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History seems to suggest that gold prices will never decline. Gold loan companies have created a growth model around this belief. But how robust is this assumption? The last of a four-part series
We have seen how gold loan companies are riding on the crest of a massive gold rally. By securitising their receivables, these fast-growing NBFCs have created a business model mainly based on the speculative price of a single product - gold. While they claim to have adequate collateral, none of the participants in the chain - borrowers, gold loan companies or banks holding the securitised assets are worried about the downside to the asset which they have leveraged to the hilt. The underlying assumption seems to be that gold prices will never fall in India. A sharp drop in gold prices is likely to set off a chain of events that may wreck havoc on the financial structure of gold loan companies.
Conventional wisdom says that gold prices never fall. Experts will back this by waving a 50-year historical chart in a sceptic's face. Through a simple extrapolation of past trends, we can assume that the gold story is here to stay. But is that a sound logic?
To understand this, we have to first figure out what drives gold prices. Contrary to normal belief, gold is not an investment asset. It is a speculative asset. The key feature about gold is that it offers no stream of fixed income, unlike real estate, stocks and fixed deposits, which yield some regular returns in the form of rent, dividend and interest respectively. If you buy a product not for income but to sell it off eventually, you are speculating.
Secondly, the price of gold is pegged to the dollar. In essence, its value is linked to the movement of the dollar currency. Also, for wealthy investors in the Middle East or Switzerland, who actually move the price of gold, gold as an asset is compared to a gold-like product like US Treasury bills. They compare the potential returns on investments in US Treasury or Japanese or European government bonds. Gold becomes attractive relative to such quasi-gold products if the returns on them are low. Gold's value then, goes up on relative terms when other secure assets yield nothing in real terms (nominal yield minus inflation). For Indians, the strength or weakness of the Indian rupee is another key determinant of the movement of gold prices. The price of gold, for us, therefore, is gold in $ terms x value of rupee.
Based on this background, let us have a look down memory lane to see how gold prices have moved. Gold has undergone three phases in its recent history. Between 1974 and 1980, gold prices surged from $100 per ounce to $850 per ounce. This was the outcome of events like the Vietnam War and the Iranian revolution, which led the world to believe that the US dollar was no longer the world's reserve currency. The capitalist economy was under threat at that point of time. In this phase, the exact rise in gold was fully reflected in rupee terms also, primarily because the rupee was then under a controlled regime and remained almost stagnant between Rs7-Rs8 per dollar. This movement of gold prices in rupee terms got fully translated into Indian prices, giving us the first taste of the 'gold always goes up' theory.
In the next phase, between January 1980 and March 2001, gold collapsed to $257, translating into a 70% fall in 21 years, as the dollar regained its supremacy after the US Federal Reserve started combating inflation under the chairmanship of Paul Volcker. What happened in rupee terms? Gold should have collapsed. But India embarked on its liberalisation regime, devalued the rupee in 1991 over two steps and the rupee became a more market-determined currency. The Indian currency moved from Rs8 to Rs46 per dollar in these 21 years. As the rupee value fell, gold rose in rupee terms during this period. So despite the 70% fall in dollar terms, the 600% devaluation led the Indian mind to believe that gold never falls.
Another bout of speculation began in phase three, gold acquired a sheen never seen before. The dotcom bubble burst, the dollar was again weak and interest rates crashed. Gold rose from $257 per ounce in October 2001 to touch $1200 per ounce in 2009-10. During this period, the rupee did nothing and has remained at that level. Once again, India received the full impact of the rise in gold prices in rupee terms. The chorus continued: "gold always goes up".
So what happens next? The widespread belief is that India is now set to carve out its own space in global economic prosperity. We don't doubt that notion. But two things can happen from now - the rupee may become stronger and the dollar may fall. What happens if the dollar falls from Rs46 to Rs37? Separately, yields may start to harden reducing the attractiveness of gold. If this happens, the combined impact of these two factors may mean 40%-50% fall in gold price. This is merely a possibility. After all, at the end of the day, gold price is an interplay between two currencies for us - the dollar and the rupee.
For now, gold prices are heading north like a prancing colt. Gold loan companies have benefited immensely from this meteoric rise. But it would be foolish to assume that gold prices will continue to rise unfettered for years to come.
While gold loan companies are sanguine, actual behaviour of borrowers, lenders and other participants under the stress of sharply falling gold prices remains to be seen. One clue: gold loan companies have never been so big, gold prices have never been so high. This article is the third in a series
As we have seen, gold companies are essentially securitising their receivables over the short-term of gold loans to create liquidity. Securitisation in small doses is a good strategy to generate liquidity but carries obvious dangers when it becomes the main source of funding for growth.
