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Gold is GOLD - Views on News from Equitymaster
 
 
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  • May 19, 2001

    Gold is GOLD

    Gold. This magical word has always inspired the world’s imagination, but even more so for India. Indians are after all one of the largest consumers of the yellow metal. Gold has always signified solidity and safety in one’s investments. Over the years as numerous others options for investments have become available, like the stock markets, debt markets, real estate, currencies and art works, the aura of gold has somewhat dimmed.

    This is not surprising considering the returns on investment in gold are lower as compared to the stock markets or even the dollar. If you had invested Rs 1,000 in the BSE Sensex in March 1991, it would be worth Rs 3,086 exactly a decade later (a CAGR growth of 11.9% per annum). If you had invested the same amount in buying US dollars in March 1991, it would be worth almost Rs 2,391 as the end of March 2001 (a CAGR growth of 9.1%). However, buying US dollars is just an example, as currently the Indian government does not allow it.

      BSE Sensex Rupee $ Gold (Rs)
    Mar-91 1,168.0 19.6 3,466.0
    Mar-01 3,577.0 46.8 4,260.0
    CAGR growth 11.8% 9.1% 2.1%

    But if you had invested the same Rs 1,000 in buying gold, it would be worth only Rs 1,229 a decade later (a measly CAGR growth of 2%). Even an investment in Indira Vikas Patra or buying a National Saving Certificate (NSC) would have more than tripled your returns. But the question is why is gold giving lesser returns?

    Currently, the global annual demand for gold is estimated to be around 4,000 tonnes per year. However, gold miners around the globe only produce about 2,500 tonnes of gold per year. That means there is supply deficit of nearly 1,500 tonnes per year. So, if the demand exceeds supply, shouldn’t the price of gold strengthen? But in reality, it doesn’t.

    To understand this anomaly let us look into the factors that have a bearing on the value of gold.

    1. Relation of gold and inflation
    2. Central bank role

    Gold and inflation

    In simple economic terms, gold moves up in tandem with inflation. In other words, gold is a natural hedge against rising inflation. It is known fact that gold prices hit the roof during the second oil shock in the late seventies. Infact from around US$ 39 in 1970, the spot gold price rocketed to US$ 139 in 1975 and then to US$ 594 in 1980.

    However, in the last three decades inflation across the developed world has been on a decline. Therefore gold value has also been on stagnant ground.

    The fact that the dollar is now the leading measure of valuation, it has led the gold valuation to be measured in terms of dollars. In hindsight this is one of the reasons for the subdued growth in the value of gold. This is because in the US inflation has been on a decline post the second oil shock in the late seventies. As such the dollar has strengthened against other currencies. On the other hand, declining inflation has subdued gold’s valuations.

    In a way relating the value of gold to a US dollar is not an accurate measure for valuing gold. This is because currencies have gained importance only in the later half of this century. But before these currencies gained importance, for centuries gold has been the unequivocal standard by which every other commodity were valued.

    The central bank role

    As gold lost its lucre against declining inflation, central banks around the world consciously decided to reduce their holdings in gold to re-invest in other investment avenues. As a result, gold holdings as a percentage of the bank reserves have been on a constant decline. In 1970 gold amounted to 43% of the global financial reserves. In October 2000 the figure stood at 12.7%.

    The central banks’ around the world reduced their holdings in two ways. One, they lent it to their respective bullion banks at a nominal interest (around 2%). These bullion banks then sold this gold at market prices and employed the capital generated in other more rewarding avenues like the stock markets etc. These banks foresaw that inflation rates are only going downhill and so it made sense for them to unlock the value of gold and invest in more lucrative instruments.

    The second method which the central banks’ employ to reduce their gold holding is an outright auction of their gold reserves. The unloading of their gold reserves is largely responsible for filling in the crucial 1,500 tonnes per annum gold supply gap. As a result, gold prices have stayed where they are.

    The auction of gold by western countries like UK is becoming more frequent. As a result, the supply is likely to keep pace with demand. Moreover, inflation around the world continues to be under control. In such a scenario gold will continue to figure in our country as more of an ornament rather than an investible avenue. About 75% of the gold produced in the world's mines goes to jewelry production. Indians have traditionally bought gold more as ornaments and less as an investible alternative.

    But before we write off gold, there are a few things one needs to analyse. For one, gold has stood the test of time as a natural hedge against inflation. No doubt that inflation levels are falling. However, some economists are of the view that inflation levels are unlikely to go any lower. In other words, there is a higher probability of inflation levels rising.

    Secondly, in September 1999 European central bankers signed what is known as the Washington Gold Agreement. The object of this agreement is to bring the selling and lending of gold under control. If the central banks do observe restraint in selling and lending gold, this yellow metal is in for good times.

    There is another reason that should find favour with gold buyers. Gold is not only a good hedge against inflation but has also proved its worth when the reverse happens i.e. depression. The best example of this is the ‘Great Depression’ in the US during 1930’s. During that time, fearing that the government would devalue the US dollar against the gold to make exports more competitive, many holders of US dollar converted to gold. In terms of purchasing power gold had risen almost 100% during the biggest deflation in America’s history.

    In effect, gold may not seem an interesting investment avenue in the current scenario, but look back at history and it is the only investment that has really counted in a crisis. Not cash, not real estate and not even stocks. ‘Gold is ultimately GOLD’.

     

     

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