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.