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Lustre Undiminished

Gold's nearly 10-year-old bull run continues. What is driving prices higher? And should you invest at today's high levels?

In recent times gold has constantly been in the news for scaling new peaks. It is therefore important to understand the dynamics of the gold market in India.

Most of India’s gold needs are fulfilled through imports. Hence India is basically a price taker: domestic price is determined by the price in the international market. An additional factor also comes into play: movement of the rupee vis-à-vis the dollar. If the rupee appreciates, then Indian investors get to buy the gold at a better price than buyers in international markets, and vice-versa.

Let us now examine some of the factors that have driven the price of gold up in the international market in recent times:

Factors driving demand
Faltering global recovery and quantitative easing. With the global economy expected to slow down in the second half of 2010 and the first half of 2011, central banks of several advanced countries have decided to provide a fresh dose of stimulus in order to drive growth. The US Fed has already announced a $600 billion bond purchase programme aimed at lowering long-term interest rates. The Japanese central bank has engaged in unsterilised purchases of foreign exchange, which is expected to result in the depreciation of the yen and thus provide a fillip to its exports.

Quantitative easing, the high US trade deficit, and high level of its debt are expected to put further pressure on the US dollar. And when the US dollar declines, gold does well as a lot of funds flow into this asset class.

Second, it has become clear that western central banks will stick to an accommodative monetary policy until growth becomes firmly entrenched. This has given rise to fears of inflation in the medium term. Gold has for long been regarded as an effective hedge against inflation. That is another reason why demand for the yellow metal has been strong.

Purchases by central banks of emerging markets. Most central banks keep their foreign currency reserves in the form of a basket of currencies and gold. But with some of the major reserve currencies such as the US dollar and the euro expected to perform poorly in the near future, central banks of emerging economies are keen to shift more of their reserves into gold. During the third quarter of 2010, the central banks of Russia, Bangladesh, and Thailand purchased gold. This again helped to firm up its price.

Buoyant jewellery consumption in China. Jewellery demand depends on economic conditions (it is higher in good times) and the price of gold (lower when price rises high). Jewellery demand in Asia and in the Middle East has been affected by the high price of gold in recent times. However, in China jewellery demand has remained robust. Recently the People’s Bank of China announced a programme called “Proposals for promoting the development of gold market", which signals that the Chinese government is likely to support the growth of the gold market.

Demand in India surging to pre-crisis levels
India is the world’s largest market for gold. In 2009 the total demand for gold fell to US $19 billion or Rs 974 billion (equal to 15 per cent of total global demand). In 2010 India’s gold demand is expected to recover to the pre-financial crisis level. Over the past 10 years India’s demand for gold has been increasing at an average rate of 13 per cent per year.

All over the world, demand from retail investors can be categorised into jewellery demand and investment demand. The Indian market is unique in that here gold jewellery is also purchased as a form of investment (though that’s not a smart thing to do).

At 30 per cent plus, India’s savings rate is among the highest in the world. Of the total savings 10 per cent gets invested in gold. A favourable demographic profile (young working population), rapid economic growth and rising per capita income are factors expected to drive the demand for gold in future.

In 2009 the Reserve Bank of India (RBI) purchased 200 tonnes of gold from the International Monetary Fund at a time when the price of gold was perceived to have run up considerably. According to a report from the World Gold Council, RBI’s purchase reinforced the belief among retail investors that gold remained a sound investment even at recent high prices. Thereafter, investors have revised their price expectations upward.

Drivers of demand
Jewellery demand. In 2009 jewellery demand accounted for 75 per cent of total demand for gold in India. Although India is the largest consumer of gold, per capita consumption of jewellery in 2009 stood at only 0.4 grams, a reflection both of the country’s large population and low per capita income. Given this low level of per capita consumption, there is still a lot of scope for jewellery consumption to increase.

