Gold on Lease: An ideal hedging mechanism?

With the growing middle class in India, demand for branded jewellery is expected to increase.

However, given the weak economy, demand has been slowing and is a cause of worry. To make things worse, the since jewellers import most of the gold they use, the falling rupee added to their woes. And of course, jewellers always have to contend with the volatility in gold prices.

This situation forces jewellers to find more effective ways to buy imported gold.

Traditionally, import of gold has been managed via inventory replenishment. In this approach, gold inventory is replenished on the same day as it is used to make jewellery and sold. Then, if the gold prices go up they purchase lesser quantity and vice versa. This method, to a large account, helps jewellers mitigate the gold price fluctuation risk.

However, given the severity of the challenge they are facing, jewellers are now increasingly moving to another option - "gold on lease or loan?" with hedging.

How does Gold on Lease work?

Jewellers use gold as raw material to produce jewellery. They can either purchase this gold from banks on loan or lease it.

If they buy, the gold sits as inventory on their balance sheets.

However, more and more jewellers prefer to lease the gold from banks. In this way, they hold no inventory, and so mitigate any inventory holding risks.

A jeweller usually leases gold from banks for a period of 180 days. A spot rate that varies daily is applied on the amount of gold they use each day. Then the jewellers settle with the banks at the end of six months. Any daily unused gold is hedged for a few days so any currency fluctuation risk is minimized or eliminated.

This gold on lease has many benefits.

The Benefits of Gold on Lease

Hedging mechanism: First and foremost, this scheme acts as a hedging mechanism against fluctuating gold foreign exchange rates. Since rates are determined daily as the gold is used, jewellers do not have the risk of buying larger amounts of gold and the price varying till it is sold. Here the gold is paid for each day as it is used.

No Inventory Risks: If gold is bought, the jeweller's inventory is valued on the constantly changing purchase prices. However, in case of gold on lease, there is no inventory, and so no inventory loss or gain occurs . Holding no inventory also protects against falling customer demand. Gold on lease from banks serve as a "just in time" inventory mechanism. With no inventory, jewellers also do not have the risk of losing inventory due to theft or natural disasters.

Lower financial expenses: Lease interest rates are normally in the 5% to 8% range. This is much lower than the 12-13% that banks charge for corporate loans.

Improved efficiency: With the gold on lease approach of holding no inventory, return on capital will be higher making the company more efficient.

Expansions: Players who usually would buy inventory for their new showrooms now benefit as they take the gold they need on loan.

All the above benefits greatly reduce risk and also improve the profitability of the company.

Does this make branded jewellers attractive?

The unpredictable global economy, and the dependence on gold imports have made it imperative for companies to hedge their commodity and foreign exchange exposures.

By procuring "gold on lease", jewellers find a number of benefits - hedging against fluctuation of gold prices as well as foreign currencies, carrying no inventory, paying lower interest rates for the gold they need, reducing pilferage and related risks and improving return on capital used.

It seems that more jewellery retailers are moving towards this approach of procuring gold on lease for these reasons.

And hopefully this gold on lease idea will make branded jewellers shine more attractively as investment options.