In times of crises, it pays to bet big on gold
Through the last 6,000 years, gold has always been the ultimate store and arbiter of value. It has survived every war, revolution and economic cycle.
By Nidhi Nath Srinivas, TNN |
NEW DELHI: Through the last 6,000 years, gold has always been the ultimate store and arbiter of value. It has survived every war, revolution and economic cycle.
In 1971, US President Nixon, for the first time, cut off the link between the US dollar and gold, which led to the breakdown of the Bretton Woods international payments system. That meant that the price of gold and of paper currencies began to float freely according to supply and demand factors in their own markets.
But the yellow metal continues to have a special significance for central banks of most countries. Unlike currencies, the value of gold does not depend on one country. Payment transactions with gold are also usually under a central bank’s control.
That is why gold, more than any other type of investment, comes to a government’s aid in crisis situations. From an investment viewpoint, the price of gold often moves opposite to other financial assets — in particular the US dollar. The New York futures market has maximum trading in gold contracts.
London is the gold clearing house. Zurich has the largest number of physical suppliers. Istanbul, Mumbai, Dubai, Singapore, and Hong Kong are doorways to important consuming nations. The Hong Kong, Zurich, London and New York gold markets are open 24 hours.
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Price: No matter where gold is mined, the price of an ounce of gold is measured in dollars or $/ounce of gold. Outside the US, the price of an ounce of gold is measured as FC/ounce of gold (where FC denotes “foreign currency”). The exchange rate between the US and foreign currency can be written as $/FC. That’s the price (in dollars) for one unit of foreign currency, in our case the rupee. Since gold is easily transportable, it obeys the “law of one price”. That is, the price in dollars is the same as the price in foreign currency after conversion. Put simply, in India $/oz of gold = $/Rs x Rs/oz of gold.
Bullion prices change with shifts in foreign currency markets, changes in industrial/commercial demand plus economic factors such as inflation. The centre of world gold trading is the London bullion market, operated by the London Bullion Market Association (LBMA).
Members are classified into market making members, that include all participants in the twice-daily London gold fix, as well as 14 bullion houses and 50 ordinary members. Most bullion houses act both as brokers and primary dealers.
Supply: There are three sources of supply: mines, official gold sales and recycled scrap. The most important distinction between gold and other metals is that the ratio of available supply to annual production is much higher for gold. In most commodities, prices rise until fresh supplies equal demand. But when gold prices rise, jewellery and coins enter the market to cool down prices.
Demand: There are two kinds of demand: fabrication, which means jewellery and industrial use; and investment. Gold buying in China, or India, or anywhere that drives up gold demand will push prices higher around the world. These higher gold prices will in turn spark interest in more investors and lead to even more capital bidding on gold, driving it even higher.
Thus a giant virtuous circle is created where higher prices drive demand creating even higher prices and strengthening the cycle. However, retail buying slows down when prices reach above a certain psychological level. So, gold prices are not only dependent on the current mine production and processing demand but also influenced by the supply and demand behaviour of existing and potential owners of gold.
Even though gold demand has sustained and should increase in the years to come, mined production is having trouble keeping pace. There are 29 new gold mines in the pipeline and even if all these are developed, it would require a further seven projects every year to make up the deficit.
Exchange-traded funds (ETFs) give investors the opportunity to make flexible and liquid investments in gold, even for small volumes. In 2003, gold ETF investments accounted for less than 20 tonne. Today, they exceed 500 tonne.
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