Are Gold and RBI confusing you? - The 5 Minute WrapUp by Equitymaster
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Are Gold and RBI confusing you?

Dec 2, 2014

In this issue:
» Government does away with 80:20 scheme
» Will negative interest rates help Europe?
» Chinese take ponzi schemes to a new level!
» The economy is running on one leg
» and more...

It is obviously tough to drive a car on an unknown highway when you see arrows pointed at opposite directions. All you can do then is to rely on your intuitions! Unfortunately investors in India hoping to have a long wealth building ride are in a similar conundrum. To add to market volatility, the conflicting economic signals are making it all the more difficult to take calculated risks.

The RBI in its Monetary Policy review today took a stubborn stance to keep interest rates unchanged. Needless to say it has policy makers coercing it to lower rates for months now. In addition, falling commodity prices, particularly oil, make the central bank's anti inflationary stance seem foolish! Moreover, even the manufacturing index has been moving up, showing signs of economic recovery.

Why then would the central bank want to keep rates stiff? Why not offer businesses and consumers easier access to credit so as to boost investment and consumption? We will come to that in a bit. First let us see what gold has to say.

The only asset class that has had inflation hedging properties for generations is headed lower. As much as hardcore capitalists reject the utility of gold as an investment worthy asset, central banks world over, have been hoarding the metal for decades now. In fact the Swiss central bank, which was the last one to let go of Gold Standard, wanted to keep 20% of its reserves in gold until recently. However, gold prices over the past few weeks revisited the 2012 lows. And that almost put an end to every speculation that hyper inflation remains a threat to global economy. Even the critics of US Fed's money printing policies rejected the possibility of hyper inflation. And therefore investors chose to dump gold rather than hold on to it as a store of value.

Therefore the RBI's views that inflation risks are here to stay are contradicting the deflationary trend reflected in gold prices. Investors therefore have every reason to be confused about what kind of risks they should anticipate and the kind of returns to expect. If inflation is indeed set to get significantly lower, they would rather invest in stocks. On the contrary, high inflation would warrant exposure to an inflation hedge like gold.

Well, according to us, neither is the RBI nor are gold prices wrong. For the signals being given out are nothing but temporary. The RBI is certainly not satisfied with consumer inflation remaining above 5%. Moreover, given that central banks elsewhere in the world have not stopped printing money, the possibility of excess liquidity creating asset bubbles remains. Meanwhile, the fall in gold prices over the last year needs to be seen in the context of rise in other asset classes. And even if lower commodity prices keep inflation tempered, liquidity risks will ensure that gold remains the best insurance against devaluation of currencies.

As an investor, therefore, you would be better off not paying too much attention to these temporary economic trends. Instead focus on the long term Megatrends taking shape in emerging countries like India. These are the trends that will play out irrespective of where interest rates and gold prices head in the near term. And needless to say that they will ensure that you fetch healthy inflation adjusted returns for a very long time to come!

What kind of economic cues do you look out for before investing in stocks? Let us know your comments or share your views in the Equitymaster Club.

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For Indian investors, there is an additional incentive for buying gold besides the fall in prices of the yellow metal. The government seems to be easing off the curbs on gold buying. After allowing gold jewelers to once again take the metal on lease, the government has removed the 80:20 rule for importing gold. You may recall that the curbs on gold import were meant to ease pressure on current account deficit. However, with oil prices too heading lower, import of gold is not really a deficit threat.

Now this could mean that banks and jewelers could once again get aggressive in offering the yellow metal as an investment. The fact that prices have revisited 3 year lows could make the proposition all the more attractive. However, as an investor, you should refrain from getting carried away by these trends. As we said earlier, the asset class is certainly a good hedge against inflation and will continue to remain so. Nevertheless, over exposure to gold is unwarranted.

As we are on the topic of interest rates, we can't help but mention NIRP. What is NIRP? It stands for negative interest rate policy. This is the ridiculous monetary policy adopted by the European Central Bank (ECB) to prevent deflation in Europe. What do 'negative interest rates' mean? In simple terms, it means that you need to pay your bank when you park your money with them! If you think this is impossible, think again. A German bank, Deutsche Skatbank, has become the first bank in the EU to introduce NIRP to the common man. It has set an interest rate of -0.25% for certain high value deposits! This means that depositors are better off withdrawing their funds and keeping it at home. The ECB hopes that this will encourage people to spend.