In the first half of 2010, India’s jewellery demand was 272 tonnes, an increase of 67 per cent y-o-y. Despite the high price of gold, market sentiment in India remains positive. Over the past couple of years, the local market has also benefited from the strengthening of the rupee against the US dollar.

Investment demand. In 2009 investment demand accounted for 23 per cent of total demand for gold. In the first half of 2010 total retail investment demand amounted to 93 tonnes, which was 264 per cent higher y-o-y. Gold’s ability to act as a hedge against the decline of the US dollar, its role as a hedge against inflation (which remains stubbornly high in India), and high risk aversion (in the wake of the losses suffered by investors in 2008-09) are some of the factors responsible for high investment demand for gold.

The availability of a wide range of investment products, such as gold coins and bars and gold exchange traded funds (ETF) has also encouraged investment demand. By the end of August 2010, total holdings in gold ETFs amounted to 11 tonnes, up 77 per cent y-o-y. ETFs appear to be catching on in India after a relatively slow start.

Industrial and decorative demand. Decorative and industrial demand accounted for just 3 per cent of total demand in 2009. Most of the demand comes from the use of jari, a gold thread used in the weaving of wedding saris. With the price of gold rising high, demand for jari has declined with artificial jari being increasingly preferred. In addition, demand also comes from the electronics manufacturing sector located in and around Bangalore.

Gold imports. India currently produces only 0.5 per cent of the gold it consumes; the rest is imported. In 1992 India imported Rs 8,800 crore worth of gold. By 2009 this figure had risen to Rs 88,100 crore, an increase of 1,015 per cent.

Recycled gold. Since 1992 Indians have recycled an average of 92 tonnes of gold per annum. But in 2009 the supply of recycled gold rose to 116 tonnes. This was owing to the high price of gold and the difficult economic conditions prevailing then.

Altogether the total stock of gold in India is estimated at about 18,000 tonnes, which represents 11 per cent of total global stock. Hence recycled gold will remain an important source of supply even in the future.

Should you invest in gold now?
This question is best answered by adopting a portfolio approach. Financial planners suggest that gold should constitute about 5-8 per cent of a long-term portfolio for its many benefits: diversification benefit on account of low correlation with other asset classes, safe-haven investment, hedge against inflation, and so on. They do not advise a higher allocation since despite gold’s 10-year bull run, there are also long periods during which its returns barely beat the long-term average inflation rate (around 7 per cent in India). If your portfolio does not hold 5-8 per cent gold, this is as good a time as any to buy the yellow metal. Since in a long-term portfolio you are likely to hold your purchase for 10 years or more, do not let the current high prices deter you.

If on account of the recent run-up in its price, the proportion of gold in your portfolio today exceeds 8 per cent, sell and bring the allocation back in line.

How to buy gold?
If you are buying gold primarily as an investment, then do not buy it in the form of jewellery. You will have to pay making charges when you buy it, which could push up the price by as much as 25 per cent higher than the price of bullion. And when you go to sell it, the jeweller will deduct the making charges. He will also dispute the quality of gold. Instead buy it in the form of bullion — either as gold bars or gold coins. Financial planners suggest that you go to a well-established jeweller and ask for gold coins certified by banks. If you buy from a bank, it will charge you a premium for the same coins.

Buying gold in the form of units of exchange traded funds (ETF) has gained popularity in recent times. The advantage here is that the purchase process is easy: all you have to do is call up your broker or place the order online. And you don’t have to worry about theft. The purchase cost is as follows: you pay the stock broker’s brokerage fee (30 to 50 basis points) and in addition you pay the ETF’s annual expense ratio. However, when you buy gold in the form of a financial product, remember that it will not serve the purpose of a contingency reserve in extreme circumstances (war and other extreme situations such as the Partition when people had to flee with their holdings) as the financial markets may close down in such circumstances (such situations are admittedly rare). For gold to serve its purpose as preserver of value of last resort, it will have to be purchased in the form of bullion.