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Sunday, August 26, 2012

Why gold price is rising? (In simple words)


There is an old Sanskrit maxim from India that says, “सर्वे गुणाः काञ्चनमाश्रयन्ति- that means all virtues lies in the person possessing gold. This importance of gold has been very well justified in recent years.
Since January 2000, gold has given a whopping 489 % of absolute return that means money invested in gold turned almost around 5 times in just 12 year. Gold prices rose steeply since the year 2007 onwards.


Gold, once considered as an idle asset suddenly turned into a desirable investment option for investors!

Why Gold Rates are increasing?

There are many reasons for the soaring of the gold prices but I shall discuss the most common of these.

(1)    Demand & Supply:  As per this economic principle, price of a commodity increases when higher demand of that commodity is not counterbalanced by its higher supply.

Demand of gold is increasing day by day while gold mine production is declining and there has been no significant success in discovering new mines.
so far only 1,65,000 metric tonne of gold has been mined.

It is evident from the graphs that demand for jewellery and bullion has been continuously increasing. Gold buying by various governments and central banks fall under Official purchase category.







Simply put, gold demand is continuously increasing and the same is not matched by the supply (mining production and resale). There has been no significant new gold discovery . Mining costs are also increasing. Unless there is significant new gold discovery, demand pressure shall continue to loom exerting upward pressure on gold prices.



(2)   Gold as an Investment option:

(2.1)  As a Hedge Against Inflation: As per the conventional wisdom, Gold is a hedge against the inflation. This means when inflation is raising prices of gold shall also increase and the investor shall be benefitted. Gold has tendency to soar aggressively during inflationary environment.

(2.2)Handsome Returns Delivered So Far:  As mentioned above, investment in gold’s price has almost quintupled in 12 years and this is why investors are tempted to buy gold in the hope of further appreciation.

(2.3)Unattractiveness of Other Asset Classes: Due to global economic turmoil and events like Europe’s sovereign debt crisis, recession in USA or slowing Chinese economy ,other asset classes -stocks, treasuries (and similar), became unattractive and funds ended up buying gold.

(2.4) Enhanced Buying Spree by Global Central Banks: Across the globe central banks of various nations are voraciously pursuing their gold buying spree. Global economic crisis forced central banks to lose faith in the currency like US dollar and instead they started parking  considerable part of their reserves in gold in a move to reduce their reliance on US dollar denominated treasuries. Such a higher reliance on gold over other fiat currencies stems from the intrinsic value of gold which every fiat currency lacks making them vulnerable.

         When and why central banks started hoarding gold?

After the demise of Bretton woods system which relied on gold in the year 1971, global central banks never needed to hoard the physical gold. 
But in the aftermath of 2008 financial crisis, central banks realized the importance of gold  owing to its underlying intrinsic value.
         

(3)    Weak Dollar & US Rating Downgrade Fear: Dollar is world’s reserve currency and gold prices are marked in dollars. This means when dollar turns weak the prices of gold shall rise.
              As evident from the above chart dollar has significantly weakened in last 10 years. 
                                                                                              
This weakening  helped gold to surge high. 
Us dollar index measures the strength of the US dollar against a basket of currencies. Investors who were earlier investing in US treasury products started allocating some part of their corpus in the gold territory.
Earlier Many foreign central banks would keep a substantial part of their reserves in US treasuries to keep their local currency competitive but weakening dollar and looming threat of US credit downgrade forced them to redeem treasuries and instead buy gold. This move exerted  upward pressure on gold prices.

(4)    Relation with other commodities: Gold plays an important relationship with crude oil. Rising crude prices translates into higher inflation and to conquer this inflation more gold buying takes places as discussed in 2.1.

(5)    Depreciation of Local Currency: This is a country specific phenomenon. If local currency of a nation depreciates against the USA dollar (being the reserve currency gold prices are marked in US dollar) then the price of the gold increases in that country.This happens even if there is no substantial change in international gold price. 
I have elaborated this point here.

(6)    Money Printing By Various Governments:Various governments over the world are printing money in one form or other- whether it be quantitative easing in USA or issuance of oil bonds in India, these are nothing but the money printing.
Simply put, money printing means artificially (without keeping any collateral like gold, money is created by an electronic entry) increasing the money supply in the ailing economy in the hope of a boost in growth.
Higher money supply results in the weaker local currency. weaker currency not only means higher gold prices but attracts higher investment in gold thus exerting further demand pressure which consequently results in higher gold prices.
Money printing makes the credit easy that leads into higher inflation as a result more money flows in the gold territory to hedge against the inflation.

(7)    Gold As A Solution To Financial Crises:


 Europe’s sovereign debt crisis fortified the need of gold as collateral- some of PIGS countries nearly reached on the verge of default on their bonds.
Europe is the largest holder of the gold reserves.
If gold reserves are used as collateral the same can’t be placed on the block for sell unless the lien is lifted off – resulting in a gold supply constraint which lasts till lien is lifted. Interrupted supply results in higher gold prices.


(8)    Excess Money in the Global Economy: due to measures like money printing by various economies, excess liquidity gets created.
This excess liquidity finds its  way into commodities making them dearer.
Not only gold but other metals (precious and base) too have been multiplied globally.

(9)    Losing Faith in Fiat Currencies: with gold-standard gone, all currencies are fiat currencies.
A 100 dollar bill is just a paper and it has no intrinsic value. Indiscriminate money printing by a country's government makes this fiat currency literally meaningless.
The best example is of Zimbabwe where to buy a groceryproduct one has to carry bundles of currency notes.The countries where currencies are losing value, investors start protecting their wealth by investing in Gold.

These gold coins have intrinsic value much higher than the denomination value.
Minting gold coins reduces the availability of mined gold and exerts upward pressure on gold prices.
This practice was implemented to mock the deterioration of the fiat currencies as discussed in point (7).

Why gold demand in increasing in India?

In volume terms India is world’s largest gold market and is continuously expanding.



India and China collectively account for around 45 % of the demand.
Demand for gold for traditional reasons like marriage, festivals, rituals etc was always there in India and it started rising exponentially after the country liberalized. The most overlooked reason for higher demand of gold is black money- which can be effortlessly employed in the gold and real estate.
Rising corruption also enhanced the demand for  gold bars (better known as Cadbury in local parlance due to its resemblance to chocolate) is a convenient way to park black money.Gold being  portable and less bulkier, can be easily stacked in a locker.

During raids and seizures it is now common to find gold bars from houses and lockers of corrupt and unscrupulous people.
Demand for gold coins and bullions which was 25 % higher in 2011 than 2010(as evident from graphs)  second this point.
Not only gold but diamond prices have jumped significantly but diamonds are generally used in very high value transactions.

What can bring down the gold price?

Huge new gold discovery or heavy gold reserve selling by official holders and big investors, could only be reasons for gold to go southwards but probability of the same is bleak.

2 Comments:

Ranita Sinha said...

A very informative post..solved a lot of my queries..thanks a lot for the upload..

Avadhoot Nasikkar said...

You're welcome :)

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