Will Gold Save The Day?

After a seemingly unstoppable run for nearly 12 years, gold prices have sprung a surprise with a strong downward spiral. While on one hand, this has surely brought a smile to the consumer, on the other, it will also ease out pressures on the economy and the markets. Will money now move away from the hitherto safe haven gold and find its way into equities?

From households to the sovereign, gold has been a measure of economic wellbeing and wealth building for ages. Believed to never lose value, it is considered to be the best hedge against all uncertainties even today. In fact, look at any economic downturn and you will see that the metal has shone brightly in times of rising inflation or any kind of financial crisis. Be it in the 1970s when the Bretton Woods Agreement* was abandoned as well as the Iranian revolution and the Russian invasion of Afghanistan that happened then or the more recent financial crisis that erupted in the US following the sub-prime crisis and the subsequent fall of Lehman Brothers, gold has only seen a one way rise to the top.

Soaring gold prices have been a sore point from the macro-economic perspective, especially in the Indian context. Rising imports have had a negative impact on government finances. So much so that there have been specific measures put in place to ensure that imports are curbed. So, what does a decline in gold prices, particularly of the magnitude that has been observed over the past couple of weeks, mean in the entire economic setting? More so, how does it help the markets? Will money flowing out of this asset class really find its way to the equity markets? How will companies which have gold at their core as well as periphery of their business be impacted by what is happening to the price of the metal? Here are some answers that will help you decipher the most talked about economic phenomenon today.

*Bretton Woods System

Post World War II, the Bretton Woods Agreement was evolved at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire from July 1 to July 22, 1944. The system was introduced to establish a stable monetary and exchange rate system in the world. What followed the conference was the formation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development and, the proposed introduction of an adjustable pegged foreign exchange rate system, whereby currencies were pegged to gold. The IMF was also handed the authority to intervene where the balance of payments went awry.

The Bretton Woods system came to an end in 1971 after US President Richard Nixon did away with the dollar-gold link. By 1973, most large world economies realigned their currencies to be determined by market forces. The changeover was a stormy one, marked by inflation, failing banks, sharply declining stock prices and oil prices shooting through the roof.[PAGE BREAK]

The Trend So Far

Gold saw a huge rally post the dotcom bubble. People’s faith in bullion further increased during the financial meltdown in 2007-08 after and gold touched new peaks thereafter. Among the many reasons for this, the most important one is that the perception about gold being just a precious metal has changed to being a proper asset class and an alternative in times of adverse economic conditions. With the passage of time, it further changed in character and assumed the mantle of being a pure commodity.

Over the last three decades, gold prices have moved like never before. The currency crisis in Asia, financial crisis in USA and the debt crisis in Europe increased the faith in the yellow metal. Persistently high inflation and global political uncertainty saw gold prices soaring as high as USD 850 per troy ounce by 1980. But from that high, prices started cracking. By 1999, gold prices crashed to USD 251 per troy ounce. This was particularly because economic conditions were on an upswing throughout the world. After the dotcom bubble burst in 2000, business sentiment weakened and gold prices again started moving up. By this time, gold had become a financial commodity.

The Iraq war in 2003 further increased gold prices. By 2004, this had touched over USD 400 per troy ounce as fund houses bought into the metal as risk insurance for their portfolios. It was then that gold prices as well as equity markets started moving in the same direction. Gold usually behaves inversely to the equity markets but the hedging of the equity and currency portfolios using gold increased the demand, which in turn firmed up its prices.

A weak dollar and firm oil prices in 2006-2007 saw gold touching a 28-year high of USD 845.40 a troy ounce. Next came the housing bubble and the financial meltdown, which was predominantly blamed for the European debt crisis. In a bid to save the economies from collapsing altogether, money supply was increased. Investors’ confidence, however, took a huge beating as many banks globally had either filed for bankruptcy or had been taken over. The reduced risk appetite fuelled gold prices again, helping them up to USD 1000 per troy ounce for the first time in its history in 2008. The bailout packages, quantitative easing and higher inflation made sure that gold remained at lifetime highs for the next few years.

