The enduring metal: 23rd October 2010 Indian Express

Gold has always been an enigma for investors all over the world. India is, of course, the world’s largest consumer of the metal — Indians have traditionally invested in gold more as a necessity driven by social compulsions. But now it has also become an attractive
investment option, since it’s viewed as a natural hedge against inflation. At a more academic level, it’s also a substitute for the dollar.

The price of gold has been increasing sharply in the last couple of months to cross $1,300 an ounce and analysts have not ruled out its touching the $1,500 mark in near future. The question is whether this trajectory will continue upwards or whether it will stabilise and then drift downwards after a while.

The price of any product is driven by demand relative to supply, and gold is no exception to this rule. At the moment, demand is moving faster than supply and that’s pushing up prices. Look at the demand side. Conventional demand has increased as more people are moving towards gold as an asset class. The weakening dollar is the economic justification and the rising price of gold on its own is creating further demand for this class of users. Second, the gold exchange traded funds have been busy buying gold and accounted for around a third of the physical demand for gold in Q2 of 2010. On the back of these purchases of gold, financial products are then offered in the market for investors. The third category of entities which demand gold are the consumers who buy jewellery, where demand has been rising, albeit moderately. Therefore, it’s the investor class, more than the consumer class, which has really driven demand.

How about supply? The World Gold Council has stated that supplies are more or less fixed in terms of what is mined annually — which is valued at around $200 billion. Q2 had witnessed a supply valued at around $40

billion. Central banks have also been active in the gold market. In the past, gold was held as a non-remunerative asset and central banks preferred to invest their surpluses in bonds rather than gold. It may be recollected that, not long ago, the fear that such sales may depress prices had led central banks of Europe to impose restrictions among themselves on the sale of gold. However, after the financial crisis there have been doubts cast on the US economy and the strength of the dollar. Hence, it’s not surprising that central banks have gone back to acquiring gold instead of selling it — a change in role from a supplier to an active buyer in the market.

In this scenario, where are gold prices headed? Gold has a direct relation with the dollar. As long as the dollar weakens, investors will move to gold, and the correlation here is as high as between 80-90 per cent. The dollar is weakening against the euro in the range of around 1.35-1.40 and this scenario will probably persist given that the US economy is shaky while the euro region is

relatively better off. However, a strong euro may not work in favour of the eurozone, and there would be resistance to the extent to which the dollar can fall. Therefore, this particular factor may not persist for too long.

Besides, the US is trying to lower its deficits, which could also help to strengthen the dollar.

This leaves the other factors at play — central banks and funds. Central banks are still in shopping mode and funds would leverage the conditions to keep their incomes ticking. Gold is traditionally a good investment option and gives returns between 15-18 per cent and can be positioned somewhere between government bonds and the stock market. This interest will always remain and hence the price may not really recede and would tend to stabilise even after global adjustments occur. As long as there is scepticism about the world monetary order, interest in gold will remain strong.

What does it mean for us in India? India, though the largest consumer of gold, is a price taker. This means we take the price that’s determined on COMEX. The prices would replicate global trends, which in turn are influenced by our demand. With income levels increasing and high inflation prevailing there has been a tendency at the margin for households to look at gold progressively — though there is not much evidence of substantially higher imports of gold by India. There will hence be a tendency for the prices to move up during this festival season.