What makes gold glitter

Gold prices have moved up sharply since 2002, gaining over 500 per cent in this period. Demand for gold exchange traded funds (ETF), central banks increasing their gold reserves and investors preferring gold over other assets due to its ability to deliver inflation-beating returns — are all factors pushing up gold prices.

On an inflation-adjusted basis, gold trades around $790 compared to the all-time high around $850 in 1980.

According to a paper by Claude B. Erb and Campbell R. Harvey titled “An impressionistic view of the “Real” Price of Gold around the World” gold prices across the sample of 23 countries, which account for 62 per cent of the world population, are near their all-time highs.

But if global economic conditions deteriorate further or geo-political tensions surface, prices might cross the $850 dollar high.

Supply of yellow metal

In the June quarter of 2012, mining accounted for 65.6 per cent of the total supply and recycle gold 34 per cent. Since mining output has been sluggish, global supply, which includes mining, scrap gold and official sales by central banks, has increased just 1.6 times since 2002.

According to Mark Cutifani, CEO of AngloGold Ashanti, it costs around $1200 dollar to mine an ounce of gold. But factors such as the risk of change in host government’s tax policy, local mining labour strikes akin to that witnessed in South Africa recently tend to reduce investments in mines.

Demand drivers

Investment in gold has been the major contributor to global demand. Size of assets held by gold exchange traded funds (ETF) has grown exponentially since 2002. ETFs held 11.96 tonnes in 2003. This increased 217 times to 2,588 tonnes towards the end-October 2012. Jewellery demand has, however, been declining since 2010, due to the price-sensitive nature of demand from this segment.

Central Banks hoard

Recent gains made by gold after the quantitative easing by various central banks in September have been erased on rumours that central banks of beleaguered nations belonging to European Union might offer gold as a collateral for raising money.

The market took it as a negative, since gold sales by these nations, that hold considerable gold reserves, will result in increased supply.

The counter argument is that demand for gold from central banks of emerging markets can easily absorb this supply.

After being net sellers for two decades, central banks became net purchasers in the second quarter of 2009. Several key central banks of countries such as China, India, and Russia have purchased substantial quantities of gold over the last three years.

The world’s central banks hold around 10.7 per cent of their reserves in gold.

The advanced economies own around a third of their assets in gold, mainly due to the old legacy of gold standard. Most emerging economies own less than 5 per cent of their reserves in gold.

According to World Gold Council (WGC), if the central banks of emerging markets allocate one per cent of their reserves towards gold, it will result in an excess demand of 900 tonnes equivalent to around 37 per cent of the annual global mining capacity.

Central banks as a whole have increased their holdings by 1,412 tonnes since 2009. Though the quantity is small, considering that they are typically net sellers, this brings an extra demand component for gold.

Globally, money supply component (M2) has increased by around 2.21 times since 2003.

Excess money supply has kept the real interest rate negative. Thus, investors wanting to save the real purchasing power of the portfolio are allocating some portion of their assets towards gold.

Besides, higher money supply also leads to currency debasement, forcing central banks to diversify their holdings in gold.

>shaurya.mishra007@gmail.com

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