Recent developments on the gold price front have been rather startling. In a matter of just two days the metal has drastically lost value by as much as 11.3 per cent. So what has brought down the prices so drastically? And more importantly what does it mean for our economy and the markets? Will falling gold prices help perk up a sagging economy?

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Reasons For The Fall

“Objects in the mirror are closer than they appear” is a very apt summation of the current situation. Everybody was expecting that the law of averages will catch up with gold prices sooner or later. However, nobody expected it to happen at such a rapid pace and in such a steep manner.

According to a report by Goldman Sachs, gold prices are expected to fall to USD 1450 a troy ounce by the end of the year and USD 1270 a troy ounce by the end of 2014. Societe Generale, one of the largest financial institutions in Europe, was more accurate in its prediction of pegging gold prices at USD 1375. But the timing differed a bit from what they had said. The slide came in much earlier than what they were expecting. It missed the timing by almost eight months. Citi Private Bank also advised it clients to exit from the positions held in gold somewhere in December of 2012. Were there indications already in place of the prices coming down so fast and so furiously? What triggered such sharp fall in gold prices?

Although, the above targets for gold have been floating for a while now, the last nail in the coffin was the rumours of Cyprus selling some of its gold reserves to cut down the austerity measures and bring the country back from a financial abyss.

Per se, Cyprus's gold sale would be small as it holds just 13.9 tonnes of the metal as at the end of March 2013. What actually led to the fall is the fear that other heavily indebted Euro zone nations such as Italy and Portugal, holding a total of 2833 tonnes of gold as reserves, could also go to market with these. This fear worked in tandem with short positions which were already built in gold by some hedge funds, leading to such a sharp cut in gold prices. This view was echoed by Naveen Mathur, Associate Director – Commodities & Currencies, Angel Broking too.[PAGE BREAK]

However, in the long run it seems that the same reasons which have led to gold prices soaring will now be responsible for bringing them down. Gold is considered to be a safe haven in the event of any financial crisis or an economic turmoil. Its unique characteristics of being an alternative currency having no credit risk and serving as a benchmark against which the debasement of all other currencies is measured give it this coveted status.

Therefore, gold prices, which were rising at a normal rate and were around USD 600 a troy ounce ahead of the global economic meltdown, increased in a flash after the financial crisis. It peaked at USD 1900 a troy ounce in September 2011, and has declined from USD 1792 a troy ounce in early October last year to about USD 1380 a troy ounce now. The reason? The economic scenario is looking better, especially in the world’s largest economy, USA. Dr V K Vijayakumar, Investment Strategist, Geojit BNP Paribas Financial Services, explains the reasons for this crash.

Moreover, strengthening of the US economy will even strengthen the US dollar that will further lead to a downfall in commodities, particularly gold, which are denominated in USD.

Now, how does all this bode for the economy? If gold prices remain subdued and in fact go lower as is being predicted, the economies of developing nations are sure to benefit. This is more so in the case of India, which is the largest importer of gold in the world. Here is what we think will be the impact of lower gold prices on the economy.

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Government Finances On The Mend

In the last quarter (December 2012), India recorded its largest ever current account deficit (CAD) in any quarter. It stood at 6.7 per cent of the GDP. On an absolute basis, the CAD stood at USD 32.63 billion for the three months ending December 2012, up from USD 22.3 billion for the September 2012 quarter and USD 20.16 billion for the December 2011 quarter. One of the prime culprits for such a large deficit was the huge import of gold.

The metal is the second largest imported commodity in India after crude oil. What is important to note is that, it has been consistently rising over the years both in relative as well as in absolute terms. The share of gold in the total imports has increased from 7.3 per cent at the end of FY06 to around 10 per cent at the end of 9MFY13. Even in currency terms it has increased by more than three times during the same period to touch USD 42 billion. Most of such increase is attributed to the rise in gold prices, as the import of gold in tonnage has remained almost stagnant, varying in the range of 800-1000 tonnes in the last few years.

