Should You Invest in Gold ?

Is Gold paving a golden path in future ?

The world seems much golden if you possess gold in your pocket. The history of gold and the desire to have gold in one’s portfolio goes back to ancient times and probably you may have heard stories of King Midas and his love for gold. Ask your parents or your grandparents and they would tell you their strong belief in having gold as their investment which passed on from one generation to another. However, the current era where we are now, Gold as a commodity is becoming a God Father of preserving value and hence is facing completely new demand dynamics and this article tries to explain one of the many reasons which will pave the future path for the demand of this Yellow metal.

Gold

The knowledge of Gold and its high ranking in the list of desirable investments goes backs to centuries. The shine of this yellow metal brings sparkles to both who want to possess it as an ornament or to back their financial balance sheets.

I might not be wrong to say that the biggest consumers of Gold reside in India, be it normal consumers like you and me who buy gold ornaments / jewellery to the extent we can afford or our dear central bank – Reserve Bank of India who in 2009 bought around 200 tonnes of gold to strengthen India’s financial position. When RBI went ahead to buy high huge quantity of gold, there were a lot of eye brows which were questioning this act considering Gold was quoting at its life time high prices (around $1050 per ounce). Within a year of this purchase, Gold again zoomed high up to approx $1450 an ounce. Have a look at the gold price movement for past 30 years. You may notice that a significant upside came post 2008 after the burst of global crises.

30 years price movement of Gold

You might be wondering that is 200 tonnes of gold is that material compared to the amount of gold which might be existing in the world. However, you may also want to consider that the total amount of gold mined till date is just over 165,000 tonnes (as at 2009) – which can be represented in the form of a gold cube measuring just over 20 meters dimension (each side). To give some perspective, an average production of Iron Ore per year is approx 2 billion tonnes. For any new gold being produced, about 50% goes into Jewellery manufacturing, 40% into investment and approx 10% for industrial usage. However, this trend may be rapidly changing in the future which a significant shift in the favour of using gold for investment purposes.

Why Am I Bullish On Gold ?

I am just reading the numbers as well what trend the financial systems are taking currently and their probably course of actions in the times to come.

Uncertain times

Our news media do a fantastic job in keeping us updated on the global crises in which we are in. It started with credit crunch and now the Sovereign defaults or the so called Euro crises. The later is actually changing the way most of the financial institutions and governments safeguard their assets. To explain it better let me take an example of a person John living in US who has 1 million dollars in his bank account. Till 2008 he trusted on companies and hence he used to invest his million into stock markets. With dwindling stock markets and the credibility of companies, he got worried and parked his funds into his bank account as fixed deposits. Sooner he realized that irrespective of the credibility of the banking system, they are getting hit by the credit crises and hence banks are no longer safe. He soon decides to park is funds into Government bonds which are considered the safest investment asset classified till date as a Government has never defaulted in repaying back the money. However, soon John realized that this assumption is no longer valid. Greece as a country is on the verge of default. Iceland has defaulted and the financial situations of other developed countries such as Portugal, Spain and Italy is being questioned.  He even couldn’t believe that the most prosperous countries in the world such as UK, USA and France were also looked with suspicion. Now John is completely lost as to whom he can trust to preserve the value of his million bucks. He can’t invest in Companies, Banks are not credible and even governments are defaulting. He gives a call to his friend in India – Amit who is in a similar dilemma. But Amit has a solution – he has put his trust in Gold which Indians consider safe haeven. Due to very limited supply of Gold (scarcity), gold has been preserving the value for households for centuries.

Flight to safety

John thinks that Amit has a point and goes to the near by gold dealer and invests his million dollars into Gold. John was just an example and the situation reflected by John is basically the situation in which all the major financial institutions and even the Governments are in. While Indians have been investing into gold for ages, Gold as an investment class has just entered into the minds of western economies just recently. Till the recent crises, western economies used to majorly invest their funds into Government bonds of AAA (triple A rated) countries such as USA, UK, France, Germany, etc. However, subsequent to the sovereign crises whereby every country is fighting hard to safeguard their credit rating, the governments as well as financial institutions are facing a question about preserving the value of their funds. Take an example if a big financial institution invested around $ 1 billion into Greek bonds and its value would have eroded by over 20-50%, it would have been devastated.

Gold Demand Structure

Gold demand is majorly classified into three categories.

Jewellery Demand : This is the biggest source for gold demand (around 50% of total demand) and includes gold used for watches, jewellery. It excludes demand for gold coins and bars. The two largest countries responsible for this demand is India and China. Total world demand for 2011 for Jewellery was 1,962 tonnes. India (567 tonnes) and China (1055) made up 82% of the total Jewellery Demand.