We believe this is desperation at its worst. NIRP will not save Europe. Only structural reforms can do that. However, such reforms will be painful in the short term and European politicians are not comfortable implementing them. Thus, they continue to keep their faith in crazy monetary policies of their central bank. While people in India look forward to rate cuts by the RBI, the developed world, which should be increasing interest rates is unwilling to do so. We don't see this trend changing anytime soon.

Speaking of desperation, we feel a bit of sympathy for the common man in China. Why? Because his plight is not too different from his counterpart in India, at least in one aspect: buying a home. It is common knowledge that rampant speculation has made real estate out of bounds for most people in China. So when genuine buyers enter the market, they find it impossible to make the down payment for a home.

In their desperation, they have turned to the Chinese shadow banking system. This US$ 6 trillion industry has come up with an innovative online solution of providing loans for the down payment! As long as it's done online, these types of transactions are not regulated. Thus, the Chinese borrower is saddled with two loans, one taken for the home and the other for the down payment.

This has all the makings of a Ponzi scheme. To keep the property bubble going, end users are a vital cog in the wheel. They are the ones who provide speculators an exit. As genuine Chinese property buyers are unable to afford their own home, they have become unwitting participants in this gigantic bubble. When this bubble bursts, the result will be very unpleasant we believe.

 Chart of the day
If global central banks seem to be eager to get people to spend their non-existent savings, the RBI has no such worries. If anything consumption is still quite strong in the economy. This fact was on full display in the recent GDP numbers. As the chart clearly shows, in the September 2014 quarter, all of the 5.3% GDP growth came from consumption. Important contributors to the economy like capital formation and the external sector were in the doldrums. Consumption by the private sector remains the only driving force in the economy. This is clearly evident on the bourses. The BSE FMCG index was up about 16% while the BSE Capital Goods index was flat in the last quarter. With pricing power still in the hands of corporates, it is really surprising that the RBI is not keen on reducing interest rates?

Can consumption growth be sustained?

There are two key takeaways from this. One is that the economy needs a lot of reforms to boost industrial activity. The second is that the consumption party may not last long. If interest rates continue to remain high, consumption growth cannot be sustained.

After the RBI dashed all hopes of a cut in interest rates anytime soon, the Indian stock markets reacted negatively and the indices stayed below the dotted line for most of the session today. The BSE Sensex was trading lower by 115 points (-0.4%) at the time of writing, with energy and auto stocks leading the losers. In the midst of broad based selling, stocks from the commodity and the banking sector were the key gainers. Barring India and Taiwan, the major Asian stock markets ended in the positive with the Hong Kong index leading the gainers. Most European markets were also trading higher at the time of writing.

 Today's investing mantra
"In the short run, the market is a voting machine but in the long run it is a weighing machine". - Benjamin Graham

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee.

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3 Responses to "Are Gold and RBI confusing you?"


Dec 3, 2014

by not reducing int rates we could again waste an opportunity which once we wasted in past. waiting too long makes no sense,when govt is trying to improve economy rbi should have supported govt they look more like being anti.



Dec 2, 2014

Easing Gold Import Norms at this time may look reasonable from the Jewellery Industry outlook. But, is it the best import needed right now. If Inflation is to be tackled well and brought down, articles contributing to Inflation must be imported so that demand pressure is eased.That should be the priority.Gold Import Norms can be eased gradually and not at one Go.



Dec 2, 2014

I certainly do not agree with RBI's perceptions this time. When Inflation, rose, RBI very promptly raised repo Rates. When prices fall, same promptness is expected from RBI to reduce Repo rates. Right now, Indian lending rates are so High that no corporate is coming forward to avail loans for capital asset building. Liquidity in Banks is used merely to fund Retail Lending. Capital Asset formation is important for long term health of the economy. This has suffered for over 3 years on the plea that Inflation is High. In fact, Inflation never ever responded to REPO rates one way or the other. Now Inflation is down, primarily because of lower Oil prices and food prices, not because of High Repo rates. If RBI wants to wait till prices rise again to justify High Repo rates,I don't think RBI is responding to Real Inflation but only to its pessimistic projections.

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