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.

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    V B Mudholkar

    8 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

    10 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 ?




    kishore ghiya

    In Reply to Prateek Sonthalia 10 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

    10 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

    10 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

    10 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


    10 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

    10 years 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.

    United Stock Exchange’s ‘big-bang’ entry into currency futures is faltering

    The newly-established USE boasted of a world record for capturing the highest market share and daily turnover. Turnover has crashed now. With trading being literally free, will the USE survive?

    The country's newest stock exchange, the United Stock Exchange (USE), was launched amid much fanfare a couple of months ago. With eyes firmly set on the skies, the USE went on a vigorous membership drive, even with established rivals like National Stock Exchange and Multi-Commodity Exchange - Stock Exchange (MCX-SX) patrolling the waters in this keenly-contested segment. It made headlines on its debut on 20 September 2010, for capturing a whopping 52% of the market share on its very first day coupled with a world record for the most contracts traded in a single trading day. This has turned out to be a flash in the pan.

    The USE clocked a turnover of Rs45,486 crore on its debut, outshining rivals NSE and MCX-SX who recorded a turnover of around Rs21,000 crore each. Volumes continued to hold steady for a few days as the USE maintained a leadership position in the segment with a market share of 38% by 6th October.

    However, this superlative performance soon started losing steam. USE witnessed a steady dip in volumes and turnover since this 'big-bang' opening. With a turnover of just Rs4,142 crore on 11 November 2010, USE has seen its market share plunge to 18%. Indeed, since 1 November 2010, its market share has averaged just 15% while NSE and MCX-SX enjoy a much bigger slice of the pie at 37% and 48% respectively. Volumes and turnover on the much-hyped new currency derivatives exchange have almost halved from mid-October 2010.

    Another important indicator of the failure of the USE is its low average open-interest position relative to volumes. Since its launch, daily open interest has averaged a measly 5% of the total daily volumes at the USE. Comparatively, the figure is much healthier at the NSE (38%) and the MCX-SX (30%). Open interest is the total number of futures contracts that have not yet been offset or fulfilled by delivery. It is an indicator of the depth or liquidity of a futures market and commitment of the participants. Low volumes and low open interest point to a shallow market, one that is dominated by day traders. In this case, a large part of such volumes are possibly created by Jaypee Capital, a stock broker that SEBI quite happily, allowed to be a promoter of an exchange.

    After making a splash initially, the USE now faces an uphill task trying to keep pace with its bigger competitors. Unless it makes some changes to its revenue model and introduces some innovations soon, it could end up the same way as the Bombay Stock Exchange's (BSE) failed currency derivatives segment. The BSE, which has a 15% stake in USE, had set up and shut down its own currency-derivatives market within a matter of months. Unfortunately, there is no revenue model possible for this segment.

    The USE is forced to impose zero transaction fees in line with the predatory move made by NSE earlier, and followed by MCX-SX. In doing so, the nascent exchange is already burning a lot of cash with each passing day. This works out for the NSE as it can use its highly profitable equity segment to subsidise the currency segment. But even for an established player like the MCX-SX, it hurts business badly. The MCX-SX, which had dragged the NSE to the Competition Commission for its anti-competitive strategies, has already incurred a loss of around Rs120 crore, reveal sources. In one of its lawsuits, it has said that it is losing Rs5 crore a month. For a relative newbie like the USE, the situation is dire. If it incurs the same costs as the NSE and the MCX-SX, its net-worth would get eroded rapidly.

    Surprisingly, the USE continues to maintain a stoic silence when asked about its revenue model, despite repeated attempts on our part. 

    Click here to view the data for currency turnover of MCX-SX, NSE and USE

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    10 years ago

    Dear Sucheta,
    From day 1 - it was apparent that - truth is getting manufactured and people are coaxed to believe through news paper ad that - here is a guy who stood first in the class before he understood the alphabets properly. I wonder why such things are not under scrutiny.

