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Are gold prices infallible?

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.
 

User

COMMENTS

V B Mudholkar

5 years ago

You say, "gold price is an interplay between two currencies for us - the dollar and the rupee." agreed; but if gold price falls due to religious sentiments & traditions in india there may be 'bottom fishing'.

Prateek Sonthalia

6 years ago

This recession has proved (or rather alerted a layman like me) to the flimsiness of all the three asset classes namely :
1)Equities : This was always speculative and risky. It remains slippery as ever more
2)Gold : Americans seemed to also try to proliferate the idea that Gold is the most useless metal, by achievers and industrialists. Intention could have been to free the USD from the fetters of GOLD pegging. Result is that the entire world does not trust GOLD as a stable ASSET Calss. Maybe it does in our generation, about the next generation I dont know.
3)Real Estate : which was always thought to be stable in India, is already in murky territory, when you see it as an investment opportunity. The flat which costed 17 lakhs, has now become 51 lakhs and my salary has trebled. What is the growth that we are having today ? It could be as phoney as the big bust in Japan, although seems like India is still far away from that situation.

Which asset class to trust ?

HUMAN ENTERPRISE AND SPIRIT :-)

Thanks
Prateek

REPLY

kishore ghiya

In Reply to Prateek Sonthalia 6 years ago

It is liquidity in market due to global recession and swish account money of indians returning back to india has skyrocketed both gold and real estate prices.One day there will be nobuyers like japan land bubble and there will be long downward in real estate.equity investment is tax friendly and it is not speculative. you have to take informed decision while investing and have to be less greedy.with 9% GDp it is equity for you both short and long term but please do not let greed tke over your mind. keep it open.

kishore ghiya

6 years ago

In india current demand of gold is because of liquidity in black money available.Land prices are soaring in small towns like rajkot as documents can be made with 90% black money. The gold prices in india will come down when liquidity dries in market.
Traditionally indian invest in gold especially ladies in rural india because of 1. Transparency in their market price ,2 100% liquid to dispose off any time of the day and fair trade practices and facility of dharam ka kanta in smallest village.If calamity strikes indian wives can sell their mangal sutra and get money can they sell satyam that liquid?.The moral is indian capital market has to go long way attracting middle class savings by making market very transparent fair arbitration and as liquid as gold at time of emergencies,till then we are better off not comparing gold investment with other modes of investment like land,company deposits or share bazar and that is why next to gold middle class go for FDs not their fault,it is for Ficci and Assochem to do soul searching why they cannot get access to household savings.
Indian investors also have habit of keeping investment in their custody they feel safe and are reluctant to part with their assests.They do not trust people who handle their savings.It is not their fault is it?
kishore ghiya mob 9825217857

Raj Srinivasan

6 years ago

Dear Debasish,

Nice analysis and for logic for a comprehensive analysis on Gold price movement. You have compared Gold as investment Vs Asset. Would you consider a third alternative which is also a deeply embedded cultural factor for India. Gold is considered a `reserve' for women (excluding the urban/working women)

kishore ghiya

6 years ago

At rajkot last week sks microfinsce manager have filed a criminal complaint against their rajkot branch manager who had advanced rs 45 lacs to fictitious persons and have run away with amount.How many frauds are commited nobody will know because they are all nbfcs unregulated and if greedy investors are duped let them lose why shoud govt funds should be spend to help them

Ravi

6 years ago

Thanks for a great series of articles on Gold. Very fair to say that gold is not an investment asset. It is a speculative asset.

Apart from the factors mentioned above, i think the recent rise in Gold related financial products (particularly ETF) have also led to an additional demand for Gold. This demand was probably missing in Pre-2000 era.

Thus Demand-supply mismatch could also be one of the major factors contributing in Rise of Gold prices in India

Tony Joe

6 years ago

Hi,

You have come up with a nice analysis on the dollar-rupee effect on gold prices. Now the main thing remaining unexplained is the last two years' technical rise of gold in pure dollar terms, which is pretty strong in its own right. There are also studies that indicate Chinese consumers are exhibiting an unprecedented apetite for gold. In fact, China is actively considering to develop its own mines into production-ready stage to corner a portion of this demand! Regarding gold loan companies, the better run ones like Manappuram are no more relying on securitisation but on 'bilateral assignments' with large banks, which even while moderating profits, makes the operation more stable and risk-free. Also, one often overlooked fact is that these companies do not lend against the bullion, but only against ornaments to enjoy a 15-25% safety margin by way of making charges, which is in addition to another 15% safety cushion they keep. So, the risks you mention, even if they should happen, should cross this 30 to 40% threshold. As you mention, it is as improbable as dollar weakening to 37 rs. Anyway, thanks for a great series of articles that put the spotlight on this sector which is now all set to have new listed entities. Many listed NBFCs and banks are also bullish on this segment as the safety margin is incomparably high in gold loans as against other loans like microfinance, realty, auto, personal & corporate loans.

