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.

V B Mudholkar
1 decade 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
1 decade 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 ?


kishore ghiya
Replied to Prateek Sonthalia comment 1 decade 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
1 decade 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
1 decade 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
1 decade 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
1 decade 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
1 decade ago

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.

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