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Gold -- no longer a store of value

Mumbai, Sept 19: Gold is widely believed to be a safe long-term investment and a good hedge against inflation. However, international prices of gold have been on the decline recently due to variety of reasons (refer to Note on international gold price movements). This in turn has affected domestic gold prices which have been moving in tandem with international prices, post the repeal of The Gold Control Act in 1991 and gold imports being allowed on payment of import duty.

The principal theme of the article is to argue that gold no longer serves as a store of value and a hedge against inflation.

Gold as a store of value

Consequent to the fall in the price of gold internationally, gold has dropped from its position as a long-term store of value and a hedge against inflation. Average inflation rates are higher than the compound annual growth rate (CAGR) of gold prices (in blocks of 5 years), both internationally and in India.

Global Scenari

  • From 1980 onwards, the average globalinflation (seen in blocks of 5 years) was consistently higher than the CAGR of gold prices in these years.
  • The major international consumers of gold in 1998 were India (30 per cent share in global demand) USA (16 per cent share) and China (12 per cent share). A comparison between inflation levels and international gold prices shows that in the case of the USA starting from 1980 onwards the increase in gold prices was lower than the increase in inflation rate. The only exception is the 1985-1989 block when the US economy showed a recessionary trend.

    While UK is not a major consumer of gold, a comparison of movement in its gold prices and inflation rates have been made as the country plans to offload a portion of its official gold stock. For UK gold ceased to be a hedge against inflation consistently from 1980 onwards. This is true also of China from 1990 onwards.

    Indian Scenario

    A comparison of gold prices (in the Mumbai market) to the average WPI and CPI inflation seen in blocks of 5years, shows that only from 1990-91 onwards the average WPI and CPI inflation has been higher than the gold price movements. This is in contrast to the rest of the world where the process took place nearly a decade earlier. This can be explained by the fact that gold imports were restricted upto 1991 by the Indian Government and therefore movements in international gold prices were not totally reflected in the Indian markets. Post 1991, when gold imports were liberalised by the repeal of the Gold Control Act, domestic prices have been benchmarked to international prices.

    Erosion of wealth

    The fall in the price of gold has led to an erosion of wealth of Indian households in the period from January to June 199. Various estimates indicate that in India around 10,000 to 14,000 tonnes of gold are being held in the form of jewellery or as liquid gold.

  • The local gold prices have dropped from Rs 4330/10 gm in January 1999 to Rs 4125/10 gm. in June, 1999, a drop of Rs 205 for every 10 gms. Assuming aconservative figure of 10,000 tonnes for the stock of gold held within India, this implies an erosion in the value of holdings by Rs 20,500 crores. However, this may be more pronounced in the rural area where people tend to save more in physical assets rather than the urban aredas where there are various alternatives for savings.
  • Out of the various types of assets held by Indian households, gold is the only asset which can be valued at an international price. No other asset such as real estate or stocks can be valued in dollars. The international dollar price of gold has fallen from $285.4/troy oz in January 1999 to $261/troy oz in June 1999, or a drop by $24.4 per troy oz. Assuming a stock of 10,000 tonnes the value of the gold holdings have depleted by $7.8 billion.

    Falling gold reserves of global central banks

    Value of gold as a percentage of total reserves of central banks globally has declined during the period 1993 to March 1998. While Central Banks have offloaded only 40 mn troyounce, that is 4 per cent of their gold holdings from 1993 to March 1998, in value terms the drop amounts to around 25 per cent in the same period.

  • The share of gold holdings in total reserves has declined steadily since 1993, falling from 25.5 per cent in 1993 to 14 per cent in March, 1998 whereas in the eighties the average holdings of gold were around 44 per cent. This indicates the increased importance attached to hard currency assets by monetary authorities worldwide - hard currency assets have increased from 75 per cent in 1993 to 86 per cent in March 1998.
  • The market value of the stock of official gold reserves held by monetary authorities has been declining. The CAGR of the value of gold (at London prices) between 1993 to March 1998 was - 5.4 per cent while the CAGR of the stock of gold holdings was - 0.9 per cent. This indicates that the fall in the relative share of gold reserves in Total Reserves was more due to a fall in the price of gold rather than dishoarding of physicalquantity of gold by the central banks.
  • Considering that around 880.5 mn. troy oz of gold is still held by the central banks worldwide, there is a potential of further drop in the value of gold assets in foreign exchange reserves.

    Gold Holdings of RBI

    Consequent to the fall in the prices of gold, the gold reserves of RBI has also been declining over the years. The status of gold in RBI's overall foreign exchange reserves has fallen due to a fall in the valuation of gold and due to an increase in foreign currency assets.

  • Gold accounted for around 34 per cent of the total foreign exchange reserves of the country in 1992-93 and this has dropped to only 9 per cent during 1998-99. A further drop is seen in the financial year so far when the value of gold dropped by $254 mn (or by 8.5 per cent) till July 16, 1999, owing to the revaluation of the gold assets with RBI consequent to the fall in the prices of gold internationally.
  • RBI had recently been contemplating using its goldreserves more productively by on lending it in the international market. A drop in the price of gold would however, diminish returns to RBI from such a move.

    International Gold Price movements

    The international movement in gold prices is analysed in two parts--first the annual movement in prices from 1970 onwards till 1998 and second, the recent monthly movements in prices starting from January 1999 till date. The graph indicates that after reaching a peak in 1980-81 at $585/troy ounce, the price of gold has been steadily falling. The fall in the gold prices is particularly sharp in the last two years. Gold prices fell by 15 per cent in 1997 and further by around 8 per cent in 1998.

    The fall in prices can be attributed to:-

  • Drop in demand in India, SE Asia, China, Saudi Arabia and the Gulf States. The fall in demand in India can be attributed to a drop in the disposable income subsequent to the relatively poor agriculture performance in 1998 coupled with the fall in industrialproduction. The East Asian demand was affected due to the currency crisis in these economies. The Korean and Thailand governments urged investors to sell their gold for US dollars in order to restore foreign exchange reserves. Demand in the Gulf region was affected by the falling oil prices during 1998.
  • Offloading of gold reserves: Apart from the above factors, gold prices have been falling over the past couple of years due to expectations that various central banks would be offloading a significant portion of their gold holdings. Countries such as Belgium and the Netherlands have been steadily selling their gold reserves for the past four years in the run-up to the EMU. During the last two years offloading of gold by Australia, Austria and Argentina have also led to an increase in supply, affecting prices.
    In the period from January 1999 to end July 1999, gold prices have dropped by a further 12 per cent. Gold in the London market is now quoted at $254/troy ounce, compared to around $287/troyounce at the beginning of the year. Offloading of gold by various central banks and expectations of further offloadings have kept the prices depressed.
  • On May 7, 1999, UK announced plans to sell around 60 per cent of its gold reserves, in order to achieve a better balance in its portfolio by increasing the proportion held in currency. The sales of 25 tonnes of gold by the Bank of England in its first tranche effort (July 6, 1999) to cut its reserves to 300 tonne from 715 tonne led to gold prices dropping to a 20-year low. This sale would be followed up by further 25 tonnes sales in September 1999, November 1999, January 2000 and March 2000.
  • The Swiss authorities have also indicated their plans of offloading1300 tonnes og gold.
  • IMF has indicated that to help the organisation in supporting the debt relief packages and the low interest loans to poor countries, it would sell around 10 million ounces of gold, or just under 10 per cent of its 103 million ounces of gold stock.

    Thisarticle is reproduced from Crisil Alert, a Crisil publication

    Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.

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