Should you buy gold?

ven as the BSE Sensex climbs steadily, another asset is scaling record highs. I am referring to that noble yellow metal, gold.

In November this year, gold prices touched Rs 6,600 for 10 grams.

As an investor one needs to ask: Are gold prices going to increase even further? If yes, should I invest in/ buy gold?

To answer these questions, we need to understand why the price of gold began to rise in the first place.

High, higher, highest

Even though the price of gold has reached its highest level in 16 years, many predict it will rise even further.

~ The dollar falls from grace and gold's sheen increases

As the value of the dollar began to fall, the price of gold began to rise. This happened because the dollar is viewed as a store of value.

A store of value is money or a financial instrument that can be reliably saved, stored and retrieved. In other words, a store of value is an asset. It could be gold, stocks, real estate or currency, to name a few. 

When the dollar began to fall in value vis-à-vis other currencies like the Euro, the central banks, hedge funds (funds where the fund manager invests in risky financial instruments to provide a higher return) and large investors began to look at gold as a safer investment.

In order to make that clearer, here's an example.

Let's say $ 1.32 = 1 Euro.

If the value of the dollar falls until $ 2 = 1 Euro, it means the dollar has weakened and the Euro has strengthened.

If the value of the dollar rises and $ 1 = 1 Euro, then the dollar has strengthened and the Euro has weakened.

Investors prefer investing in a strong currency. So, when the dollar started weakening, they began looking at gold. And when they started dumping their dollars to buy gold, the price of gold began to increase.
 
What about the future?

It does not look like the dollar will be getting stronger in the near future. The US economy is now battling a huge trade deficit (this happens when imports exceed exports) and a weak dollar invariably helps US exports.

To understand this further, here's an example.

Let's say the dollar value is $ 1 = 1 Euro.

Let's also say that a US businessman exports goods to Europe for 10,000 Euros.

At the current exchange rate, he will get $10,000. Now if the dollar weakens and $ 2 = 1 Euro, the exporter will earn $ 20,000.

This means the US makes money when it exports goods or services. At the same time, imports now become more expensive.

To import something costing 1 Euro, an importer would have initially paid a dollar. Now he has to pay $ 2.

Hence, a weak dollar tends to curb imports and increases the revenue of exports. At the moment, this is good for the US because it will narrow their trade deficit. In other words, as far as this aspect is concerned, they are not too unhappy with the falling value of the dollar.

~ As the world gets a little more chaotic, gold looks more stable

The world runs on fuel.

When the crude oil prices rise, it causes the prices of all goods to increase. This results in inflation and the world begins to panic.

The price of crude oil recently rose to $ 54 a barrel. This is not good news.

The flip side is that gold immediately begins to look like a better investment.

Gold is viewed as a hedge (safe investment) against inflation. Its value rises over time and will counter the effects of inflation.

Look at it this way: As inflation rises, your rupee will buy you less than what it did earlier but the price of gold will continue to rise. That means your investment in gold does not lose its value; in fact, its value could increase.

There is talk that the war in Iraq could cause the next 80's great depression in year 2005-2006 or that it could cause an American Waterloo.

The passing of Palestine leader Yasser Arafat has led to uncertainty and the entire Middle East whirlwind may be about to suck us into it.

Not to mention North Korea's nuclear ambitions and the growing threat of terrorism.

When there is a lot of uncertainty, people tend to buy gold. In case of war or terrorism, gold is safe. No matter what happens, gold is still an international currency.

~ Give me more!

India, the world's largest consumer of gold, could gobble up an estimated 880 tonnes this year. The Indian demand for gold this year alone can absorb what the French want to sell over five years!

Every year, Indians buy gold worth Rs 40,000 crore on top of gold worth Rs 6,60,000 crore which we actually hold.

At final count, Indians hold almost 13,000 tonnes of gold.

The demand for gold in India is likely to increase as more and more people begin earning higher incomes.

Do you know what the per capita consumption of gold (how much of gold is consumed per individual) is?

UAE: 31.5 grams (that is high!)

USA: 1.4 grams

India: 0.5 grams (very low).

India is in the 18th position on this list because of its huge population. Considering India's growing population, even an increase of 0.1 gram per capita consumption in India can send gold prices sky-high!

Indians have always been known for their intense love affair with this metal, but the Chinese too are openly displaying their affection for it, especially as they get richer. In fact, the demand for gold in China is expected to rise sharply.

~ Is there enough for everyone?

You know the first lesson in economics; if demand is greater than supply, then the price of the product increases. This is especially true of a scarce commodity like gold.

Gold production (supply) doesn't change very fast. Hence, demand will push up prices.

~ The major sources of gold

There are three:

Seventy percent of the gold available comes from gold mines

The remaining 30 percent consists of recycled gold and the reserve that is maintained by central banks all over the world.

Even if the gold mines begin to produce more, any new supply will take some time to satisfy the huge demand.

Central banks, which hoard almost a quarter of gold mined till date, will not sell it. If they do so, it would cause the price of gold to start falling drastically and that will affect them negatively.

Interestingly, in 1999, central banks in developed countries agreed upon to restrict the sale of gold. Only France expressed a wish to liquidate 500 tonnes of gold in the next five years.

The demand-supply mismatch -- demand is rising, supply is not -- is highly skewed in favour of gold prices increasing.

This points in one direction: The yellow metal may even break its all-time high of $ 850 (Rs 43.83 = $ 1 as of December 21, 2004) an ounce (1 ounce = 28.35 gms) soon.

Figures please!

Now for the real math.

Earlier this year, international gold prices had plummeted to their 19-year nadir of $ 280 an ounce.

The reason? Hard news and rumours that central banks the world over were dumping their gold stocks. Today? It hovers at around $ 450 an ounce. If you had bought when it fell and sold now, you would have made a whopping return of 60 percent in less than a year!

~ A walk down history lane

In the 1970s, gold had peaked to a high of $ 850 from $ 35 per ounce. That meant a mind-chilling return of 2,328 percent over a 10-year period or 232 percent every year.

But those were extraordinary times, highlighted by events like the oil price shock, supply scarcities and cold war fears.

Agreed that gold, unlike stocks and bonds, is notorious for not paying any income money like dividend and interest. But this lacuna is more than made up by capital appreciation (rise in value of an asset) and its value as a cushion against crises.

Image: Dominic Xavier