A steel manufacturing company may securitize a small part of its export receivables to create temporary liquidity but can the steel company fund its entire business of steel manufacturing by securitising its export receivables? A bank can securitize a small part of its loan book (say, auto loans) but can it run the whole bank and expansion of loan book only by this, if it has no access to stable and low-cost current accounts and savings bank accounts?
What are the issues gold loan companies would actually face under stress if the bulk of their funding is securitised receivables? Remember, it’s the mortgage-backed securities, which fuelled the housing bubble in the US. Shaky home loans were securitised, bundled and accorded higher rating which investment banks sold to “smart” hedge funds while “smart” insurance companies like AIG insured them. Underlying this chain of transactions was a key assumption. House prices in the US never fall all across the country for a prolonged period. It is the same assumption for gold loan receivables too — gold prices never fall in India. In the US, when house prices crashed everywhere in 2007 and 2008, the securitised loans and the insurance written on it (credit default swaps) started to blow up. Massive losses, bankruptcy and financial panic followed in a quick succession.
There is no question of that kind of panic here because the gold loan market is too small and localised. But to assume gold prices do not crash or that it will leave no impact are both dangerous. A sharp drop in gold prices is likely to set off a chain of events that may wreck havoc on the financial structure of gold loan companies. If gold prices fall by 30%-40%, the loan provider would either need the borrower to put up more gold or make good the margin in cash. What if the customer is unable to meet the shortfall and starts defaulting on her loan? The company will be forced to auction off the pledged jewellery at a much lower price in the market. Selling used household jewellery in a falling market will invariably lead to a still lower realisation. What will creditors (the banks) to gold loan companies do in such a situation? They will be left holding receivables from housewives of Kerala which would have declined in value and which they would find it impossible to liquidate. A small panic would ensue.
At the very least, there is a possibility of a temporary asset-liability mismatch in the company’s books. Gold loan companies would find it difficult to meet short-term payment obligations towards creditors, the banks. In short, if gold price were to crash there could be a sudden pressure on cash flow and balance sheets. New borrowers would also hold back from lending (if the need is not pressing) now that she would get a lower amount thanks to a declining value of gold. The overheads of gold loan companies, however, are fixed in nature. Branches, staff and other expenses cannot be cut down overnight, just because gold price is down 40%. All expansions would come to a halt. It would be chaotic. If the loan book shrinks, profits would decline as sharply as they went up.
I Unnikrishnan, managing director of Manappuram Finance points out that such imbalances, if any, would only be temporary and will be ironed out. “We maintain a margin of up to 25% on the gold loan value, plus the making charges of around 15%, giving us a cushion of up to 35-40%,” he says. “Most of these loans are taken for bridge financing purposes, where customers need funds to take care of short-term mismatches. These loans are taken for tenure of up to 1 year, but borrowers mostly prepay the loans within 3 to 3.5 months. So even if this price correction occurs in this 90-day period, we are covered to that extent.”
Countering our scenario of default on the customers’ part and the likely impact on the company’s receivables, Mr Unnikrishnan said, “Normally, these loans are secured against family jewellery, which belong to the women of the family. Family jewellery carries a lot of sentimental attachment. When the men take the loan, there is a pressure from the women to redeem the gold as soon as possible. Most of these borrowers choose to prepay the loans and the chances of default are very unlikely. In India, gold is not a commodity for the common man; it is ‘Lakshmi’ (the Hindu goddess of wealth). They would think of losing that jewellery only if they are in severe difficulty. So this question of risk in terms of imbalances does not arise.”
Manappuram claims that it has provided for an adequate cushion against a sudden liquidity crunch in the form of a high capital adequacy ratio (CAR), which is around 22%. Muthoot Finance’s CAR is considerably lower at 14.79%. For NBFCs without the support of adequate capital, this business model does appear to have some structural weaknesses.
What Mr Unnikrishnan says is the best-case scenario. It would be nice if this is what actually happens in real life. It is not clear whether all gold loan companies do have a margin of 35%-40% of safety. Especially since they do not assess the purity of gold and seem to assume that the gold being pledged is of 22 carats. If it turns out to be inferior quality of gold, say 22 carats, it means that a 10% margin of safety is gone. Also, under the pressure to deliver continuous scorching growth, margin of safety is likely to be sacrificed. New borrowers would shop around for the highest loan-to-value and it would be remarkable indeed if all gold loan companies show great discipline to stick to a wide margin of safety. Most importantly, the actual behaviour of borrowers, holders of securitised receivables and buyers (of auctioned jewellery) in a situation of falling gold prices (how shocking, after a decade of humungous rise) remains to be seen. The fact is, gold loan companies have never been so big, gold prices have never been so high and gold loan companies have never had such huge overheads. If gold crashes, whatever happens would be for the first time. Especially since it is conventional wisdom that gold prices never fall. How robust is that assumption, based on simple extrapolation of the past trends? We will deal with that in part four of this series - which would be on gold prices.