If gold prices fall sharply, what happens to gold loan companies, their borrowers and their lenders?

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.

User

COMMENTS

mcaggarwal

6 years ago

There is never ending craze for gold in India and hence falling of gold prices do not affect so much in India.

k a prasanna

6 years ago

The bubble will burst. The loanees will forfeit their gold, the financier gold companies will default the bank. The promoters of these companies will continues to live like Maharajas. Banks, mostly PSUs will write-off the loans.

REPLY

puneet vij

In Reply to k a prasanna 6 years ago

nothing will happen , no need to worry, all these things is fictious gold prices never down by more than 5% . all companies are financial strong & regulated by R.B.I.

K Narayanan

In Reply to puneet vij 6 years ago

Let us not be misled by the false notion that some entities are regulated by RBI,dept of company affairs,Govt of India etc.and our money is safe with them.Though limited companies are regulated by dept of company affairs many companies raised capital from the public and vanished.The dept is unable to do anything except publishing a list of vanishing companies.RBI does not have time to manage forex reserve,monetary mgt and plethora of activities like inflation mgt..They cannot manage the day to day affairs of the entities they are regulating.RBI provides a shoulder to cry and if possible they may help.That is all.So many industries and business houses have borrowed from the banks and some have failed to pay off the amount(in some cases it is genuine business problems and in some cases they are wilful defaulters-to use RBI language..The NPA in the banking system is Rs100000 crores.That doesn't mean that banks shd stop lending.If gold finance companies get refinance from the banks against the loan borrowed by their customers pledging gold, it is for the banks to monitor the co.If they run away -may be in some cases it might happen-it is the headache of the banks-you cannot run a bank without any bad loans.Risk taking is their job.If the promotors run away then also the customer lose only about 20% of the margin stipulated by the companies(of course the sentimental value attached the item pledged is a different matter).Moneylife can only caution but it is upto the customers to decide where to take the gold loan.

puneet vij

In Reply to K Narayanan 6 years ago

u r right but as mr prasanna said that in 1980,s some companies defaulted. now after gap of 30 years R.B.I. regulates in much effective manner by learning from past mistakes. also economy has changed rapidily, consumer is much more aware unlike past. it is the fastest way of getting loan without going to banks with their difficult procedures. the worst scenario is that customer will loose 20-25% of money(gold) as u said. but it does not means gold loan companies should not be here. AUTHOR only highlighted some negative point but this is not reality. i personally visit to muthoot finance branch in new delhi & i saw nothing wrong. people r happy for getting fastest loan & there is various schemes which money life did not raised. this artical tries only to malign gold loan companies image. thanks

k a prasanna

In Reply to puneet vij 6 years ago

During 1980s many finance companies like CRB capital, Prudential and others, who were financially strong and which were regulated by RBI, collapsed. The most respected finance company of the south - the Pais of Manipal group, defaulted to its depositors.

Tony Joe

6 years ago

Hi,

Your third part has come out more balanced, mature, and technically far better than the first two parts. Please note that securitisation is not the only source of funds for well rated companies like Manappuram. In fact, securitisation is all set to evolve as the minor part in the coming quarters and years. Your fourth part on gold prices would be great if you can include three aspects - their sophisticated and almost real-time stop-losses, the gold price hedges through ETFs/Futures, and how unlikely is gold to fall in the face of the exponential money-supply growth post-2008 and the resulting inflationary trends. In fact, there are technical studies that gold would double from present levels within the next 2 to 3 years, solely on the excess liquidity that the world governments are unable to suck back from the system. If this happens, companies like Manappuram will rock, and many private and PSU banks would jump into the fray, much like how HDFC Bank and Syndicate Bank have now turned bullish on gold loans.

pushkar kulkarni

6 years ago

when was the last time in world ghistory the gold price crashed y by 40%?? we can say 10 , max 15 % price reduction wd be there, again this shd be taken care by the available margin. the only worrying part is how can the company be sure that it is 22 carat gold?? it can be lower grade gold , passed as 22 carat ,,then it is a big problem. if the gold price really crashes, there wd be more buyers in india!! for such case the usd shd become much stronger(@rs 40??? a dream!) more gdp growth, no wars, etc

REPLY

Madhur Kotharay

In Reply to pushkar kulkarni 6 years ago

Pushkar saab,

Where did you get this profound knowledge about Gold prices? Do some basic homework before giving confident explanations.
http://www.kitco.com/scripts/hist_charts...

Gold prices have dropped 40% many times in last 31 years, 1979-81, 1982-84, 1987-92, 1995-99. If you add up, 15 years of these 31 have seen falls, i.e. downtrends. That is 50% of the time.

Are you sure it cannot happen in near future? Remember, Black Swans exist.

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