Gold: The glitter and gloom

Reshma Krishnan

GOLD was the metaphor for wealth.

In many parts of the world, it is still so. It was also once the preferred hedging instrument against inflation. Post-September 11, gold prices soared 6 per cent when the rest of the markets plunged. Yet, it is no longer the preferred investment option. Why has this once-coveted form of wealth lost its lustre? Why has it fallen almost 40 per cent in value since 1996? Why have capital market instruments replaced gold as choice of investment? Is there hope yet for the yellow metal? Is it still a safe investment from a long-term perspective?

The most visible trend is of stagnating and crashing prices. The world gold demand is inching forward. It has increased about 18.4 per cent since 1996, growing from 2,779.5 tonnes to 3,293 tonnes in 2000. The first two quarters of 2001 showed an increase of one per cent over the first half of 2000. This year-on-year increase of 1-2 per cent has been the trend the last few years. A positive is that this is the first steady increase for the third consecutive year since 1996. But the growth has been marginal and not strong enough to change the trend.

India is the major consumer of gold, accounting for about 25 per cent of demand. It is followed by the Americas (North America, Brazil, Mexico) and then Greater China (China, Taiwan, and Hong Kong). India's demand growth has been strong, rising 50 per cent since 1996, as has been the Americas'. But the combined growth of 55 per cent recorded by these two was offset by the steep fall in demand from Japan, Thailand, Indonesia, and Greater China. This also means a reshuffling of demand.

One reason for the fall in the demand from South-East Asia was the crisis of 1998, which led to liquidation of gold holdings totalling over 200 tonnes. This destabilised prices. Demand has also started waning in Europe and the US. The trend indicates low interest in investing in gold.

Why? The returns from gold have not matched that from other investment avenues. The stock market was definitely a more attractive prospect in 1998. The demand for any investment is predicated on its ability to deliver returns, and gold has failed on this parameter. A look at gold prices since 1980 clearly demonstrates this.

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The price of gold has fallen 28 per cent since 1996 and a whopping 54 per cent from its high of $612 per troy ounce in 1980. After its all-time high in 1980, gold traded for eight years in the $350-450 range. Around 1997, it started falling. Many called it a correction. But it was more a bubble. The 1970s and the early 1980s belonged to gold, but when investment demand waned, it fell to the $250-270 range.

Even the South-East Asian crisis failed to pep up gold prices, as the bull run in the equity markets of the West lured investors to equity. The same happened in India too.

Compare the return on gold prices to the Nifty in the bull market of 1999. Between the first quarter of 1996 and the last quarter of 1999 -- when the Nifty touched its all-time high -- a Nifty stock would have fetched a return of 63 per cent, while gold lost 25 per cent.

Why are prices falling?

Theoretically, gold prices should be soaring. The reason: Supply shortfalls. Over the past 10 years, the annual production of gold, including scrap sales, fell short of the fabrication demand for gold by a cumulative total of 2,764 tonnes. This is more than one year's total supply of gold from mining. On an average, the deficit amounts to 276 tonnes per year, 12 per cent of the average annual mine production. In fact, in 1997, the supply deficit reached 796 tonnes -- a whopping 32 per cent of that year's total mine production. So why are gold prices not soaring?

Gold prices did not increase in line with the supply deficit. In fact, from 1994 to 1997, the supply deficit increased 348 per cent while the international gold price declined 14 per cent. Since 1996, the gold price has dropped as much as 40 per cent. While domestic prices too have seen negative returns, falling almost 16 per cent since 1996.

**Unlike commodities such as oil or cotton, gold stocks do not diminish. This, in turn, leads to excess availability. Though production is actually lower than annual demand, availability of gold far exceeds the annual demand. Look at the investment holdings of gold funds and large central bank gold sales in the last few years.

In 2000, for instance, the UK Treasury's plan to offload 415 tonnes of gold as part of restructuring its portfolio impacted adversely on the market. In September 2000, the Bank of England auctioned its gold at $255.75 per ounce, and this put a great deal of pressure on the prices. Switzerland is now set to offload 1,300 tonnes (350 tonnes have been sold).

Gold as an investment

What is the future for gold? To present a balanced picture, the returns on gold during bear runs (like the recent one in the market) since the beginning of this year were analysed. And true enough, gold acted as a hedge against losses because while the Nifty fell almost 45 per cent since its high of December 1999, gold prices remained the same. Domestic prices have, on the contrary, gone up 9 per cent.

The surge in gold price because of the recent terrorist attacks is partly responsible for this.

The role of gold as a hedging instrument is based on economic theory and is debatable. But it is useful to those who have large portfolios and require hedges to balance them. From a long-term perspective, it does not look like there is going to be a tremendous increase in the demand for gold. With more central bank sales, there will be increased availability in the market. Gold looks like stabilising in the $250-270 range. The current $290 level is by virtue of US-Afghan crisis.

Even if the world financial market gets into a steep downward spiral, the huge reserves of gold will, probably, absorb any substantial increase in demand. The problem with gold is that it is fundamentally weak. So gold has little place in a small investor's portfolio.

A `golden' crisis

THE yellow metal has landed buyers in a crisis. After the September 11 attack on the World Trade Centre, while every other financial market was down, gold was up 6 per cent to $280 a troy ounce and continued to go up to $290 where it stabilised. This was proof that once again, in times of crisis, gold can beat other markets. However, this time, the rise was only a modest 6 per cent, compared to how gold prices reacted in times of crisis in the early 1970s and the 1980s.

Gold prices, for instance, doubled in the late 1970s when the American Embassy in Teheran was taken over, followed by the Iran-Iraq war. Oil prices rise while stocks fall. Again, in October 1978, gold prices went up from around $220 to around $370. But the most significant jump was during the Iran-Iraq war when prices soared to an all-time high of $612 from $306. The $600 range did not sustain, and prices eventually returned to the earlier levels. In the 1980s, gold prices stabilised at $400 and hovered in the $350-450 range till 1998.

Another important factor is that during both the World Wars and the great Depression of 1929, gold prices witnessed no wild swings. The 1970s and the early 1980s were the `golden years', and the prices seen then may not be reached again. Just as the $600 price after the Iran-Iraq war was not sustainable, so too the current $290. In time, prices will probably stabilise in the $250-$270 range.