Why gold prices will continue to stay high

Vivek Kaul, Economic Times 21/6/2011

Source: http://economictimes.indiatimes.com/markets/commodities/why-gold-prices-will-continue-to-stay-high/articleshow/8931820.cms

Gold prices have been on a roll over the past few years. The precio US metal has given a return of about 160% in the past five years. That is, if you had invested rupee 100 in gold back then, it would be worth around rupee 260 today. Now, compare that to the investment made in the stock market during the same period. The 50-share NSE Nifty Index, which is a broad representation of the Indian stock market, has grown by around 83%, which means that rupee 100 invested in the stock market five years ago would have grown to rupee 183 by now.

The point is: return from gold has been almost double than from stocks. But that, as they say, is the past. What about the future? Will gold continue to perform as well as it has in the past? The answer is most likely yes. Gold prices will continue to rise even further in the days to come. Here are some reasons why.

CENTRAL BANKS BUYING GOLD For many years, central banks around the world have been net sellers of gold. But in 2010, after a very long period, they became buyers again. "Central banks have been net buyers of gold in 2010 for the first time in the past 21 years," says Devendra Nevgi, founder & principal partner, Delta Global Partners. In 2010, central banks bought nearly 76 tonnes of gold.

This trend further accentuated in the first quarter of 2011, when central banks were net buyers of gold to the extent of 129 tonnes. Central banks were selling gold for a while, reaching a peak sale of 674 tonnes in 2005. "The current purchases are a reversal of that trend – a case of sell low, buy high (a curious recipe for gain with public money!)," remarks Satyajit Das, a world-renowned derivatives expert, and the author of the soon-to-be-released Extreme Money: The Masters of the Universe and the Cult of Risk.

WHY THE TURNAROUND Over the years, the central banks have had a major portion of their reserves in US dollar, with a minor portion in other currencies like euro and yen. This trend is now changing. As Ritesh Jain, head of investments, Canara Robeco Asset Management, explains: "The rise in gold prices has caught the eye of various central banks who believe it is a welcome addition to their reserves given its status as ‘store of wealth’ even during periods of crisis. Thus, the central banks have indicated their preference to hold gold over a depreciating asset (read US Dollar)."

Most of the bigger economies around the world have been printing currency big time to revive their moribund economies and also to pay off the loads of debt they have accumulated. This has led to a threat of paper currencies collapsing and, hence, the flight to the "safety" of gold. "There is concern over the major reserve currencies like the dollar, euro and yen," says Das. "The only way for the over-indebted western economies to get out of the mess is to print more money," says Jain. "Since gold cannot be printed or mined that fast, the value of currencies is sinking against gold." This means the price of gold is rising.

China’s foreign exchange reserves currently stand at $3 trillion and gold as a percentage of these reserves forms only a miniscule 1.8%. But this dependence on the dollar is gradually coming down. "Countries like China who are amongst the largest holders of US dollars are, in fact, diversifying away from the dollar by selling dollar and buying gold," explains Jain of Canara Robeco.

As a recent report titled In Gold We Trust, brought out by Standard Chartered, points out: "Currently, 1.8% of China’s forex reserves is in gold; if China were to bring this percentage in line with the global average of 11%, it would have to buy another 6,000 tonnes of gold, or more than two years’ global mine production (of gold)." Imagine what that would do to the price of gold. This is also true of other major holders of foreign exchange reserves like Japan as well as India. Japan’s gold reserves stand at a miniscule 3.2% of its total foreign exchange reserves of $1.14 trillion. India’s gold reserves at 8.2% are much closer to the world average of 11%.

Over the past 20-odd years, the supply of gold has been growing at the rate of 0.7%. The main reason for this has been the decline of South Africa as a major supplier. As the Standard Chartered report says: "A very important driver of the slow production growth was the dramatic decline of South Africa (as a producer),which produced about 1,000 tonnes in 1970, but below 200 tonnes last year (ie, 2010)." The supply is likely to remain tight as very few large gold mines are expected to come up.

Over the next five years, only seven gold mines that are capable of producing more than 500koz (1 oz =31.1 grams) are expected. Also, gold mines have a high lead time and take time to set up. As the report points out: "According to a study conducted by MinEx, the average lead time for the 214 greenfield projects in 1970-2003 was about 5.4 years in Australia, Canada, and the US, and 8.3 years for other countries." Also, as explained above, central banks, which were major suppliers of gold, have now turned buyers.

This means a lot of supply of gold will come from scrap sales. As Nevgi explains: "Supply mainly comes from mines and recycled scrap; there is no central bank sale happening now. The scrap supply though tends to be more price sensitive. Since the demand-supply situation remains tight, any incre-mental new demand for investments or from China would take the prices higher." Due to these reasons, the supply of gold will be lower than the demand over the next five years. Even if the demand remains flat for the next five years, there is likely to be a supply deficit of 665 tonnes, the Standard Chartered report says. This clearly will lead to a higher price.

The rise in the price of gold has shown an almost one-to-one correlation with the rise in incomes in China and India (as can be seen from the accompanying table). While Indians have been traditional buyers of gold, the Chinese have been fast catching up. "India and China continued to provide the bulk of the demand as they contributed to more than 1/3rd of the entire demand in the first quarter primarily on account of rising inflation," says Jain. "Another key statistic which came out was that the annual gold demand in 2010 from China crossed the 700-tonne mark for the first time."

"I can only quote JP Morgan and say ‘it will fluctuate’," says Das. Nevgi feels gold has the potential to easily rise above $1,600 per ounce (or about .`23,200 per 10 grams) or more in the medium term. Jain is more optimistic. He feels that gold prices will continue to accelerate over the next 4-5 years and will enter the last phase of bull run from 2012. "After a period of consolidation and sideways movement in the $1,400-$1,500 band, gold will break out to $1,700 per ounce (.`24,600 per 10 grams) before the end of this year. Gold prices are set to surge to $2,000 per ounce (.`28,900 per 10 grams) by 2012 and $3,000 per ounce (.`43,400 per 10 grams) by 2015," he says.


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