Investment Demand : is the next biggest cause of gold demand (approx 40% of the total demand). It includes gold bars, coins, ETF holdings, etc. Again, India & China are market leaders in creating Investment demand for the world.

Technology Demand : comprises of around 10% of the global demand. This primarily refers to the usage of gold for industrial purpose such as electronics, medical, dental, etc.

Have a look at the table below. It shows the overall world’s demand for Gold, broken up by different categories. You would notice that in 2002, Jewellery demand was 79% and Investment demand was approx 10% of the overall demand for Gold. These ratios were nearly maintained right upto the onset of global crises in 2007-08 which gave a big stimulus to the Investment Demand. Jewellery demand witnessed a steep fall and became 58% in 2008, 50% in 2009, 50% in 2010 and 48% in 2011 of the overall demand. Even in turns of actual tonnes, the gold demand for jewellery consumption came down.

On a sharp contrast, demand for Investment (reflected by Total bar & coins + ETFs) reflected a mind boggling increase from just over 10% in 2002 to over 40% in 2011. The major push came from 2008 onwards due to the global crises and the investor rush to safeguard the value of their funds.

source LBMA, Thomson Reuters & World Gold Council

Supply of Gold

Those who are familiar with the term ‘Elasticity of Supply’ may understand in one shot – Gold supply is price inelastic. It means that irrespective of price increase, the supply of gold being mined can not be increased quickly to match the demand. One of the fundamental factors which also affect the prices of gold is the difficulty in extracting gold from the depths of earth. I am not sure if it would surprise you that in order to extract it takes around 1 kilogram of gold bearing rock to be extracted to produce approx 1 to 4 mg of Gold. Hence to produce 10 grams of gold, a miner would need to extract approx 10,000 to 50,000 kilogram of Gold ore. With increasing prices of gold, the Gold miners are facing challenges to increase the production of gold.  The relative number of new gold mine findings are also not keeping in pace with the demand. Even the new finds are mostly to replace the existing stock of dying mines, hence not really resulting in increase of gold supply.

Foreign Exchange rate

This is also one of the important factors which influence gold prices, especially in developing economies. Gold is traded in international markets in US Dollars. Exchange price movements can easily add or shave 10-20 % off the prices of Gold ruling in the respective country. For example, have a look at the gold movement in different currencies. On a full year on year comparison, return in US dollars was 8.9%, but return in INR was 28.8%, an over 20% return due to the foreign currency movement.

Import Duty on Gold

While India manufactures some amount of Gold, but it is a big time importer of Gold and import duties end up affecting the gold prices ruling in the economy. 2012 budget has increased the custom duties on import of Gold from 2% to 4% which would directly result in Gold becoming 2% expensive in India. In the past you may be aware that huge amount of gold was smuggled into the country due to ban on import of gold for good part of 1970-1990s. Subsequently the import ban on gold was lifted in 1990s and an import duty of around 15% was levied on gold. During this time gold used to be cheaper outside India owing to the import duties and cost of importing gold. Over a period of time, the government reduced the duties to 2% and now it is ruling at 4% which made gold prices in India close to the prevailing prices in international markets, reducing the incentive for people to procure gold illegally from outside India.

Price Trajectory

Many of my friends and my contacts ask me as to where do I see the value of gold in the coming years as if I am a head Gold Trader in a major investment bank and my whims and fancies would result in moving the gold prices. I am not going to give any gold forecasts for a simple reason that I don’t want to be held accountable if the prices take an opposite direction. However, what I can mention is a few facts which can help an individual to do their own forecasts. Please refer to the gold prices chart in the article above. You may notice that post 2007-08, gold prices zoomed to their life time high and increasing with every passing year. It is the same time when the global uncertainty was and still is on its life time high. The prices of gold are very much related to the overall demand and supply of this scarce commodity.

More and more banks are now investing their funds into Gold to preserve the value of their funds and with even a minor allocation towards gold would result in extremely high demand for Gold. With a very limited supply of Gold, and increased demand for Gold, it would result in high volatility and increasing the price of gold.

If what I mentioned in the previous paragraph holds true and the Western economies start pumping their funds into Gold, I won’t be surprised that within 5 years gold prices are 3-4 times of what they are now. Probably at that time it would be out of question for a common man to possess gold !

You may want to hence start taking some exposure of gold in your investment portfolios. Luckily we have many options to invest into Gold today then our earlier generations had. Our article Different Options Of Investing in Gold details upon the next steps to get an exposure of the Yellow Metal.

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