Gold has been the trade of the decade. Buy the dull metal against almost anything: stocks, currencies, debt, anything but 'precious commodities', i.e., commodities in short supply because India or China is a big incremental user of it. Gold's relative movement has always been accompanied with lower risk or volatility and it has always given higher risk-adjusted returns. Importantly, gold was the best place to be in during the desperate days of late 2008 to early 2009.
Does it deserve such a standing in the world of investment? It has no productive use; the only feature that speaks for it is that its (incremental) supply is not in human hands. If some alchemist could suddenly find a way to produce gold, it would have disastrous consequences for the world economy. The US dollar used to be the world's 'gold' for a while, until fiscal and monetary indiscipline by the custodians of the dollar's reputation brought it to its current pass.
So has gold reached bubble territory? A bubble happens when asset prices rise, with a corresponding rise in debt levels, used to buy or hold the asset. In case of gold, its price is rising at a time when worldwide leverage is falling, especially in the developed countries. So the most important defining condition of bubble territory is not met. Hence, you should not expect a sudden collapse in the price of gold, as happened in the mid-eighties. But you can expect (and should be prepared for) a slow letting out of air, as its movement relative to some other assets (principally currencies) shows a drop in outperformance. This might even look like a price drop, especially if you think nominally (i.e. in terms of the home currency, say, Euro or rupee), but it will not be a bubble collapse.
Gold does well when governance does not. When Nixon delinked the US dollar from gold, he gave unlimited cheque-writing powers to the US Fed. This power got progressively misused, but there was some forbearance, until Greenspan happened. Then came 'helicopter Ben', who may have had no intentions of actually dropping dollar bills from helicopters, but was forced to do virtually that, since he took over as Fed Governor. It took almost a generation, 30 years, for its reputation to build up, but the US dollar today is a shadow of its former self, in terms of credibility versus gold.
Has US fiscal and monetary credibility reached its nadir? Is it time to buy this 'value pick' called US credibility? Is the US so chastened that it will give up its entitlements, stop running a (budget) deficit and get its public debt in order? Already, individual Americans are behaving better, domestic savings are up, and private sector leverage is falling. But it will take time to work away the excesses of the past.
The US government, however, continues to try and spend its way out of trouble. It is trying to replace falling private (domestic) demand with more debt-fuelled government spending. Even as tax revenues fall, and the government's revenue deficit balloons, its public debt ratio is going to double in the next three years. Yet the US government is not ready to clamp down because its bond markets have not revolted…yet.
So the drunkard is still at the bar, quaffing his 14th peg, and asking for more. The bartender is worried on both counts: can this customer pay his bills, and can he stand steady enough to go home? At some point in time, the bartender will call in the bouncers, usually the foreign country that is subscribing to the deficit in the bond markets. China puts in 8 per cent of its 55 per cent savings rate into US bonds. That is not a small amount, even though it is reducing steadily.
Which brings me to the central question of this column. Gold has to be sold, simply because it has gone up for too long. Maybe it has still not gone too far, but it has gone up for too long. It should be time to worry now.
So where in the world has governance reached its nadir? That would be the country or currency to buy against gold. Let me try a hypothesis: it could be Greece, maybe Argentina (which has twice gone to the cleaners). Who else has a bankrupt government, no tax revenues, huge government spending and banana republic politics which is all set to change? In effect, if Bihar was a separate country with its own currency, that is what I am looking for.
To make the picture even clearer, I am looking for “the next Indonesia”. Remember Indonesia in 1997: a tinpot dictatorship, huge spending imbalances (both private and public), large real estate investments, all funded with short-term foreign borrowings. The result: food riots, and a currency that went to nothing. An 83 per cent drop in nominal currency rates against the US dollar led to a monthly 83 per cent drop in GNP, and a cumulative 43 per cent drop in per capita GDP. Interest rates went to 65 per cent: in other words, a Great Depression that ensured that in 2005 the economy was still smaller in PPP terms than in 1997. No ageing population, no structural deficiency in demand, yet enormous political and economic upheaval, that will stay embedded in the psyche of its populace (and its politics) for at least a generation to come.
India went through something much smaller but similar in 1991. Remember the loan melas of the eighties and the subsequent NPA crisis of India's banking sector? From that nadir, which hit us 20 years back, we now claim to have one of the most stable banking sectors in the world, a level of prudence that you don't see elsewhere in Indian business or politics.
So great disasters create huge psychological scars, which create sudden, corrective behaviour in populations: in 2008, 10 years after the Asian crisis, nobody even whispered about Indonesia. In the US, Paul Volcker took over as the Fed governor shortly after the 1982 recession. The hardliner governor, who took Fed Funds rates to 14 per cent in order to combat inflation and bring it down from 12.8 per cent to 3.5 per cent, is an example of how human behaviours can change dramatically and diametrically (opposite). The profligacy of Indonesia has been replaced by fiscal and monetary prudence, even as the “next thing to gold, i.e., the US dollar” is a picture of fiscal and monetary imprudence.
These contradictions have been captured in the concept of “the historical process” enunciated by George Soros. One of the behavioural rules of “the historical process” is that every (behavioural) trend reaches an irrational crescendo before dying out completely, or reversing 'permanently'. The Nazism of Germany was followed by democracy for the next three generations. Lebensraum is now a dirty word in Germany. The Berlin Wall came down under one of the most Stalinist leaders of Communism, one who spent his entire life in the KGB. For a generation, India (and Asia) has been terrified of a forex crisis, which has pushed up savings rates and the propensity to export (forex) surpluses, either through capital flight or through central bank investments.
So what is the answer to the questions I have posed at the beginning of this column? I do have an (instinctive) answer, but I want to arrive at it through a structured process of exploring all viable alternatives.
Somewhere among the basket cases of government imprudence lying around the world is a country that is going to come back very strongly. That country has some intrinsic competitiveness, but has got 'caught in the crossfire'. Either it was growing, investing into capex at the wrong time, and suffered an asset-liability mismatch, which has driven it to insolvency (Iceland? Ireland?). Or it had too much savings, and lent it to the wrong part of the world (Austria? China? Japan?)
Such a country would be now gritting its teeth and putting in place an attitude towards savings and investment (or borrowing and consumption) that will see its governance improve dramatically. It would help if the said country was currently in serious crisis, because its currency and bond markets would reflect that. Otherwise, there is no point in taking a contrarian position on gold (i.e. sell it). If you buy gold, at least you will be rich(er) in dollar terms; so what if the currency is discredited by the end of the decade? You can always shift to the US and enjoy yourself.
This article was originally published on October 01, 2010.
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