand from US and Eurozone [5]. Further, fall in industrial production in March compared to first two months, slower spending in real estate and fixed assets exuded negative signs for the economy.

Exchange-Traded Funds

With the successful run of gold in the past 12 years, investors have flocked to exchange-traded funds (ETF). Gold ETFs have intrigued traders and hedge fund managers due to benefits that ETF brings on the table such as lower cost involved in tracking commodity prices, getting rid of buying bullion and easy trading similar to shares. SPDR Gold Trust is the world’s largest gold ETF which had 1221 metric tons of gold and $62.7 billion in assets at the end of March 2013. ETF outflows or the selling in ETF has risen after the biggest plunge in gold prices in three decades. Holdings in exchange-traded products contracted 13 percent after the slump and bullion holdings of SPDR took a big blow and fell to the lowest level since September 2009. This outflow reinforces the lack of investor confidence in the metal. Investors investing heavily in the past few years were eager to sell amid growing concerns of further downfall of gold due to stronger U.S. dollar and probable increase in liquidation by central banks. Investors looked for options such as equities and other assets. However, surprisingly, ETF outflows were mostly limited to gold whereas silver, palladium and platinum outflows were maintained at nearly constant level which does not augurs well for the future of gold.

While outflows have worried investors about uncertain economic conditions, slump in gold prices brought good news for physical buyers who were thronging the market to take advantage of lower prices. Heavy disinvestment from ETF was countered by physical demand particularly from Asia. Buyers were more interested in buying coins and bars which led to shortfall of coins in US. This shortfall caused the rise of premiums of gold bars in Singapore and Hong Kong. Although investors are still mulling over the future of gold, this unprecedented demand improved the sentiment that it can provide support during time of economic weakness. John Paulson reiterated that demand from India and China will continue to support prices and gold will act as a hedge against inflation. This gave an assurance to the investors, however, it will take time for conviction to be regained.

Implications on Indian Economy

India’s voracious appetite for gold is long-standing, where gold is seen as a symbol of purity, social status and good fortune. Gold imports for 2012-13 stood at $57 billion whereas the net oil import bill for the year was $11 billion higher than 2011-12 level. High prices of commodities such as crude oil and gold have led to current account deficit of over 5 percent of GDP (Figure 2). The economy is grappling with high account deficit due to weakening of rupee against U.S. dollar, lack of reforms and political paralysis because of corruption scandals. The weaker currency has led to increase in the import prices, thus fuelling inflation. Although government increased the duty on gold imports, which led to a decrease in gold imports for a while before the demand surged again. After the plunge, gold prices went below 27000 rupees per 10 grams, which is 17 percent less than the highest price of 32,464 rupees observed in November 2012.   

Gold has given tremendous returns in the past decade which has attracted Indians than going for traditional savings account, which is although stable, yet gives lower returns. However, gold can have several negative impacts such as it widens current account deficit, deprives financial markets of liquid funds, increases market volatility, and has no direct return. Moreover, vaulting gold is expensive. India needs to provide investment plans which can guarantee returns equivalent to gold which will lure more investors and infuse liquidity into the system. Further, the plan should channelize gold lying in family vaults into productive investments. The government needs to increase the outreach of banks particularly in rural areas which lack formal banking structure and leads to dearth of saving options. There is a need to educate people about adverse impacts of gold on economy as well as make people aware about various investment opportunities such as gold deposit schemes [6]. To wean investors away from gold, the government announced sale of inflation-indexed bonds (IIBs), which are linked to wholesale price inflation [7]. In the long run, measures like these will prohibit people from buying gold, thus leading to lower imports, lower inflation rates, fall in current account deficit, lower interest rates, higher liquidity, higher investments and a stronger economy.

Finally, even after extensive analysis of the market conditions, analysts have failed to come to a conclusion about what transpired with gold. In the future, whether gold prices help boost the economy or prove disastrous, one thing is sure, with festivals and wedding season in the coming months, my love for GOLD has not dampened.

References:

[1] World Official Gold Holdings, retrieved from {https://www.gold.org/download/value/stats/statistics/archive/pdf/World_O...}

[2] Shortage of gold bars and coins in Dubai, says World Gold Council, retrieved from

{http://articles.economictimes.indiatimes.com/2013-04-19/news/38674413_1_...}

[3] The Effects of Economic News on Commodity Prices: Is Gold Just Another Commodity?, retrieved from {http://www.iadb.org/intal/intalcdi/pe/2009/03913.pdf}

[4] US Federal Reserve Balance Sheet Trend, retrieved from

{http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm}

[5] China’s GDP Annual Growth Rate, retrieved from

{http://www.tradingeconomics.com/china/gdp-growth-annual}

[6] Know all about investing in gold deposit schemes, retrieved from {http://articles.economictimes.indiatimes.com/2013-02-11/news/37039177_1_...}

[7] Inflation Bonds: To Buy, or Not to Buy?, retrieved from

{http://blogs.wsj.com/indiarealtime/2013/05/20/government-bonds-to-buy-or...}

 

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