    The more important thing - How do you get USE turnover data? I have tried several times - those guys have made it impossible to download historical data. I do not think it is technical error. I am afraid it is a tactical decision to hide the long time series data. If you happen to have it, could you post it in your site in a time series manner.

    with regards,



    In Reply to Rishi 10 years ago

    As per your suggestion, pls find the link for the turnover data below the article.

    Crude oil prices to remain range-bound, but below $90 a barrel: Analysts

    Despite the financial measures that the US is trying to push through, American demand is expected to stay suppressed due to the faltering economy, and prices are expected to remain in check

    Global crude oil prices, which hit a new two-year high of $88 a barrel on Thursday, will not rise much and will remain range-bound below $90 per barrel, say analysts.

    In a report, BRICS Securities said, "We expect oil prices to average between $70-$80 per barrel at least till FY12, even as global demand crosses 2007 levels in 2010. The likelihood of demand flagging appears limited as global governments are determined to stimulate their economies at (the) slightest hint of a slowdown. With no large incremental supply expected, we have assumed the long-term oil price at $75 a barrel."

    Global oil prices dropped below $87 a barrel in Asian trade today due to a decline in regional stocks amid a strong dollar. According to the US Department of Energy, oil prices surged after a decline of 3.3 million barrels in US crude oil stockpiles in the first week on this month.

    "This is a seasonal phenomenon, as in the US, this is the hurricane period which leads to supply disruption. In this season, demand for heating oil and diesel is always high and the drop in inventories is just a weekend activity. Until the trend continues for eight to ten weeks, we can not jump on this demand trend," an analyst from Emkay Global Financial Services Ltd told Moneylife.

    The depreciation of the US dollar is pushing up oil prices. However, high prices will not sustain until the world's largest oil-consuming country recovers completely.
    On the subject of recovery, according to Nobel Laureate economist Joseph Stiglitz, the US Federal Reserve's policy of quantitative easing will do little to boost the US economy. The recent bout of quantitative easing by the Fed has boosted commodity markets. However, crude prices may remain in check due to the long road that the USA has to limp along for economic recovery.

    "The falling dollar and the quantitative easing measures by the US Federal Reserve are supporting commodity prices; but oil has remained at the downside compared to other commodities because there are still concerns over the US and European economies. So until there is concrete growth in the US economy, oil prices will not reach $100 a barrel," the analyst from Emkay added.

    Mayur Matani, research analyst, ICICI Securities, said, "The Organization of the Petroleum Exporting Countries (OPEC) has predicted that crude oil prices will remain around $74-$75 a barrel for this fiscal year. Over a period of time, crude oil prices will be about $80 a barrel, where (both) oil-consuming companies and OPEC are comfortable."

    "Many stimulus packages are being poured into markets by the US and a few European countries. This has already fuelled oil prices - they touched $88 a barrel recently. And to touch higher levels of crude oil prices, more stimulus packages are required, which seems difficult at this time" added Mr Matani.

    However, some market pundits are also predicting that oil prices would be seen at $100 a barrel. According a report which quoted Dallas-based energy investor T Boone Pickens, oil prices will rise to $90-$95 a barrel next year, and may touch $100.

    However, Mr Matani told Moneylife, "It's difficult to touch the level of $100 a barrel. The economic situation in the US and European countries is not encouraging. Prices may touch $95 a barrel on speculation, but it would be difficult to sustain prices at this level. I don't think crude oil prices would go beyond $90 a barrel."

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    V Malik

    10 years ago

    Good article, thanks.

    However, it is not just the price of benchmark crude at loadport which is relevant, but also the rapidly increasing cost of transporting and converting this crude oil into usable products.

    That the increasingly stringent requirements for cleaner low sulphur fuels as well as the rapidly increasing cost of ensuring safe passage of crude has gone up by almost 100% or even more in dollar terms, and even more when calculated in SDRs or some other currencies, needs to be factored in too.


    Sharad Matade

    In Reply to V Malik 10 years ago

    Thanks sir for your suggestion. Next time I will definitely take that factor into account.

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