For example in 2010, total gold imported by India stood at 851 tonnes and this increased to 969 tonnes in 2011. But then, it dropped to 864.2 tonnes in 2012. Therefore, the sharp rise in the prices resulted in a big hole in the government finances. In the last four years ending 2012, gold prices have almost doubled from an average of USD 972 a troy ounce.

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The government did try some options earlier to reduce this import, but it failed to achieve its objective. In the month of January 2013, in a desperate move to curb gold imports, it raised the import duty from four per cent to six per cent. Although, there was a slight drop in gold imports, it was mainly due to the heavy buying that had already happened in the month of December foreseeing government action.

Considering all this, the recent decline in gold prices spells much relief for the government, which is struggling to mend its finances. Assuming that gold prices remain at current levels and India still continues to import around 800 tonnes of gold, a few points of improvement can now be expected in the CAD. However, it will be naive to believe that imports will remain at such elevated levels especially after gold losing its safe haven status for investments.

According to a report by the World Gold Council in the year 2012, out of total gold imported by India, almost 37 per cent was for investment purposes and the rest was for jewellery. Therefore, we may see some decline in the quantum of imports too. This will further narrow down the current account gap. According to V Balasubramanian, Vice President & Fund Manager, IDBI MF, “The CAD can come down to 3.5 per cent, and if it continues this way for the entire year, it will come down considerably”.

Besides this, the fall in gold prices along with a declining crude will help in bringing down imported inflation. This will give the apex bank (RBI) much more elbow room to lower interest rates.[PAGE BREAK]

Impact Of Price Decline On Listed Companies

Any discussion without an impact analysis on the markets will be futile. There are many companies that totally depend on gold for their business. Yes we are talking about the companies like jewellery manufacturers as well as retailers, banks that provide gold loans and last but not the least the non baking gold loan companies that have managed to post strong growth since the yellow metal consistently witnessed an upward trend.

The worst of the lot to be affected by this steep fall in gold prices will be the non-banking gold loan companies. The reason being that gold loan companies have never been so big, gold prices never so high, and gold loan companies have never had such huge overheads. 

Over the past few years, the non-banking gold loan companies have witnessed exponential growth. The asset sizes of these companies have grown geometrically. The emergence of this lot of companies as an organised sector has happened a little over the past five years. This would be the first big jolt to them since gold has only moved up over the past decade. Will they be able to cope with the situation?

Well, the answer to this question is a fairly obvious one. Delinquencies will increase as gold prices fall. However, George Alexander Muthoot, Managing Director, Muthoot Finance expressed a different opinion on the subject when he spoke to us.

But this segment is just a fraction with only a couple of players in the fray. What is more important is to gauge the impact on other players like banks who have entered this business.[PAGE BREAK]

The gold loan portfolio of the larger organised banking sector is hardly a matter of worry. It would neither impact the banks nor have an implication on the gold prices even if these banks were to sell their holdings to recover delinquencies.

Most jewellery players have been affected. Historically, whenever there has been a decline in gold prices, jewellery demand has increased even during periods which are not really times for buying the metal (read auspicious periods). And the present trend is not different. Hence, rather than playing negative, the fall may help companies like Gitanjali Gems, TBZ, Shree Ganesh Jewellery and Titan (Tanishq) to witness higher volumes.

As regards losses on inventories on account of a fall in gold prices, we feel that the companies have very little, if anything, to lose. When we spoke to Sanjeev Bhatia, President – Finance, P C Jeweller, he seconded this view. Overall, it is clear that the impact of volatility hardly impacts the retailer.

In contrast, it will help jewellery companies following this model. Bhatia explains, “A drastic reduction in price thus reduces the overall outstanding with the bullion bank. This benefits PCJ in two ways; one by freeing up capital and two, by reducing the interest payment on the lease”. However, falling prices may impact the margins as the making charges tend to decline. Apart from these marginal losses, we do not expect any major impact on the gold retailers.

Overall, declining gold prices surely mean good news in the economic context. On one hand, there will surely be an improvement in government finances, and on the other, money will now begin to find its way into the equity markets. While gold dealers grapple with a declining price trend, consumers and economists will be laughing their way to the coffers.