Gold – a tale of two priorities

My submission for the May edition of Wealth Insight

What a fall!

Over two day - 12^th and 15^th April 2013 - gold prices dropped an astonishing 18%. Volumes on the derivative exchanges were twice that on a “normal” day. The effect of the short-selling (selling without owning the gold – in the expectation of buying it back at a lower price) was to force traders having “long futures” (buy positions using leverage) positions to sell. Their stop loss orders would be triggered.

Was this just a trade based on technical analysis of price movements, or was there some “co-ordinated” trading. For this, we have to see what happened in the physical market (physical or cash market is where the underlying gold is traded). Despite the fall in “futures” prices, physical gold and silver prices are relatively firm. The price of “American eagles bullion coins” was at one point 26% higher than what “futures” prices indicated. Despite the price fall, in the days following the crash, the US Fed had to deliver over 2 tonnes of gold in the physical market as demand from US investors for the metal rocketed. In Asia, anecdotal evidence suggests that gold markets witnessed “sell-out” crowds at jewellers. Further, physical gold prices remained stubbornly higher than the “futures” market. The price fall seems largely restricted to the derivatives market.

Is there a shortage of metal building up?

Germany has nearly 3600 MT of gold reserves – highest among countries, next only to the USA. 1536MT of this reserve is in the custody of the US Fed Reserve of New York. Germany also has 374 tons stored with the French Central Bank and some at the Bank of England.

Germany recently requested the US Fed to return 300 MT of their gold. It also requested the French Central Bank to return its holding. The USA has informed Germany that return of the 300MT demanded will be executed over a period of 7 years. Incidentally, 300 MT of gold can be “couriered” in less than 10 airplane trips. The US Fed apparently owns 6700MT of gold – so why does returning 300 MT pose a problem?

Central banks like all other banks often hypothecate client deposits as collateral against other lending. Could it be that the US Fed has rehypothecated gold so much and among so many counterparties, that it is unable to demarcate the gold that belongs to Germany?

In the first week of April, ABN Amro bank changed its precious metal custodian rules and indicated to clients that they will no longer allow physical delivery. Accounts will now be “cash settled”. In other words, you cannot now get your metal – just the difference in price between your purchase and sale price. At the commodity exchange – Comex,  gold vaults have witnessed a withdrawal of 2 million ounces of physical gold – the largest in one quarter over the past decade. Physical gold seems to be in short supply.

  

 The gold conspiracy theory

Gold bulls have presented data indicating volatility in gold prices as a result of central bank action. Since gold is often viewed as an alternate currency, and confidence in “fiat currency” is being undermined by repeated money printing, a rise in gold price signals a lack of confidence in printed money. This can have disastrous consequences for financial markets if the trend catches on. Increased volatility in gold prices will erode its acceptability as an alternate to fiat money. A sharp fall will shake the confidence of investors.

Central bank action is difficult to prove or disprove as it is shrouded in secrecy, allowing speculation to gain traction. The circumstantial evidence forwarded starts with the question - who else could sell 400 tonnes of gold futures in a few hours – except central banks? Falling prices are not good for a seller unless the idea is to create market panic. This costs money, and only a money printing bank can afford this.

Central banks too have to operate through “agents” – the banks. The gold market action started just a day after a meeting called by the US Administration where the top 14 banks were present – to help coordinate bank trading action say the conspiracy theorists.

Another view point is that orchestrated sales were necessary since physical stock of gold and silver were insufficient to make good contracts that banks had signed to deliver gold to clients – and they needed to stop the requests. Without the coordination among all banks, a price crash of this magnitude would have been difficult since traders would have entered the market on both sides. By forcing out the buyers, the demand for physical delivery has been reduced significantly – allowing banks to prevent what could have been a catastrophic default – and would have lead to further erosion of credibility of paper currency.

The impact on India

India remains the largest “consumer” of gold. Economists have celebrated fall in gold prices arguing that this will lower current account deficit and reduce pressure on the currency. While this may be true, there is another point of view worth considering.

Unlike other consumption goods, gold is really in the nature of an investment. It can be seen as an attempt by Indian savers to invest overseas. A fall in its value reduces the “wealth effect” for investors. This is similar to the case of a foreign investor investing in India. When the Indian currency depreciates, the stock market is cheaper for the new investor, but an investor who is already invested sees a loss. Very conservative estimates of gold holdings of Indian investors would value it at $500bn. This is almost 25% of India’s GDP. A fall in the value of these savings will have a direct impact on the wealth effect. This could have a serious and negative impact on domestic consumption. At a time when growth of GDP is already weak, a further drop in consumption can hardly be treated as “good”.

Another point to note would be the effect on gold loans and their lenders. The gold loan industry had witnessed remarkable growth over the past 5 years. It is likely that a sharp fall in gold prices if sustained, will lead to significant NPA’s with attendant risks.

The pressure on the rupee will likely ease as oil prices weaken in the face of continued global economic weakness. All countries are now engaging in competitive devaluation of currency to enhance their exports. In such a scenario, the rupee may not face significant downward pressure – irrespective of gold prices. In trying to “cure” Indian investors’ desire for gold, India’s western educated economists would do well to understand the viewpoint of India’s unwashed masses. Often the unlettered are wiser.