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Sunday, Jun 23, 2002

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Is the glitter for real?

Aarati Krishnan

AS GOLD prices in the international markets sailed past the three-year high of $326 per troy ounce early this month, the event divided investors into two warring camps. On the one hand are the inveterate gold enthusiasts cheering the "second coming" of the yellow metal and predicting that prices may breach $650 or even $1000 per ounce in the coming months.

On the other are the diehard sceptics who see the recent surge in gold prices as nothing more than a temporary boost, and predict that gold will soon retreat to $280-290 levels. Both sides appear to have fairly strong arguments. But the fundamentals of gold appear to tilt in favour of the sceptics.

The gold lobby sees the recent surge in gold prices as a reaffirmation of the investor's faith in gold. They point to the terrorist attacks of 9/11, the resurgence of militarism in West Asia, the recent stand-off between India and Pakistan, and the seemingly unending economic crisis in Japan.

They assert that the recent surge in gold prices shows that investors have lost confidence in "paper" money and are thus turning to "real" assets such as gold to strengthen their portfolios. They stress that the recent ebullience in gold has done its bit to restore the yellow metal's tarnished image as a "safe haven" investment.

In contrast to gold's heady rally to $700 levels during the oil crisis of the early 1980s, prices have failed to pull out of a secular downtrend even amid the wars and the economic crises of the 1990s. The Gulf War of 1990-91 and the South-East Asian economic crisis of 1997-98 failed to spark any sustained rally in gold prices.

For much of the 1990s, the continuing strength of the dollar and the booming equity markets ensured that gold remained a poor investment alternative for individual and institutional investors.

If investors have indeed turned to gold this time round, this is probably because returns from alternative investment avenues are on the wane. The technology stock meltdown and the series of scams (Enron, Global Crossing) have undermined investor confidence in stock markets, especially in the US. And slowing economic growth in the US has weakened the dollar.

Sluggish economic growth in Europe and elsewhere have made these currencies less desirable investment options. While these factors have prompted investors to shift from other asset classes to gold, a reversal in any one of these factors can also reverse the gold rush.

Viewed solely on the basis of its fundamentals as a commodity, gold prices appear to rest on fragile foundations. In 2001, the annual demand for gold at around 3,200 tonnes outstripped production by roughly 25 per cent. Such a gap between demand and output would lend strength to any normal commodity. But not so for gold.

This is because the annual consumption of gold is dwarfed by the mammoth above-ground holdings in and outside the official sector (the gold reserves lying in central banks and IMF vaults). The central banks and the IMF together held 32,600 tonnes of gold in the beginning of 2002.

Non-official stocks of gold are estimated to be even larger, at around 1 lakh tonnes. Over the past five years, the official sector has liquidated around 1,200 tonnes of gold, shifting to more lucrative investment avenues in the currency and derivative markets.

Even if only a small part of the above-ground holdings are likely to be dis-hoarded, this is a large potential source of supply and, thus, a perpetual destabilising influence on gold prices.

Of late, certain supply side factors have supported gold prices. The Washington Agreement of 1999, in which 15 European central banks promised to curtail their sales to roughly 400 tonnes per year until 2004, has helped hold off the bogey of unexpected central bank sales to some extent in the past two years.

But it would be wrong to see this agreement as a reaffirmation of the central banks' faith in gold as a reserve asset. Rather, it should be seen as a pragmatic effort by the central banks to protect the value of their residual gold holdings. After all, the central banks do have a vested interest in maintaining stability in the gold market.

Predictable and orchestrated sales would ensure that the central banks get a better price at the time of sale and also protect the value of their residual reserves (which still hold significant gold stocks) by preventing a sharp plunge in gold prices.

Low gold prices have also moderated mining activity, with the mine output of gold increasing negligibly between 1995 and 2001.

However, if supply-side factors favour a firm trend in gold prices, they could well be undermined by weakening demand. Over the past decade, the demand for fabrication of jewellery has emerged as the most important determinant of the offtake.

Gold demand for investment purposes has paled significantly. In 2001, for instance, 88 per cent of the demand for gold originated from fabrication, with just 12 per cent bought for investment purposes.

In contrast to investment demand for gold, which may rise in periods of rising gold prices, fabrication demand is quite price-sensitive.

In India, the largest consumer (India accounts for a fourth of the global offtake), gold demand plunged by 40 per cent in the first quarter of 2002 as gold prices rallied by 8 per cent.

West Asia, another large consuming centre for gold is also a price-sensitive market, where the resistance to a sharp spike in prices would be high.

In fact, in these key markets a sharp spike in the gold price usually leads to dis-hoarding or the liquidation of gold holdings by consumers.

Like any other consumer good, fabrication demand for gold is also income-elastic and depends on disposable incomes and economic prosperity in the consuming country.

Therefore, any economic slowdown in the US or the Eurozone is likely to shrink demand from this region as well. Demand from this region (which accounts for another fourth of total offtake) has already shrunk around 6 per cent over the past three years.

All this tends to weaken the argument that gold prices will head for the stratosphere if a major part of the world economy sinks into a recession.

For lay investors wondering if they are missing out on the next big investment idea by refraining from buying gold, these are risks worth considering.

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